You can use home’s equity but be careful

Question: A couple years ago we took out a home equity line of credit. Since then, we have used it to pay for some major improvements to the home, such as a new roof, rewiring, etc.

This is a big source of arguments between my wife and I. Even though we have lots of credit left to draw on, I’m reluctant to use the credit line much more.

I think it should be used carefully, since it’s our house we’re talking about, after all. Any thoughts about this?

N.J., Bothell

Answer: The main question is: “How secure is your income?” If you have a steady, dependable income stream — whether it’s from a good job or your own business — and you feel confident that you won’t run into financial difficulties in the foreseeable future, there is nothing inherently wrong with using the home equity line of credit to pay off your other bills. Your monthly expenses will be lower and the interest will be tax deductible.

One reason for the popularity of home equity loans is that interest expense on credit cards, car loans and other consumer borrowing is not tax-deductible. The interest expense on home equity loans is one of the few remaining tax shelters left, so many people now use tax-deductible home equity loans to purchase cars rather than non-deductible auto loans. If you can handle the monthly payments, there’s nothing inherently wrong with that. But just remember that if you take out a car loan and you don’t make your payments, the lender will repossess your car. But if you get over-extended with a home equity line of credit, the lender can foreclose on your home.

A large percentage of the foreclosures in the Puget Sound region are a direct result of homeowners leveraging themselves up to their eyeballs with home equity loans. In many cases, they owe more than their home is worth. It’s sad to see a job loss or other economic calamity force people out of homes they’ve lived in for 10 or 20 years. In some cases, the added debt load from a home equity loan or cash-back refinance is the difference between keeping or losing their home. This has become a serious problem as home values have decreased throughout the Puget Sound region.

Home equity loans were originally designed to finance home improvements. That makes sense because improvements add equity value to your home, which increases the collateral value for the loan. If you ran into financial difficulties that forced you to sell the home, the increased market value would hopefully cover the additional debt. But that theory doesn’t work when market-wide home values are falling faster than the appreciation that results from home improvements.

Another factor to consider is the interest rate risk. The interest rate of most home equity lines of credit is tied to the prime rate, which this week dropped to only 4 percent. That makes home equity lines of credit very cheap right now. But don’t forget that the prime rate can rise very quickly. In 2004, it was also at 4 percent but only three years later it had more than doubled to 8.25 percent. So your home equity payments can increase very quickly — even if you don’t borrow any more money.

Now, if you can afford it, there is one reason why you might want to consider pulling some extra money out of your home equity line of credit right now: Banks have recently been freezing home equity lines of credit because of falling home values.

For example, let’s say you have a $200,000 line of credit on your home, but so far you have used only $50,000. That means you still have $150,000 worth of credit that you could use by simply writing a check. But if the bank decided to freeze your line of credit at its $50,000 balance you would no longer have access to any of that extra credit. So if you needed that money for business purposes or investment you’d be out of luck. That’s why you might want to consider pulling more cash out now before you lose the ability to tap the equity line on your home.

But again, let me emphasize, use your home equity line of credit very carefully. Never borrow money unless you really need it and can afford to pay it back, even if interest rates rise.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.

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