How to Tap Home Equity Wisely
Many of the people losing their homes to foreclosure today find themselves in this situation because they used their home as a piggy bank: tapping their home equity beyond what they could truly afford to carry. If you're thinking of tapping into the equity in your home, be sure you can afford to make the payments.
Remember you put your home at risk when you take an equity line. Your home becomes collateral; and if you can't make the payments, you could lose your home.
Also, given the uncertainty in the housing marketplace, don't even think about taking a loan that would be above 80 percent of the market value of your home. That leaves you some room in case house prices drop further. You'll also get better interest rate offers when you'll still have 20 percent equity left in your home.
Now let's map out the decision-making process for tapping equity safely:
Turn 1: Should you take a equity loan or equity line?
When borrowing against the equity on your home you can choose one of two types of loans. One is a equity loan, which is usually at a fixed rate for a fixed amount of money and time. When you pay off that loan the loan will be closed. The second option is an equity line of credit, which is usually at a variable rate. The advantage of an equity line is that once you have it in place you can pay it off and then tap it again through the term of the loan, which is usually 15 years, but other terms may be available. Check with your bank about the specific terms of their equity line or loan programs.
So which type should you take? That depends upon your plan. Also consider which way you think interest rates will be moving. A fixed-rate equity loan may be your best choice if you know that you only want to use if for one specific purpose, pay it off and close the loan. With a fixed-rate you know the interest rate won't change.
An equity line of credit might be best if you know you have a series of projects you want to do or more than one major purchase you want to make. Your plan is to pay each project or purchase off and then tap the equity. If that's what you want to do than an equity line of credit may be your best bet, but do remember that the interest rate will be variable and could start to creep up when the Federal Reserve starts to raise interest rates again.
Turn 2: What interest rate should you expect?
Interest rates will vary based on your credit score. Those with the best credit scores of 740 or above can get the best rates that you'll see quoted on the Internet. For example, currently you can get a $50,000 equity line for as low as 4.84 percent and a $75,000 equity loan for 8.25 percent.
But those favorable rates only go to people with the best scores. FICO has an excellent breakdown showing what you can expect to pay in interest based on your credit score. This will not necessarily be the final quote that you'll get from your bank, but it gives you an idea of how much more you might have to pay if your credit score is below 740. For example, someone with a credit score of 700 to 719 would pay 0.8 percent more for an equity loan. You can check your credit score for free at CreditKarma.com.
The final interest rate you're actually offered will depend on the lender. Shop around for rates based on your credit score. Some lenders may offer better rates than others.
Turn 3: Check out the fees
You may find a great interest rate, but if the upfront fees are high that could wipe out any savings from a slightly lower interest rate. Generally it's best to look for the lowest fees. In fact, some banks are even offering to pay your appraisal costs and waive any application fees. Make sure there aren't any hidden fees, such as a broker fee to be paid to a third party. Some fees you will likely have to pay include recording fees and an annual fee to use your credit line.
Turn 4: Understand the Tax Benefits
Some people say an equity line is the best way to go, even better than an auto loan or other type of loan, because you can write off the interest. If an auto loan is being offered at 0 percent and you get a good price on the car you want, why put your home at risk at all?
In order to write off the interest on an equity line, you must itemize deductions. If you're not doing that now, the interest on your equity line likely will not be enough to make it worthwhile in the future. So if you're choosing an equity line so you can write off the interest, be certain you'll be able to do so. Also, you can only write off interest on up to $100,000, so if you're taking an equity line of greater than that amount, the interest on the loan above $100,000 won't be deductible.
Equity loans and lines of credit can be a good option for you, but use them wisely. Be sure you'll be able to make the payments for the length of the loan. If you have any doubts about your income, don't put your home at risk.
Lita Epstein has written more than 25 books including The Complete Idiot's Guide to Personal Bankruptcy and The Complete Idiot's Guide to Improving Your Credit Score.