Q: A year or two ago, we took out a home equity loan — a line of credit really. Since then, we have used it to pay for some major improvements to the home, such as a new roof, rewiring, etc. This is a big source of arguments between my wife and I. Even though we have lots of credit left to draw on, I’m reluctant to use the credit line much more. I think it should be used carefully, since it’s our house we’re talking about, after all. Any thoughts about this?
A: The main question is: “How secure is your income?” If you have a steady, dependable income stream — whether it’s from a good job or your own business — and you feel confident that you won’t run into financial difficulties in the foreseeable future there is nothing inherently wrong with using the home equity line of credit to pay off your other bills. Your monthly expenses will be lower and the interest will be tax deductible.
One reason for the popularity of home equity loans is the 1986 Tax Reform Act, which eliminated the tax deduction for interest on credit cards, car loans and other consumer borrowing. The interest expense on home equity loans is one of the few remaining “tax shelters” left, so many people now use tax-deductible home equity loans to purchase cars rather than non-deductible auto loans. If you can handle the monthly payments, there’s nothing inherently wrong with that. But just remember that if you take out a car loan and you don’t make your payments, the lender will repossess your car. But if you get over-extended with a home equity line of credit, the lender can foreclose on your home!
A large percentage of the foreclosures in the Puget Sound region are a direct result of homeowners leveraging themselves up to their eyeballs with home equity loans. In many cases, they owe more than their home is worth. It’s sad to see a job loss or other economic calamity force people out of homes they’ve lived in for ten or twenty years. In some cases, the added debt load from a home equity loan or “cash-back” refinance is the difference between keeping or losing their home. This has not been a big problem recently due to the hot housing market, because appreciation can add enough value to allow homeowners to sell their house and net enough cash to pay off their debts and selling costs. But who wants to put themselves in that kind of situation?
Home equity loans were originally designed to finance home improvements. That makes sense because improvements add equity value to your home, which increases the collateral value for the loan. If you run into financial difficulties that force you to sell the home, the increased market value would hopefully cover the additional debt.
It can also make sense to use a home equity loan to pay off non-deductible, high interest rate credit cards because you are eliminating some of your monthly payments. If you use a home equity loan to purchase a car, you could always sell the car to help pay off the loan. But if you use a home equity loan to pay for a family vacation, the money is simply gone. There is no increased equity to cover the debt if you get into financial trouble.
Another factor to consider is the interest rate risk. If you took out a home equity line of credit in 2004 when the prime rate was 4 percent, you have seen the interest rate on your line of credit more than double to 8.25 percent today. Home equity rates are not likely to increase significantly during the rest
Of this year, but if you were not financially prepared to have your payments during the past 3 years, you could be in serious trouble.
I’m not trying to be an alarmist. I know that most people who use home equity loans never have a problem. Just make sure you have the financial resources to make the payments — and be aware of the consequences if you don’t. Many equity lines of credit actually come with credit cards that allow you to tap into your available credit balance. Don’t fall into the trap of thinking as you home equity as just another VISA card.
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