Real Estate Investing

Home equity debt has become considerably more affordable recently with the many fed rate cuts over the past year, which has a direct effect on mortgage interest rates. Whether a home equity loan or a home equity line of credit, the interest rates on home equity debt can be much lower than many other types of debt – and are typically tax-deductible.

You can lock in the lower interest rates with a home equity loan, which is essentially a second mortgage. This establishes a fixed interest rate on a fixed loan amount as part of a fixed repayment plan over a certain number of years. Interest on a home equity line of credit (HELOC), on the other hand, is typically prime rate or prime plus 1%. HELOCs function much like a credit card. For instance, the average HELOC is $58,800, but consumers do not have to max out their credit line.

One common use – and the originally intended use – for home equity debt is to fund a home remodeling project. This makes sense because the home remodeling project drives up your home’s value, which can ultimately help pay off the loan upon resale. For a one-time remodeling project, a home equity loan may be most appropriate. However, a home equity line of credit may be better suited for an ongoing remodeling project stretched out over several years.

Other uses for home equity debt include a vacation home or debt consolidation. This makes sense if the interest on the home equity debt is less than the credit card debt and if the consumer can exercise financial discipline in paying off the home equity debt. Some use home equity debt to fund a lifestyle that is beyond their normal, day-to-day financial means. This is a recipe for disaster.

Home equity debt is not inherently evil, but there is high potential for disaster. You do not want to mismanage this debt. It’s not fun, it’s not easy, but full attention must be paid to this debt because your house is at stake. The following points should be considered before taking out a home equity loan or line of credit.

-Analyze your financial management patterns. What is your debt-to-income ratio? Are you actively trying to pay off debt or paying off your credit card balance each month? Or are you taking out more and more loans, making minimum payments on all and even running late on some?

-Decide what your total monthly payments will be and whether that is affordable. It should ideally be around one-fourth of your monthly net income (after taxes).

-Decide whether you would rather pay more money per month over a shorter period of time or less money per month over a longer period of time with more total interest payments.

-The total amount of your current mortgage combined with the “second mortgage,” or home equity debt, should not exceed the value of your home.

-Along the same lines, never take out a no-equity home loan where the amount of the loan itself is more than your home is worth. These typically have much higher interest charges and are probably not tax deductible. Ultimately, there is little more stressful than being upside down in your home. It’s a good way to lose money fast.