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Home Equity Credit Lines
by
Charles Lamson
Here is a familiar situation. A couple buys a home for $85,000; some 10 years later, it is worth $165,000. The couple now has an asset worth $165,000 on which all they owe is the original mortgage, which may now have a balance of, say, $45,000. The couple clearly has built up a substantial amount of equity in their home: $165,000 - $45,000 = $120,000. But how can they tap that equity without having to sell their home? The answer is to obtain a home equity credit line. Such lines are like unsecured personal credit lines except that they are secured with a second mortgage on the home. Offered by most banks, S&Ls, major brokerage firms, and a growing number of credit unions, these lines of credit allow you to tap up to 100 percent of the equity in their homes, or in some cases, even more---the majority of the lenders set their maximum credit lines at 75 to 80 percent of the market value of the home, which reduces the amount of money they will lend. For a variety of reasons, including attractive tax features, the popularity of home equity credit lines has grown almost exponentially. Indeed, the amount of home equity loans outstanding today actually exceeds the amount of credit card debt outstanding! | ||
Here is how these lines work. Recall the couple in our example has built up an equity of $120,000 in their home---equity against which they can borrow through a home equity credit line. Assuming they have a good credit record and using a 75 percent loan-to-market value ration, a bank would be willing to lend up to $123,750; that is, 75 percent of the value of the home is .75 x $165,000 = $123,750. Subtracting the $45,000 still due on the first mortgage, we see that our example could qualify for a home equity credit line of a whopping $78,750. Note, in this case, that if the bank had been willing to lend the couple 100 percent of the equity in their home, it would have given them a (much higher credit line of $120,000, which is the difference between what the house is worth and what they still owe on it. Most lenders do not like to do this because it results in very large credit lines and, perhaps more important, it does not provide the lender with much of a cushion should the borrower default.
Home equity lines also have an interesting tax feature that you should be aware of---that is, the annual interest charges on such lines may be fully deductible for those who itemize. This is the only type of consumer loan that still qualifies for such tax treatment. According to the latest provisions of the tax code, a homeowner is allowed to fully deduct the interest charges on home equity loans of up to $100,000, regardless of the original cost of the house or use of the proceeds. Indeed, the only restriction is that the amount of total indebtedness on the house cannot exceed its fair market value---which is highly unlikely, because homeowners usually cannot borrow more than 75 to 80 percent of the market value of the house anyway. (Effectively, the interest on that portion of the loan that exceeds $100,000, or 100 percent of the market value of the house---whichever is lower---cannot be treated as a tax-deductible expense.) In our preceding example, the homeowners could take out the full amount of their credit line ($78,750), and every dime they paid in interest would be tax-deductible. If they paid, say, $7,400 in interest, and if they were in the 28 percent tax bracket, this feature would reduce their tax liability by some $2,070---(i.e., $7,400 x .28)---given, of course, that they itemize their deductions.
Not only do home equity credit lines offer shelter from taxes, they are also among the cheapest forms of consumer credit. For example, while the average rate on standard credit cards in mid-2003 was 13.8 percent, the average rate on home equity credit lines was less than half that, or 6.2 percent. To see what that can mean to you as a borrower, assume you have $10,000 in consumer debt outstanding. If you had borrowed that money through a standard consumer loan at, say, 9.5 percent, you would pay interest of $950 per year---none of which would be tax deductible. But borrow the same amount through a home equity credit line at 6.2 percent, and you will pay only $620 in interest. That is all tax deductible though, so if you are in the 28 percent tax bracket, the after-tax cost to you would be $620 x (1 - .28) = $446. This is less than half the cost of the other loan! So, which would you rather pay for a $10,000 loan, $950 or $446? That is really not a tough decision, but it does explain, in large part, why these lines have become so popular and are today one of the fastest growing forms of consumer credit.
Home equity credit lines are offered by a variety of financial institutions, from banks and S&Ls to major brokerage houses. All sorts of credit terms and credit lines are available, and most of them carry repayment periods of 10 to 15 years, or longer. What is perhaps most startling, however, is the maximum amount of credit available under these lines---indeed, $100,000 figures are not at all unusual. And it is precisely because of the enormous amount of money available that this form of credit should be used with caution. The fact that you have equity in your home does not mean that you have the cash flow necessary to service the debt that such a credit line imposes. Remember that your house is the collateral. If you cannot repay the loan, you could lose it! At the minimum, paying for major expenditures through a home equity credit line should be done only after you have determined that you can afford the purchase and the required monthly payments will fit comfortably within your budget.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 248-250*
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