Home Equity Loan - Case Studies
Case 1: Using a home equity loan
for debt consolidation.
 Tony
has racked up $20,000 in debt on several credit cards which have
an average APR (annual percentage rate) of 18%. Tony can get a home
equity loan with an APR of 8%. Tony has heard that a home equity
loan can be a good way to manage credit card debt but he is not
clear about all of the advantages and disadvantages of borrowing
from the equity he has in his home for debt consolidation. If a
home equity loan is a suitable for his situation, what type of loan
should he get?
Analysis: A home equity loan can be a very smart way to
clear up credit card debt for two reasons: 1) home equity loans
most often have a much lower interest rate than credit cards and
other types of non-secured debt, 2) the interest paid on the first
$100,000 borrowed is tax deductible where as the interest paid on
credit cards is generally not tax deductible. Tony should consult
a tax advisor for the specific tax benefits available to him.
Tony must realize that in taking out a home equity loan, he is
reducing his equity or ownership that he has in his home. He is
in fact borrowing from a portion of his home that he has already
paid off so that he can have money to pay off his credit card debt.
While a home equity loan may be useful in clearing up Tony's debt,
there may be situations where a home equity loan may not be good
idea for debt consolidation. Say for instance that you had $5,000
in credit card debt. Taking out a home equity loan is not free -
in addition to interest there are associated closing costs. It would
likely not be worthwhile to take out a home equity loan and incur
closing costs to clear up a small amount of debt.
In Tony's situation, he has a large amount of debt and the home
equity loan interest rate available to him is much lower than his
credit cards so a home equity loan makes sense. Which type of home
equity loan is right for Tony? Tony has likely lacked financial
discipline and that is why he is in debt in the first place. For
this reason, Tony should get a standard home equity loan and not
a home equity line of credit.
A standard home equity loan is a conservative loan choice that
has fixed payments and a fixed interest rate. Home equity lines
of credit should not be used for debt consolidation since a line
of credit gives you have the option of making minimum payments on
the amount owing - this practice can lead to an unpaid balance at
the end of your loan which is a very similar situation to credit
card debt.
If Tony is serious about being out of debt, he should cut up his
credit cards as they could get him into the same situation once
again.
More Related Information On...
tax benefits - see Advantages
& disadvantages of a home equity loan, Uses
of a home equity loan - Debt Consolidation
reducing equity/ownership - see Advantages
& disadvantages of a home equity loan
the standard home equity loan - see The
Standard Home Equity Loan
choosing a type of home equity loan - see Which
home equity loan type is right for me?, Types
of home equity loans
loan costs - see Loan
Costs
Case 2: Using a home equity loan
for home improvements.
 Charlene
and Russell are considering borrowing from their home equity to
make home improvements. They plan on doing most of the work themselves
and they have several jobs in mind including remodeling the kitchen,
knocking down walls and adding a back room. They have a rough estimate
of costs and they plan on doing the work over the next year. What
type of home equity loan is right for them?
Analysis: Charlene and Russell's situation points to a home
equity line of credit being the best option for them. Since they
are doing the work over the next year, they will need to spend money
on supplies and tools at intervals. A home equity line of credit
is ideal for this situation since it allows you to access money
at intervals - you benefit by using the money only when it is needed
and therefore avoid paying interest until that time.
A home equity line of credit works a lot like other lines of credit
- you have a limit or a maximum amount that you can borrow against
as you need it. The line of credit also works well for Charlene
and Russell since they do not know exactly how much they will need.
When they have an estimate of how much they will need, they should
probably 'pad' or add a little extra money to the loan amount for
safety. When they have received their line of credit, if they decide
not to do certain parts of their renovations or if they over-estimated,
they do not have to borrow that amount from their credit line.
More Related Information On...
home equity lines of credit - see Home
Equity Lines of Credit, Types
of home equity loans
choosing a type of home equity loan - see Which
home equity loan type is right for me?, Types
of home equity loans
Case 3: Should you use the equity
in your home to buy a car?
 Christine
wants a new car but she has no savings. Should she use a home equity
loan to buy a new car?
Analysis: Christine should not use a home equity loan to
buy a new car. Cars and luxury items are depreciating investments.
It is not the smart to reduce the equity you have in your home to
buy a car, a boat or another luxury item. Save until you can afford
it.
More Related Information On...
reducing equity/ownership - see Advantages
& disadvantages of a home equity loan
good and bad uses of a home equity loan - see Uses
of a home equity loan
other ways to borrow money - see Other
ways to borrow money
Case 4: Cash-out refinancing?
John wants to borrow $30,000 from the equity he has in his home
to make home improvements. Mortgage rates have dropped 4% since
John took out his mortgage and he has $100,000 left on his mortgage.
Should John get a home equity loan or should he refinance his first
mortgage and use a 'cash-out' option to get the money he needs for
his home improvements.
Analysis: Even if John did not want any money for home improvements,
he should most likely refinance his first mortgage. As a rule of
thumb, if mortgage rates have dropped two 2% or more since you have
taken out your mortgage, it most often makes sense to refinance
your mortgage. Factors that may not allow refinancing to be a viable
option include: 1) a pre-payment penalty on your mortgage, 2) a
small amount left on your mortgage which may not result in enough
benefit to offset refinancing costs.
Since rates have come down sharply since John took out his first
mortgage and he still has a sizable mortgage to pay off, John should
refinance his mortgage. If he also wants to borrow from the equity
he has in his home, cash-out refinancing is a sensible option.
If John was to 'cash-out refinance', John would take out a new
mortgage for $130,000. He would pay off his current mortgage of
$100,000 and the $30,000 that he has left over would be the equivalent
of a home equity loan. John would therefore lower his mortgage rate
and the $30,000 he has borrowed from his home's equity would also
likely be at lower rate than if he were to take out a separate home
equity loan.
More Related Information On...
cash-out refinancing - see Cash-out
refinancing, Types of
home equity loans
choosing a type of home equity loan - see Which
home equity loan type is right for me?, Types
of home equity loans
Case 5: Ramifications of accepting
a loan offer.
Milton is thinking of accepting a loan offer. How will this affect
future selling, future home equity borrowing and what will be the
tax implications?
Analysis: With any second mortgage product, (a home equity
loan or a home equity line of credit), you generally must pay off
the loan in full if you sell your home.
With regards to future borrowing: lenders have typically allowed
the combined value of your first mortgage and your home equity loan
to be 80% of the home's value. If Milton's combined value of first
and second mortgage has exceeded 80%, some lenders will not allow
him to further borrow against his home equity. It should be noted
that some lenders do allow a higher loan-to-value of 90% and some
lenders go as high as a loan-to-value of 125%.
Milton should consult a tax advisor for the specific benefits available
to him but generally... he can reduce his taxable income by the
interest paid on the first $100,000 he borrows regardless of the
way the money is used. If a home equity loan is used for home improvements
or to buy another home, interest paid on the first $1 million borrowed
can be deducted. When you exceed 100% loan-to-value, the portion
of your home equity loan in excess of your home's value is not tax
deductible unless it is used for home improvements or to buy another
home.
More Related Information On...
borrowing affected by loan-to-value - see How
much can I borrow?
tax benefits - see Advantages
& disadvantages of a home equity loan, Uses
of a home equity loan
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