- The Washington Times - Friday, October 12, 2001

Washington-area homeowners have enjoyed watching their home values increase in the past few years. Home prices in some neighborhoods have risen as much as 10 percent, 15 percent or even 20 percent since 1999.

This price escalation has blessed many owners with significant equity in their homes. Equity is simply the difference between your home's market value and the amount you still owe the bank. That difference is money you may tap for other purposes, such as buying a car, paying for home improvements or college tuition.

The most compelling reason to borrow against your home equity is that such loans are tax-deductible, just like your original mortgage. There are two types of equity borrowing. You can either get a home equity loan or a home equity line of credit (HELOC). Both are attractive options today because cuts in the interest rate by the Federal Reserve Board have made equity loans affordable.

Whether you choose a home equity loan or a line of credit, you are actually getting a second mortgage on your home. You do not have to take out a second mortgage to free up some of your equity. You can do a cash-out refinance.

This is a new mortgage for a larger amount, and you keep the difference. The downside of this approach is you are increasing your loan payment for the full 30 years of the mortgage, rather than the shorter terms typical of home equity loans and lines of credit.

Instead, you can keep your original mortgage and borrow against your equity. To do so, you need to understand the differences between the home equity loan and the HELOC.

"A home equity loan, generally speaking, is a fixed-rate, one-time dispersal of funds paid back over a set period of time," says Bill Tessier, a financial consultant with Weichert Financial Services. "You get the money all at once, and you start paying right away."

If you know how much you want to spend, and you want a simple repayment program, this may be the way to go. For instance, if interest rates for car loans are high which they are not right now buying a car with home equity can make a lot of sense. You can get a home equity loan for $20,000 for 7 percent to 8 percent these days. Even if car loan rates are a few points lower than that, the interest on your home equity loan is deductible.

"People who want a straight loan and want to know how much their payments will be prefer the equity loan," Mr. Tessier says. "If you are financing a car or home improvements, this is a way to do it."

If, however, you are borrowing to pay expenses over a period of time, you may want to get a HELOC instead.

"What's nice about a line of credit is it can cost you less money," says Faron Lamb, assistant vice president at Riggs Bank. "You only pay for what you need."

You apply for a HELOC in the same way as a home equity loan, and the lender puts a lien on your property for the full amount of the credit line. But if you don't use any of the credit, you don't make any payments.

"I have an equity line I used for putting an addition on the home," Mr. Lamb says. "It took a year to do the work, and I didn't want to be paying interest on the entire thing. Instead, I just wrote checks as needed throughout the year."

With today's interest rates, a HELOC is also cheaper because most are adjustable-rate instead of fixed-rate loans. Rates should be 1 percentage point to 2 percentage points lower for a line of credit, but remember that the rate could go up in the future. Depending on your credit history, your rate on a HELOC should be somewhere between 5 percent and 7 percent.

"If you have great credit, you might get a better rate," Mr. Tessier says.

Before you run out to get a HELOC, be honest with yourself about your fiscal discipline. Consumers who have problems with credit card debt might encounter the same struggles with a line of credit. Minimum payments are usually required on a HELOC, but they are often interest-only payments. You won't pay off the principal unless you decide to. But taking too long to pay off your HELOC can make an otherwise-affordable loan rather costly.

Consider carefully what you are paying for with your line of credit. Home improvements increase the value of your home and are a good investment. You could also buy a Jet Ski and wide-screen television with your HELOC, using up your equity to do it. Think down the road a bit, however. When it comes time to move, you'll have some nice stuff but less money to use for a down payment.

While the chief attraction of a home equity loan or HELOC is the deductibility of the interest payments, there are limits.

"Generally speaking, the first $100,000 of a home equity loan is tax deductible, as long as the total of your mortgages doesn't exceed the fair market value of the house," says Rob Huey, a certified public accountant and president of Huey and Associates. "So if your first trust is $350,000 on a home worth $400,000, you can only get a home equity loan for $50,000 and have it be automatically deductible."

You should also note that these loans are limited to $100,000 if you are single or married filing jointly. Couples who are married but filing separately may each take out home equity loans for $50,000.

"The advantage of equity loans is that the interest is deductible and the rates are good," Mr. Huey says. "The downside is that any form of credit can be abused, and if you aren't careful with an equity loan, you could put your house at risk."

The most dangerous type of second mortgage or refinance is one for more than your home is worth. Some companies will lend you as much as 125 percent of your home's value. Consumers sometimes find these loans an attractive and cost-saving way to escape high-interest debt, but borrowing that much against your house can be a gamble. If you need to move before your home has appreciated 25 percent, you could be paying money to sell it.

"These loans are very risky, not only for the consumer, but also for the lender," Mr. Lamb says. "If the home goes to foreclosure, the first-trust lender gets their money first. The lender for your equity loan only gets what is left over. This added risk is the reason the rates are so high on second-trust loans over 125 percent loan-to-value."

Lenders always lower rates as their risk decreases. If you leave 10 percent to 20 percent equity in your home, your equity loan will come with a lower rate.

So just how much equity can you draw out of your home? Do some simple math.

If your lender uses an 80 percent loan-to-value ratio, calculate 80 percent of your home's value. Then subtract the amount you still owe on your first mortgage. Whatever remains is available for you to borrow at affordable rates.

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