A column on personal finance prepared by the Virginia Society of Certified Public Accountants
SMART WAYS TO USE THE EQUITY IN YOUR HOME
(May 27, 2003) – It used to be that owning a home was the American dream. These days, more and more homeowners are using the equity in their homes to pay for even bigger dreams, like down payments on vacation homes and college tuition. Despite the popularity of home equity loans and credit lines, the Virginia Society of CPAs cautions homeowners to understand how these lending options work before they turn their homes into checkbooks.
The Basics of Borrowing Against Your Home
Homeowners looking to tap the equity in their homes can choose either a home equity loan or a home equity line of credit. Most banks let you borrow up to 75 or 80 percent of your existing equity, which includes not only the amount you’ve paid against your mortgage to date, but the appreciated value of your home. And unlike other forms of nondeductible consumer debt, when you provide your home as collateral for a loan of $100,000 or less ($50,000 or less if you are married and filing separately), the interest is likely to be tax deductible.
Address One-Time Borrowing Needs
A home equity loan is best used for large one-time expenses such as financing a major home improvement project, starting a business, purchasing a high-ticket item, or consolidating high- interest rate credit card debt. Such a loan is also better suited to those who don’t foresee future borrowing needs.
Home equity loans, which resemble a second mortgage, provide you with a lump sum of money repayable over a fixed term, usually five to 15 years. A home equity loan gives you the security of a locked-in rate and the same monthly payment.
Using Line of Credit
The flexibility of these loans makes them ideal for irregular or unanticipated expenses such as those related to large medical bills or losing your job. A home equity line of credit can also help parents finance a child’s college education. It may be particularly helpful for higher income families, who don’t qualify for financial aid and are certain they will have the resources in the future to pay off the loan.
With a home equity credit line, you are approved for a specific credit limit determined by the lender, typically based on your income, debts, ability to repay, and credit history. Once approved, you can borrow any amount – up to your credit limit – on an “as needed” basis. You draw against your credit line by using checks or a special credit card linked to your credit line. Some plans require that you borrow a minimum amount, say $500, each time you draw against your credit line. Home equity lines of credit are usually variable-rate loans with payments that change from month to month based on your outstanding balance and fluctuations in the prime rate.
Some Words of Caution
CPAs say that using the equity in your home is not a matter to be taken lightly. While these loan products are especially good for consolidating high-interest rate credit card bills, this strategy works only if you stop creating new debt. If you keep charging items on your credit card, you will continue living above your means and put yourself further in debt.
Be aware that while credit card companies cannot foreclose on your home if you have financial difficulties, that does not hold true for home equity lenders. If you don’t make the required payments on a loan secured by your home, you risk losing it.
CPAs also emphasize the need to shop carefully for the best rates and terms that most closely suit your needs. Negotiate with a few lenders, and don’t be swayed by low teaser rates that apply only to transferred balances or escalate sharply after a short introductory period. When you find a deal that works for you, be sure to read the loan closing papers carefully before signing.
The Virginia Society of CPAs is the leading professional association dedicated to enhancing the success of all CPAs and their profession by communicating information and vision, promoting professionalism, and advocating members’ interests. Founded in 1909, the Society has nearly 8,000 members who work in public accounting, industry, government and education. This Money Management column and other financial news articles can be found in the Press Room on the VSCPA Web site at www.vscpa.com.
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