Here are answers to the more frequently asked home equity questions.

Questions
  • Getting out of a HELOC.
  • Comparing HELOCs to home equity loans.
  • Using a HELOC for an emergency fund.
  • HELOC vs. refinance.
  • Tapping home equity to buy a car.

Getting out of a HELOC

I have a home equity line of credit (HELOC) for $30,000 that I took out a few years ago during my first refinance to get rid of my original 80/15/5 situation. We wanted to get rid of that 15 percent 30-year term loan, so we went with the line of credit.

Unfortunately, it’s tied to prime (prime plus 1 or 2) and has skyrocketed our payments due to the rate hikes from 2004 to 2006. Any advice on how we can get rid of this line of credit through a no-cost refinance to a low, fixed rate that’s more beneficial and still offers the tax benefits? Our balance is $20,000.

— Michelle Mortgages

There are a lot of people out there in your situation, even though you got there in a fairly novel way. I’m assuming the refinancing took you from a home equity loan to a home equity line of credit at a point in time when there was a pretty big difference in the interest rates on the two loans.

As I write this, the interest rates on the two loans are very close, with the national average for a home equity line of credit at 8.16 percent and the interest rate on a home equity loan at 7.94 percent. If you pay prime plus 1 percent to 2 percent, and the prime rate is currently 8.25 percent, that makes the interest rate on your loan 9.25 percent to 10.25 percent.

Depending on your credit score and income levels, switching back to a home equity loan could give you a little relief if you would qualify for a home equity loan at a rate close to the national average. Going from 9.25 percent to 7.94 percent reduces your interest rate by 1.31 percent and converts it to a fixed rate.

If you got the line of credit a few years ago, the loan should be past any prepayment penalty period. Still, it’s a good idea to confirm that either by reviewing your loan documents or asking the lender. Closing costs on home equity loans typically are quite low, so you shouldn’t have to chase the illusion of a no-cost loan, which doesn’t really exist — the fees are just built into the loan somewhere else.

Depending on how your first mortgage is structured and the interest rate on that loan, it could make sense to pay off the HELOC with a cash-out refinancing of the first mortgage. That’s especially true if you’ve built up enough equity in the home that the new mortgage wouldn’t require private mortgage insurance, or PMI. The national average as of mid-May for a 30-year, fixed-rate mortgage is 6.29 percent.

The downside to that recommendation is that closing costs in refinancing a first mortgage are fairly expensive. Check Bankrate’s annual survey of closing costs. If you don’t plan on being in the house for long, or you have a very low interest rate on your existing first mortgage, then a cash-out refinancing isn’t for you.

Comparing HELOCs and home equity loans

What is the difference between a home equity loan and a home equity line of credit?

A home equity loan has a fixed interest rate, monthly loan payments sized to pay off the loan over its term, also known as a self-amortized loan, and you receive the entire loan amount as a lump sum when you close on the loan.

In contrast, a home equity line of credit, or HELOC, is a variable-rate loan, with changes in the interest rate typically tied to changes in the prime rate, which is itself tied to changes in the targeted federal funds rate. The Federal Reserve Board’s Open Market Committee meets eight times per year to discuss the economy and decide whether to change the targeted federal funds rate. The committee raised the federal funds rate by one-quarter percent each time, 17 times in a row from June 2004 to June 2006 but has kept the rate constant since.

Besides having a variable interest rate, a HELOC has interest-only payments, at least in the early years of the loan. Some HELOCs are structured to have interest-only payments over the entire loan term with a balloon payment at the end of the loan. Other HELOCs become self-amortizing loans after an initial period of interest-only payments.

Because it’s a line of credit, you only borrow what you need, although there might be a minimum draw against the line when you close on the loan. At least for part of the loan term, the credit line is a revolving credit. Paying down the loan balance frees up credit capacity.

The changes in the federal funds rate from June 2004 to June 2006 caused the interest rates on HELOCs to rise above the fixed rate of a home equity loan. Bankrate’s national average for a HELOC is 8.16 percent and for a home equity loan it is 7.94 percent as I write this (mid-May 2007). That doesn’t mean that the loan is necessarily the better choice. What you plan to do with the money and managing the monthly payments are important considerations, as well as what you think will happen with interest rates over the life of the loan. It’s important to know how the interest rate is set with the HELOC. These loans can have rate ceilings and floors that limit how the rate adjusts.

Those are the basics on HELOCs and home equity loans. For more information on home equity lending, including tools to help you decide which loan is right for you, see the home equity toolkit.

Using HELOC for emergency fund

What do you think of having a home equity line of credit (HELOC) on your home? My parents have no money saved at all but they have about $300,000 in equity in their home. Would it be wise to open a line for $25,000 just to have for emergencies?

I think a home equity line of credit can be a realistic alternative to an emergency fund, although there are some downsides to this approach. First, it’s common for the line to require a minimum withdrawal when the loan closes. So on top of the closing costs for the HELOC, the homeowner faces the interest expense on this minimum draw. Since most lines of credit have a prepayment penalty, the homeowner has to find a place to invest the money to mitigate that interest expense.

If the minimum draw is $10,000, the interest rate is at 8¼ percent, and your parents can only earn 5¼ percent on savings, there’s a 3 percent spread between what they pay and what they earn. That’s $300 per year. Let’s say that closing costs were $800. Ignoring any tax impact from the potential mortgage interest deduction on their taxes, they spent $1,100 in year one to have a line of credit in place for financial emergencies. If an emergency fund is typically sized at three to six months worth of living expenses, you have to ask what percentage of the emergency funds $1,100 represents.

Another issue is that being able to draw against the line is only allowed in the early years of the loan agreement. As the ability to draw against the line expires, your parents would then have to pay off the old line and take out a new line to keep having the money available.

