Bad Home Equity Moves

By Meiling Hunter
Mortgage Credit Problems Columnist

While there are good reasons to take out home equity loans such as consolidating and paying off bad credit, making home improvements, paying college tuition or preparing for those "just-in-case" times, be aware of the risks and pitfalls associated with doing so. Home equity loans and home equity lines of credit (HELOC) are collateralized by your home and are mortgages. Fixed rate home equity loans deliver a lump sum and are often used for one-time costs such as adding a bathroom to your home, while HELOCs are an available line of credit that you can tap into at anytime -- perfect for unforeseen expenses and emergencies. 

Tax Deduction

Yes, the interest paid on your home equity loan or HELOC can qualify as a tax deduction. However, in order to claim the interest paid, you must itemize when filling out your federal tax return rather than taking the standard deduction. Also know that the interest is not always a dollar-for-dollar tax deduction and varies according to your tax bracket. While tax deductibility does effectively lowers the cost of a home loan, it should not be the main reason for tapping into your home equity.

Financial Stability

If you are in a tight financial spot, it's generally not a good idea to take on more debt and put your home at risk. First consider if there are other avenues to accomplish your goal. Can your college-bound child apply for loans himself or qualify for grants? Can you become a one-car family to cut down on car payments and gas money?

Owing More than your Home Is Worth

You may end up upside down on your home if you have a high loan-to-value (LTV) home loan. A high LTV loan may allow you to draw up to a hundred percent or more of your home's value. If you plan to sell your home in the next couple of years, know that your high LTV loan may leave you owing more on your home than you can sell it for, so plan to bring cash to the table when you sell it.

Taking on Risk

Home equity loans and HELOCs generally carry lower rates than unsecured credit cards and loans because lenders transfer some of the risk to you. With any type of loan, there is the risk of default (not paying back the loan). With unsecured debt -- particularly for those with bad credit -- the interest rates are higher because the lender is assuming the bulk of the risk. With secured debt, like your home equity loan or HELOC, you are using your home as collateral and assuming some of the risk.

Your Emergency Funds

Planning for unexpected life events -- getting sick, hurt or losing a job -- is a smart thing to do, and keeping equity available to bail you out can accomplish this.  If you use up all of your equity in the good times-- like buying wish list items-- you will not have that cushion in the bad times.

Source
The Tax Foundation

About the Author
Meiling Hunter has worked in the mortgage industry for four years. She graduated from the University of California, Davis, with a double major in Economics and Philosophy.

Share This Article:

Other Recommended Home Equity Articles

• Home Equity Loan Costs
• The Home Equity Line of Credit: Is it Right For You?
• Home Equity Loans for People with Poor Credit