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Making Sense of Home Equity Loans

By Jeff Brown
With all the attention on foreclosures and “underwater” mortgages, it’s easy to forget that millions of Americans have owned their homes long enough to have substantial equity. It’s still possible for many to tap that wealth through a home-equity loan.

There are two ways, each with pros and cons.

With a home equity installment loan, you borrow a lump sum with a fixed interest rate and then make monthly payments that stay the same until the loan is paid off, just like a mortgage or car loan. You generally pay a lower rate for a loan to be paid off in three to five years than for one spread over 10 or 20 years.

The second type is the home equity line of credit, or HELOC. It works like a credit card, letting you borrow as much as you choose up to your credit limit. Interest rates change every month or so, depending on market conditions, so your payments can vary as the rate and outstanding debt fluctuate.

Both types are “secured” loans which use your home as collateral. That means they offer lower interest rates than “unsecured” loans like credit cards, but if you fail to make home equity payments the lender can foreclose on your property.

Homeowners can use equity loans for any purpose, from home renovations to paying for college or cars.

Home equity installment loan rates average about 7.98 percent for a 36-month loan and 8.58 percent for a 10-year loan – a bit more than you’d pay on a mortgage. Some HELOCs are charging as little as 5.3 percent to start, though that could rise substantially as conditions change. In comparison, you’d be hard pressed to find a credit card that doesn’t charge in the double digits.

Another benefit: interest payments on both types of home equity loans can be deductible on federal taxes if you itemize your return and meet certain qualifications.

The deduction can make the home equity loan substantially cheaper than other loans. If you are in the top 35 percent tax bracket, a $100-a-month interest payment really costs you just $65 because it cuts your tax bill by $35. A homeowner in the 15 percent bracket would end up paying $85. A $100 payment on a credit card or car loan really does cost you $100, since there’s no deduction.

To figure the after-tax equivalent of the rate on an equity loan, subtract your tax rate from 1 and then multiply the loan rate by the result.

If the loan charges 8 percent and you are in the 35 percent bracket, multiply 8 by 0.65. Your after-tax loan rate is 5.2 percent. [8x (1-0.35]

An installment loan is best if you have a single, large need, like a home renovation, since you know the rate will not go up even if you stretch the payments over many years. The HELOC is best used as a back-up fund, to get you through short periods when expenses exceed income. Because the rate on your balance can rise, it’s best to use a HELOC sparingly, and to pay your balance off as fast as you can.

Loans are offered by well-known firms such as LendingTree (Stock Quote: TREE) and PNC (Stock Quote: PNC), but be sure to shop at sbup and  your local banks as well.

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