There’s enough variability in closing cost, interest expense, prepayment penalties and draw requirements that it’s worth it to compare different HELOCs. I suggest doing this without filling out an actual loan application because they don’t want a series of loan applications on their credit reports. Just ask the lender for its HELOC terms. Low closing costs, low interest expense, long draw periods and short prepayment periods all contribute toward making a HELOC a viable alternative to establishing an emergency fund.

Finally, this alternative is for people with the financial discipline to use the loan for financial emergencies only. It’s not meant to be a substitute for a credit card. People who can’t keep their credit card balances under control probably shouldn’t use a HELOC as an alternative to an emergency fund.

Comparing HELOC to refinance

I currently owe $137,000 on a first mortgage at 6 percent and am considering a HELOC for home improvements. Most banks are offering interest-only loans. I’m wondering if this is a good choice or should I refinance the current mortgage to get cash out at 25 years.

— Jenn Jumble

Although home equity lines of credit, or HELOCs, have interest-only payments in the early years of the loan, you can still make additional principal payments on the loan to pay down the outstanding balance. The loan is likely to have a prepayment penalty for paying off the line too rapidly, but small amounts aren’t likely to trigger a prepayment penalty.

The good thing about the HELOC is that you don’t have to borrow the whole amount at closing. You can draw on the line as you need it, although it usually requires a draw at closing.

If you’re spending all the money in a short time span on home improvements, then a home equity loan may be the better choice. It will have a fixed rate and the monthly payments are self-amortizing, meaning the loan will be paid off with the last loan payment. The Bankrate interactive feature, “Home equity loans vs. lines of credit,” can help you choose between a line and a loan.

A cash-out refinancing will give you the money upfront, but you’re not likely to improve on your current 6 percent mortgage. The refi will have much higher closing costs than the home equity line or loan. The amount of closing costs and how long you plan to be in this home both weigh heavily on your choice of financing these home improvements.

Using a home equity loan to buy a car

We are looking to buy a used car and trying to think of a better way to finance the purchase. I found out that we could take out a second mortgage, which is tax-deductible, to finance the car purchase versus getting a straight car loan. Is this a good idea? Thanks.

— Tamara Taps

For people who have a fair amount of discipline in how they manage their finances, a home equity loan or home equity line of credit, HELOC, can make perfect sense as a way to finance a car, new or used. If you’re struggling with large credit card balances or have problem credit, a home equity loan might not be right for you.

Not everyone can make use of the mortgage-interest deduction when filing his or her income tax return, but if you’re using the deduction now on your first mortgage, odds are you’ll be able to use it on your home equity loan, too. IRS Publication 936, Home Mortgage Interest Deduction 6, lays it all out. Talk to a tax professional if you’re still not sure.

By being able to deduct the interest expense, you reduce the effective rate of interest on the loan. The interest expense on a conventional auto loan isn’t tax-deductible. Bankrate’s national average for a HELOC as of May 2007, is 8.16 percent and 7.94 percent for a home equity loan. The national average for a three-year auto loan on a used car is 8.46 percent. If you’re in the 25-percent marginal federal income tax bracket, the effective rate on the HELOC is about 6 percent.

A HELOC is a variable-rate loan, and the interest rate is normally tied to the prime rate. Since the prime rate moves in lock step with changes in the targeted federal funds rate, and that rate rose steadily for more than two years, it takes a bit of courage to sign up for a HELOC to finance your car.

In contrast, a home equity loan will have a fixed interest rate, and the loan payments are self-amortizing, meaning the payments are large enough to pay the interest expense and pay off the loan over the life of the loan. In the early years of a HELOC, its required loan payments are interest-only, and you have to have the financial discipline to make principal payments, too.

You can use the Bankrate rates home equity rates search tool to comparison-shop for a loan or line of credit.

A car is a depreciating asset. You don’t want to take 10 years to pay off the loan on a car that you’ll drive for five years. Regardless of which loan you choose, plan on paying off the used car over the time you expect to own it. That way you’ll have some equity in the car when you go to buy its successor.

Using refinancing or home equity loans to consolidate deb

First, I don’t know much about finances. I have a question. I share a home with my mother. We have a small $9,000 loan on our home. I would like to build a garage and consolidate about $8,000 in credit card debt. Also, my lease is up on my vehicle, and I need another one. Would a home equity loan be the right way to go? Our home is worth around $95,000. With a home equity loan, won’t my payments be much less than paying each bill or loan separately? Thank you for any help you can give me.

— Steven Solidify

Using a home equity loan has two advantages over other types of nonmortgage consumer debt. First, since the loan is secured by the equity in your home, the interest rate is typically lower than the interest rate on unsecured debt. Second, if you can use the mortgage interest deduction on your income taxes, the effective interest rate is even lower.

One disadvantage of using home equity loans to consolidate debt is that you spread the debt out over a much longer period, typically 10 to 15 years. Taking 10 years to pay off a car or credit card debt will actually increase the total interest paid, even though the interest rate is lower because of the longer loan term.

Another disadvantage is that many people don’t have the discipline to stop using their credit cards, and before they know it their credit card balances are right back to where they were before the debt consolidation. All they gained from debt consolidation is the ability to buy more stuff on credit.

I used Bankrate’s mortgage calculator along with some guesstimates on how much you would pay for a new car, a new garage, and how many years you have remaining on the mortgage to come up with a table.

The table shows how extending the loan term reduces the monthly payment. It also shows you how adding additional principal payments to the monthly payment can shave nine years off the 15-year mortgage and dramatically reduce your total interest expense. Even though the table won’t match your situation exactly, it provides a framework for you to use in constructing a table to calculate your numbers.

Has home equity funded your dreams or turned into a nightmare? Share your story.

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