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How to Choose a Home Equity Loan

Home Equity Loan

Home equity loans are big business. Just ask your banker. He or she loves these second and third mortgages on the borrower’s residence because the default rate is so low. To obtain more of these very profitable loans many lenders advertise no points, no fees and no costs. Some lenders are so anxious to originate home equity loans they even pay out-of-pocket expenses, such as for appraisals, credit reports and title insurance.

Tax Deduction Feature

A major advantage for borrowers is the tax deduction for interest on a home equity loan. The result is many homeowners pay off their auto loans, credit card loans, and other personal loans which have nondeductible interest. In addition to the interest deduction, the interest rates on home equity loans are usually lower than for other types of loans.

The after-tax rate makes them even more attractive. For example, the interest rate on my home equity loan is 7.3 percent. But considering the income tax savings in the 28 percent federal tax bracket, the after-tax interest rate is only about 5.26 percent, a genuine bargain.

Two Major Types of Home Equity Loans

There is virtually no secondary mortgage market for home equity loans and they are so profitable the originating lenders rarely want to sell them to raise cash. As a result, there are no standardized home equity loans. Each lender seems to put their own unique twist on these loans.

For example, most home equity loans provide some loan amortization payoff. But many home equity loans are “interest only” with no amortization for 10 or 15 years when a balloon payment becomes due. Or, amortization may begin in 10 or 15 years with interest only payments until then.

The first type of home equity loan is a closed-end mortgage where the full amount is borrowed at the time the loan is originated. In other words, additional amounts cannot be borrowed later. These loans often have 10, 15 or 20-year amortization.

The second type of home equity loan is an open-end mortgage where a maximum loan amount is agreed upon, and the borrower receives a checkbook which is used to borrow funds up to the loan limit. Until funds are borrowed, this type of home equity loan costs the borrower nothing, except perhaps for a modest annual fee.

Most homeowners choose this type of home equity loan best because it is the most flexible. As the loan balance is paid down, those funds immediately become available for borrowing again, if needed. Or, if the homeowner doesn’t need the entire loan limit immediately, the open-end type saves on interest. These loans are especially advantageous for financing college tuition which is needed year by year.

Unless the homeowner needs a specific fixed amount, such as money for remodeling the house, the closed-end home equity loan offers the fewest benefits. Most home equity borrowers choose the open-end loan because of its low cost and flexibility.

Adjustable rates prevail for most home equity loans

Although a few lenders offer fixed interest rate home equity loans, most lenders only offer adjustable interest rates. The interest rates are a total of the index rate plus a margin. For example, the cost of funds index is currently at 4 percent. If the home equity loan has a 3 percent margin, the total interest rate will be 7 percent. Other widely used indexes include the various Treasury bill indexes, the prime rate, CD interest rate indexes, and LIBOR (London Inter-Bank Offering Rate).

A few home equity lenders make loans at the prime rate with no margin. The prime rate used to be the rate at which major banks made loans to their best corporate customers. However, the nation’s banks now artificially inflate the prime rate, usually keeping it higher than it should be while making loans to their best customers at rates below prime rate.

Why home equity loan defaults are so rare

Although reliable statistics on home equity loan default rates are difficult to obtain, most lenders say their default rate is almost nonexistant. The primary reason often is lenders will usually loan up to only 70 or 75 percent total loan-to-value. For example, if your home is worth $100,000 and you already have a $50,000 first mortgage, most home equity lenders will only loan you up to $25,000 additional to reach a 75 percent loan-to-value ratio.

Since the loan-to-value ratio is usually low, if the borrower runs into financial difficulties then the home can be easily sold to avoid foreclosure since there is plenty of protective equity.

Home equity loans can be an excellent way to use your home’s equity to pay off existing consumer debt and make the interest tax deductible or borrow for worthwhile expenses, such as home remodeling and college tuition, at low interest rates. These loans have proven to be very safe and profitable for the lenders. But homeowners should be aware if default occurs their residence might have to be sold to pay off the home equity loan.

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