One of these days, you’re bound to open up your mail (or your email) and find an offer for free money.
This so-called free money doesn’t come gift-wrapped, although the lender may want you to think it’s as easy as harvesting it from your own backyard money tree.
What you’re being offered is an opportunity to tap into your home equity.
The equity you have in your home is the amount someone is willing to pay for your home at any given time, minus your mortgage.
For example, let’s say your home is worth $150,000, but you have a $100,000 mortgage. Excluding, for the moment, any costs of sale you may have, your home equity is approximately $50,000.
Your home equity increases in one of two ways. First, your home’s value rises, either because of repairs and renovations you’ve done, or because the neighborhood is simply more valuable. Second, with every mortgage payment you make, a portion is interest and a portion pays back the principal balance due on the loan.
In the early years of your loan, almost everything you’re paying is interest. At the end of the loan, almost everything is principal.
Lenders will allow you to tap into your home equity to either consolidate your bills or to give you some extra cash. Currently, the home equity market is very competitive, which means that you’ll pay less in fees than you might otherwise.
That’s the good news. The bad news is that some lenders will charge you at least a point over the prime lending rate, which means you could wind up paying between 8 and 10 percent for your home equity loan. Hardly a cheap way to tap into your own cash.
Still, it’s probably cheaper to get a home equity loan to pay for a car, for example, than to have a dealer finance it for you. Not only will your interest rate and fees be lower with a home equity loan than a car loan, but the federal government allows you to deduct the interest paid on home equity loans up to $100,000.
With interest rates rising, however, choose your home equity program carefully. Making the right choice can save you thousands of dollars in interest:
How long do you plan to keep the loan? If you’re using a home equity loan to help your short-term cash flow, and if you plan to pay it off in less than five years, you may want to gamble that short-term interest rates will stay about where they are. If that’s the case, choose home equity loan with an adjustable interest rate. You’ll pay less up front, and may even pay less over the life of the loan. But if you plan to keep your loan as long as you own your home, consider a fixed-rate loan to build in some security.How fast do you need the cash? Are you buying a car or doing a large home renovation project that will take six months to finish? If you need cash all at once, you may be better off taking your home equity proceeds in one lump sum. But if you plan to dribble out the cash to your contractor over time, get a home equity line of credit.
That way, you’ll only pay interest on the money as you use it, not from the day you sign your loan documents.
Be on the look out for better deals. Because the home equity market is so competitive, lenders are falling all over themselves to entice consumers to sign with them. Some lenders are offering vacation packages, while others are giving you free cash, akin to a manufacturer’s rebate on a new car. Evaluate the financial benefit of these freebies carefully. A free trip to Disneyworld sounds great. But if it only includes the admission tickets and you have to pay for the rest, you’re far better off taking the cash rebate, if that’s an option.
Finally, many home equity lenders will only allow you to borrow up to 90 percent of your home’s value. So if, as in our earlier example, you have $50,000 in equity in your $150,000 home, the lender may allow you to borrow only up to $135,000. If you subtract the $100,000 of your current loan, that only gives you about $35,000 in cash.
That’s more than if you did a cash-out refinance. If you refinance an existing mortgage, you’d only be able to borrow up to 80 percent of the value of your home, or $120,000. That would give you only $20,000 in cash.
If you go to a sub-par lender, also known as a B or C lender, you might be able to borrow more, but it will be at a far higher interest rate.
Which brings us to the bottom line: You don’t want to stretch yourself so thin that you’re in financial jeopardy. If you stop paying on your car loan, they’ll repossess your car. If you stop paying your mortgage or home equity loan, the lender is likely to foreclose and you could lose your home.
Sept. 6, 1999.
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