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When can a good deal become too good a deal? When it comes to home equity loans, caution some financial planners.
Taking out a loan against the equity in your home is a commonly recommended strategy for paying off accumulated high-interest credit card debt or to pay for large-ticket expenses such as home remodeling or college. Home equity values have climbed substantially in recent years in most places, and home equity loan rates are at near record lows. In early December 2003, rates ran around four percent for some home equity lines of credit and just under seven percent for fixed home equity loans, versus 14 percent for a standard variable credit card. Furthermore, interest on the first $100,000 in home equity loans is generally tax deductible. All in all, it can be a good deal. But…
The very features that make home equity loans so attractive these days—especially rising equity values and low loan rates—may be the very features putting some homeowners at a potentially huge financial risk, say planners. Remember, a home equity loan is a loan secured with your home. If you fail to keep up the payments, you could lose your home!
Apparently, many households are forgetting that. A record number of homeowners were expected to have home equity loans during 2003, and the value of those loans was expected to be up 20 percent from 2002, according to SMR Research Corp. In short, homeowners are using their homes like their checkbooks or credit cards.
To get a clearer picture of the risk of home equity loans, you first need to understand the two types of loans. A standard home equity loan is for a fixed amount at a fixed interest rate for a fixed period of time. This type of loan is particularly good when you have a known cost—such as remodeling your kitchen or consolidating credit card and auto debts.
A home equity line of credit operates more like a credit card. The lender gives you a credit line—say $50,000—and you can borrow as much or as little against that as you need. Interest is charged only on what you actually borrow. Interest rates usually are not fixed, but change with general interest rate movements, particularly the federal prime rate.
Lines of credit tend to be better for ongoing expenses such as college or even as a backup should you suddenly need cash due to a job loss or unexpected medical expenses. Lines of credit are especially popular right now due to their flexibility and the fact that their rates are lower than fixed home equity loans. And therein lies some of the risk. Fixed home equity loans at least lock in what are currently historically low rates. And while rates are low now for lines of credit, those low rates are expected to rise as the economy rebounds. And the rise could be swift. Only three years ago, the interest rate on home equity lines of credit was running over ten percent.
A lesser-known risk of lines of credit is that they count more heavily against your credit score than fixed equity loans. Lenders look at your credit score when determining your credit-worthiness. The more you’ve borrowed against your maximum credit line, the lower sinks your credit score. Another risk, facing both types of equity loans, is a drop in home equity values. Home values have done remarkably well through the bear market and sour economy, but there is always the risk of a decline in real estate values. Some experts fear a real estate bubble could burst in some parts of the country, and should they prove right, homeowners could find themselves with more equity debt than they have equity.
Perhaps the biggest risk is that the low rates and large equity values make borrowing just too tempting—like “a giant credit card” as one observer described it. It’s not uncommon for households to pay off their credit cards with a home equity loan and soon start racking new credit card debt—this time, with their home at risk.
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