Taking Out a Home Equity Loan
Reasons to Tap Your Equity
Convenience and tax-deductible interest make tapping the equity in your home appealing. Just be careful that you don't take a casual view about draining the equity in your home—it could jeopardize your most important asset. If you fail to make the loan payments, you could ultimately lose your home in a foreclosure.
Many people use home equity loans and credit lines to finance a variety of things. Because the interest is generally tax-deductible, this very often makes sense. As you may already know, Uncle Sam has taken away almost all interest expense tax deductions. Exceptions include mortgage interest (including home equity) and investment interest, and some student loan interest.
Have you been thinking about putting an addition on your house? Or have you always wanted to finish the basement or add a bathroom? Using the equity in your home to finance its improvement could make a great deal of sense. After all, you are tapping the equity in your home to turn around and build more equity.
The types of improvements that you have always dreamed of can range in price from $100 to $1 million. When you use a home equity loan or a refinance to make major capital improvements to your home, interest on a loan of up to a total balance of $1 million is deductible. Make sure you borrow only what you can afford to pay back.
Because auto loan interest rates are generally higher than mortgage rates, people often tap the equity in their homes to finance the purchase of an automobile. Sometimes the dealer who sells you the car may be offering a promotional financing rate. It would be wise to see how it compares to the rate on an equity loan or refinance. But, you can't just compare interest rates, because there is a tax deduction for the interest on a home equity loan or a refinance. Interest on an automobile loan is not tax-deductible. The following illustration compares an auto loan and a home equity loan with the same terms and shows the effect the deductibility of the home equity interest has on the net annual cost of borrowing.
Auto Loan versus Home Equity Loan Comparison*
*Assumes a 25% marginal tax rate and the same repayment period for both types of loans. Also assumes that there are no fees charged for either loan.
As you can see from the illustration above, the cost of borrowing is generally less with a home equity loan than with an auto loan since the home equity interest is tax-deductible. However, it may not be wise for you to tap the equity in your home to buy a fancy car that you really can't afford. Also, don't overextend the debt on what is probably your most important asset. You have to feel comfortable with the fact that you are borrowing against your home and that there is a risk that it could be taken away from you if you cannot keep up the loan payments. Also, keep in mind that you may be paying on your home equity loan for 15 years. You may be making payments on an automobile that you have long since sold. (A rule of thumb is that you shouldn't stretch any loan, including a home equity loan, past five years for the purchase of a car.)
Consolidation of Debts
Do you cringe every time you open the mailbox and another credit card bill arrives? Do you have a wide array of debt that is strapping you? Tapping the equity in your home to pay off your high-interest consumer debt may be something that you should consider. By doing this you can accomplish several things:
IMPORTANT NOTE: Home equity terms can stretch to as many as 15 years. In order to keep your monthly payment low, your temptation may be to go for the longer term. Your best bet when refinancing consumer debt is to limit your loan term to a maximum of five years.
What do you do when your child gets accepted to an expensive school and you really want them to attend? You didn't anticipate the cost when you planned a college fund. A home equity line of credit can be set up in advance, and you can borrow what you need each year for the expenses.
IMPORTANT NOTE: Equity in your home is not counted as an asset when applying for financial aid. Therefore, you should wait until your financial aid application is accepted or denied before tapping into the line of credit.