Examples of Home Equity Loans - Help and Information on Home Equity Loans

Home Equity Loan Examples

Example 1: Using a home equity loan for debt consolidation.

Frank has racked up $20,000 in debt on several credit cards which have an average APR (annual percentage rate) of 18%. Frank can get a home equity loan with an APR of 8%. Frank 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. Frank should consult a tax advisor for the specific tax benefits available to him.

Frank 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 Frank'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 Frank'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 Frank? Frank has likely lacked financial discipline and that is why he is in debt in the first place. For this reason, Frank 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 Frank 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.

Example 2: Using a home equity loan for home improvements.

Christina and Steven 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: Christina and Steven'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 Christina and Steven 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.

Example 3: Should you use the equity in your home to buy a car?

Mary wants a new car but she has no savings. Should she use a home equity loan to buy a new car?

Analysis: Mary 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.

Example 4: Cash-out refinancing?

Joe wants to borrow $30,000 from the equity he has in his home to make home improvements. Mortgage rates have dropped 4% since Joe took out his mortgage and he has $100,000 left on his mortgage. Should Joe 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 Joe 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 Joe took out his first mortgage and he still has a sizable mortgage to pay off, Joe 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 Joe was to 'cash-out refinance', Joe 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. Joe 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.

Example 5: Ramifications of accepting a loan offer.

Bradley 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 Bradley'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%.

Bradley 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.