Home equity loans are hot. And if you haven't been approached to
sign up for one, you probably will. On TV commercials, celebrities
brag about all the cash you can pocket with just one easy toll-free
call to a lender. In the mail, home owners will find plenty of offers
as well. Tear open these envelopes and you'll often see fake checks
written out for incredible amount of money. Act immediately, the
letter urges, and you can redeem a real check for that whopping
Of course, you should stop and wonder why lending institutions
are so eager to thrust money in our faces. The answer is simple.
The banks aren't really risking anything. Since you'll use your
home as collateral, the banks may legally confiscate your house
if you can't make the payments. For this reason, you have to consider
the consequences very carefully before you make this move.
There are, however, plenty of reasons why home equity loans are
enticing. For starters, the interest on home equity loans is still
tax deductible. Let's say a couple, who is in the 28% tax bracket,
paid $2,000 in interest payments in 1998. They could shrink their
tax bill by $560. You won't get that same break on credit cards
interest. But you should know that you can only take advantage
of this tax deduction if you file a tax return that itemizes deductions.
With a home equity loan or a line of credit, you borrow against
whatever equity you have in your house. Equity is the portion
of the home that you actually own. For instance, if your house
is worth $175,000 and there's a $100,000 balance on the mortgage,
your equity is $75,000. Banks will often loan you 80% of your
equity, which in this case would be $60,000. Some financial institutions
will approve a loan that equals 100% of your equity and sometimes
even 125% or 150%. It's unwise, however, to borrow more than your
home is worth. If you do that, you could be paying on a loan for
a decade or more and still not even own your front door.
The traditional home equity loan works like a traditional second
mortgage. You borrow for a set number of years and the loan is
usually offered at a fixed rate. You repay little by little every
month for a preset number of years. Your other option is a home
equity line of credit , which is sometimes referred to as a HELOC.
This type of loan works a lot like a credit card. A bank will
approve you for a certain amount of credit up to a ceiling. You
don't have to use that money all at once or ever, but it's there
if you need it. Let's say you have a $40,000 line of credit, but
you only use $19,000 to pay off old credit card bills. You'll
still be entitled to borrow the remaining $21,000 any time you
want. As you repay what you owe, the amount available to borrow
Home equity lines of credit are usually offered with variable
interest rates. The rate will be tied to the prime rate-the rate
the best corporate customers receive--or some other index. Lenders
will often generate business by offering teaser rates--a ridiculously
low rate that may vanish in six months. Make sure that you know
what will happen to the interest rate after the introductory offer
Historically, home equity loans were primarily used for sprucing
up a residential property. Borrowers would take the money and
replace a hideous kitchen or add a bedroom or two when the family
outgrew their living space. But home equity loans can be used
for many other purposes, including car loans and college tuition.
But perhaps the most popular use of home equity loans today is
debt consolidation. A study conducted by the American Community
Bankers Association suggests that an amazing 40% of home equity
loans are now being earmarked to pay off mountains of bills.
It's not hard to see way so many people are taking out these
loans to wipe out their debt. The interest rate you obtain can
be far lower than what credit cards charge. How much will that
save you in the long run? Here's just one example from "Debt
Consolidation 101," a booklet written by Gerri Detweiler,
the author of "The Ultimate Credit Handbook." Let's
suppose you owe $10,000 on credit cards that charge 19%. If you
just pay the minimum every month, you'll ultimately write checks
totaling an amazing $46,596. But what if you had instead obtained
a home equity loan that charged 9%. If you paid off this loan
in five years, you'd owe just $12,455.
Some soul searching is necessary, however, if you expect to use
a home equity loan for debt consolidation. The loan can be a great
tool to break free of the grip of plastic, but only if the borrower
decides to stop overspending. If you use the money to pay off
your credit cards, but you continue to charge the way you did
in the old days, you may sink into even more serious financial
If you're interested in a home equity loan, be sure to shop around.
The home equity market is extremely competitive. And don't just
compare interest rates. Find out whether a lender will waive the
cost of the appraisal and other charges for such things as credit
and title reports. Also find out if you'll get hit with a yearly
fee for your loan--many lenders charge $25 to $50. In addition,
be sure to inquire whether the lender will charge you if you decide
to terminate the loan after a year or so. Sometimes there is a
stiff penalty of several hundred dollars.
If you do shop for home equity loans, watch out for unscrupulous
lenders. They could try to entice you into signing papers for
a high-cost loan that could ultimately become a financial nightmare.
While you might not fall for these slick come-ons, perhaps your
mom or dad or a grandparent would. These shady companies typically
prey on homeowners who are elderly, as well as those who are experiencing
In 1998, the Federal Trade Commission issued a consumer alert
on these home equity scams. Here are some unethical practices
to look for:
Equity stripping. The lender issues a loan, based on the equity
of your home, not on your ability to pay. If you can't make the
payments you could lose the house.
Loan flipping. You are urged to refinance over and over again.
Each time you refinance, you pay extra fees and interest points
which only increase your debt.
Bait and switch. The lender offers you one set of loan terms when
you apply and then pressures you to accept higher charges when
you sign the final papers.
Credit insurance packing: Some lenders will attempt to sneak in
charges for credit insurance and other so-called benefits that
you did not request. The lender hopes you don't notice this and
just sign the loan papers.
Mortgage servicing abuses. You never get accurate or complete
account statements. That makes it almost impossible to determine
how much you've paid or how much you still owe. You may pay more
than you should.
What if you get cold feet shortly after you sign the loan papers?
Don't worry. Federal credit law gives you three days to reconsider
a signed credit agreement and cancel the deal without a penalty.
(Sundays and legal holidays won't be counted.) You can pull out
as long you are using your principal resident to secure the loan.
The same right doesn't apply if you use a vacation or second home
If you cancel the loan by the three-day deadline, you won't be
liable for any amount, including finance charges. The lender must
return any money paid toward the loan within 20 days.
Based in San Diego, O'Shaughnessy is a financial journalist,
who writes for such publications as Mutual Funds Magazine, The
Wall Street Journal, Bloomberg Personal, Better Homes & Gardens
Family Money, Working Mother and Good Housekeeping.