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Home Equity Lines of Credit
26 08 05  19  20
-------- And Why You Should Avoid Them
It is hard to understand how people could be so fanatical about Home Equity Lines, Second Mortgages, Equity Loan, whatever you want to call it: a mortgage applied on the Equity of your home. To be more specific:
A seccond secured loan on a real estate property that must be
repaid, ussually at a higher interest rate than the original loan, in a
shorter time period, and on which the bank has the right to reposess
your house and auction it if you fail on payments. -- Jose Anes (My own definition).
Many of the goals of Ownership, Finantial Freedom, Investing, and Real Estate Laddering are thrown away every time someone gets a Home Equity Line. The Equity and Ownership that is so hard to obtain in a home is commonly eliminated or destroyed when people take these kinds of loans.
I do not want to say that that Home Equity Lines are absolutely
bad. There are good times to use them, and bad times (mostly
bad).
Lets start by the good reasons to use them (The Good):
- 80/10/10 Loans: A great way to avoid PMI,
and about the best way to use a Home Equity Line. Some banks
allow you to take a conforming 80% loan to value mortgage with no
PMI. For the 20% of the down payment they allow you to take an
inmediate Home Equity Line of Credit to cover 10% of the property
value, and you just have to put 10% of the property value as a cash
down payment. In effect, it is as if you had taken a single
mortgage for 90% of the property value but avoided Private Mortgage Insurance.
I like this kind of loan: it maximizes the capital you have; it
does not destroys the capital you have like other uses of Home Equity
Lines of Credit. Ussually, the Home Equity Line of Credit (HELOC) has to be paid off in a shorter time than the original loan, and carries a slightly higher interest rate. (Thanks to five cent nickel for reminding me of this one).
- Home Improvement, Value Increasing: Most of the
improvements done on a home don't really increase the value of the home
for the same amount of money you put into it. Most of the home
improvements that pay off the same amount you put into the improvement
or even more are those that fix things that where worn. Replacing
an old kitchen or an old bathroom, or a new roof and/or vinyl siding
for a house that has seen its best years already gone by. Be sure
you do the repairs before you start selling the house so that you can
at least enjoy some of it. Even better, plan ahead for those
repairs since the moment you buy the house and you may not have to take
an equity line at all.
- College Education for Jr: Education is expensive,
but ignorance is worse. A good college education for your
kids will jump start them in life and will allow them to accomplish
their goals and the happiness you want them to have. It costs
dearly, however. That equity line has to be repaid with a lot of
sweat from work long after they have left the nest.
Things Home Equity Lines are Bad For (The Bad):
- Home Improvements, Non Increasing Value: Yes, most
home improvements increase the value of the home, but the question is
by how much? A Pool may even decrease the value of your
home. New hardwood floors, over sized decks, finished
basements: they do increase the value of the home, but not by as
much as you spent on them... unless you do them yourself. Do
those projects with saved money, not from a loan. And do them
well before you sell the home, or you may not get to enjoy the money
you put into them.
- Consolidating Debt: Yes, you may be able to deduct
the interest on the debt from taxes: that is a small advantage
compared to putting your house at risk, AND feeling that you have
"eliminated" the debt issue. Psychologically you have transfered
the debt issue from one place to the other. I do believe in a more disciplined debt reduction approach, where you build up discipline while keeping the problem latent: in your face until you pay off.
Things Home Equity Lines are Terrible For (The Ugly):
- Travel: I love traveling, and I think of it as continuing
education for me. But don't spend the next 15 years paying for
the enjoyment of a week. Save for travel using Short Term Savings.
- Car:
The car will be gone long before the equity line is paid off (unless
you are disciplined, in which case you probably do not need the line
any way).
- Furniture and Trinkets:
As with the car, things will wear off long before you pay them
off. The happiness will also wear off after the first couple of
payments, and it will convert into sadness when you find out you do not
have enough equity to accomplish higher goals in life -- or even to
fully own the house and be able to retire.
There used to be a time when banks asked you a bunch of questions
on what you would be using the Equity Loan. They even sent the
check directly to the company where you would be using the money for
the loan. Now days they are not so careful. They just want
you to get up to your chin into debt, and keep working for them (paying
them the interest) for the longest amount of time possible.
Don't play into the banks game. Own your own life. Save for
your own things. Avoid debt as much as possible.
BUILD EQUITY, don't destroy it.
What do you think about Home Equity Lines?
As a side note, Americans are so used to increasing
their home backed debt and paying interest for a fairly safe loan that
owning mortgages is a good, fairly safe investment that provides a
steady stream of income. Right now I would not buy bond funds, as
the interest rates may be rising in the near future.
Consider mortgage backed securities mutual funds once the rates rise to a more stable level. Some good examples:
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