Exercise Caution with Home Equity Loans

Physician's Money DigestFebruary15 2004
Volume 11
Issue 3

Taking out a loan against theequity in your home is a commonlyrecommended strategyfor paying off accumulatedhigh-interest credit card debt or payingfor large-ticket expenses such ashome remodeling or college. In mostplaces, home equity values haveclimbed substantially in recent years, and home equityloan rates are near record lows. In early December2003, rates ran around 4% for some home equitylines of credit and just under 7% for fixed homeequity loans, vs 14% for a standard variable creditcard, according to BankRate.com. Furthermore, intereston the first $100,000 in home equity loans isgenerally tax-deductible.


However, the very features that make home equityloans so attractive these days—especially rising equityvalues and low loan rates—may be the very featuresputting some homeowners at a potentially huge financialrisk. A home equity loan is a loansecured with your home. If you fail to keep up thepayments, you could lose your home.

SMR Research Corp projected that a record numberof homeowners were expected to have home equityloans in 2003, and the value of those loans was expectedto be up 20% from 2002. In short, homeowners areusing their homes like their checkbooks or credit cards.

Types of Equity Loans

To get a clearer picture of the risk of home equityloans, you first need to understand the two types ofloans. A standard home equity loan isfor a fixed amount, at a fixed interestrate, for a fixed period of time. Thistype of loan is particularly good whenyou have a known cost—such asremodeling your kitchen or consolidatingcredit card and auto debts.

A home equity line of credit operatesmore like a credit card. The lender gives you acredit line and you can borrow as much or as littleagainst it as you need. Interest is charged only onwhat you actually borrow. Interest rates are not usuallyfixed, but change with general interest rate movements,particularly the federal prime rate. Lines ofcredit tend to be better for ongoing expenses such ascollege tuition or even as an available backup shouldyou suddenly need cash due to a job loss or unexpectedmedical expenses.

Lines of credit are especially popular right nowdue to their flexibility and the fact that their rates arelower than fixed home equity loans. However, fixedhome equity loans at least lock in what are currentlyhistorically low rates, and while rates are low now forlines of credit, they are expected to rise as the USeconomy rebounds.

Risky Equity Business

A less-known risk of lines of credit is that theycount more heavily against your credit score thanfixed equity loans. Lenders look at your credit scorewhen determining your credit worthiness. The moreyou've borrowed against your maximum credit line,the lower your credit score sinks.

Another risk facing both types of equity loans is adrop in home equity values. Home values have doneremarkably well through the bear market and sour economy,but there is always the risk of a decline in real estatevalues. Some experts fear a real estate bubble could burstin some parts of the country, and if that happens, homeownerscould find themselves with more equity debtthan they have equity.

Perhaps the biggest risk is that the low rates andlarge equity values make borrowing just too tempting.“It's like a giant credit card,†one observer said. It isnot uncommon for American households to pay offtheir credit card debt with a home equity loan andsoon start racking up new credit card debt—this timewith their home at risk.

This article has been produced by the Financial Planning Association(www.fpanet.org), the membership organization for the financial planningcommunity.

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