A home equity loan is one which lets you borrow money using the equity in your property as collateral. Equity is the amount of money you've already paid on your mortgage. With a home equity loan, you can borrow against the equity, and what you do with the cash you receive is up to you. However, there are good reasons and bad reasons for getting a home equity loan. Before you start shopping for one, make sure you that you have a definite goal for the money – one that is part of a financial strategy that will increase your overall wealth.
The Good Reasons
Taking out a home equity loan for the purpose of putting the money back in the property is perhaps the single best reason for getting this type of loan. If you make improvements wisely, you can increase your property's value far beyond the cost of the loan. A kitchen or bathroom remodel or the addition of an extra bathroom generally offers the best return on your investment. If you decide to finance home improvements in this way, bear in mind that you should not increase your home's value more than 15% over the average value of those in your neighborhood. Going beyond this figure means that you potentially limit the resale value of your home, because your property's value is dragged down by the average value of those surrounding you.
Using the cash from a home equity loan to finance higher-yield investments is another good option. You might, for example, consider using a home equity loan to finance the purchase of an investment property, retirement, or vacation home. If you decide to purchase a second home or investment property, make sure you do some research and find out about applicable tax laws. For example, estate taxes on a vacation property are tax-deductible as long as you live there for more than two weeks per year, and don't rent it out for more than two weeks per year.
The Bad Reasons
Debt consolidation sounds like a great way of solving credit card problems, and it is in fact how most people use home equity loans. It's an attractive prospect, because you can use a home equity loan to pay off multiple smaller debts, leaving you with one monthly payment that has a lower interest rate than your credit card debts. However, by using a home equity loan for this purpose, you're also turning unsecured debts into a debt that's secured against your house. Just as important, you're not really addressing the problem that put you in this position in the first place. Rather than get a new loan to pay off old debts, it's better to fix the problems that led to accumulating that much unsecured debt.
Don't use a home equity loan to finance cars, boats, recreational vehicles, expensive electronics or vacations. It's an attractive idea to use one to finance a dream vacation or an expensive new car – but you're putting your property on the line for something that will lose its value long before your home does.
DEAR BOB: My husband and I recently purchased our first home. Although we both earn good money, our credit isn't so good. On the advice of our mortgage consultant, we obtained an interest-only 100 percent mortgage in my father's name. Both of our names are on the title, but not on the mortgage. It was explained to us that in six months my father would sign a quitclaim deed and title will be in our names alone. Can my husband and I claim the tax deductions on the house although we are not listed on the mortgage? We will be making the payments. To do a quitclaim deed, must we refinance the mortgage in our names at that time? --Josette R.
DEAR JOSETTE: Because your names are on the title to your personal residence, you are obligated to pay the mortgage and property tax payments or lose the property by default. Therefore, you are entitled to claim itemized income-tax deductions for the mortgage interest and property taxes you pay.
Your name need not be on the mortgage obligation. Millions of U.S. homeowners own their homes "subject to" an existing mortgage that is not in their names. But they are the "beneficial owners" entitled to the itemized tax deductions for the mortgage interest and property taxes they pay.
However, you should get your father to sign and notarize the quitclaim deed now so it will be ready for recording (just in case anything should happen to him). For more details, please consult your tax adviser.
CAN TREE OWNER PENALIZE NEIGHBOR FOR TRIMMING IT?
DEAR BOB: I own a beautiful old oak tree which overhangs the lot boundary with my neighbor. While we were away on vacation, he trimmed it back to the property line. Now the tree looks awful as it is unbalanced. When I confronted him, he said he was tired of the mess the tree made on his property. Does he owe us damages? --Margo W.
DEAR MARGO: Perhaps. The general rule is a property owner can trim a neighbor's overhanging tree back to the property line. However, the tree trimming must be done with care so the tree does not die as a result.
If your tree dies due to the neighbor's severe trimming of the overhanging branches, you could then sue him for the lost value of the tree. Let's hope that doesn't happen.
WHEN DOES 12-MONTH LONG-TERM CAPITAL GAIN PERIOD BEGIN?
DEAR BOB: Does the 12-month long-term capital gain period for real estate begin to run when a firm purchase contract is signed by both parties or does it start on the date of the actual closing of the sale? --Bill B.
DEAR BILL: The 12-month long-term capital gains real estate holding period starts when the buyer becomes the beneficial owner with rights and obligations. This is usually the date the sale closes and the deed is recorded.
The date the purchase contract was signed is irrelevant. For full details, please consult your tax adviser.
When you sell your home, the profit you make can be subject to the capital gains tax. Understanding how the capital gains tax laws operate may help you pocket more of the profits. While it's important to talk to your tax advisor about your specific situation, here are a few guidelines to help you get started.
If you're not familiar with the various types of mortgages and loans, you stand the chance of paying out thousands of dollars more than you should during the life of your loan. There are several different types of mortgages and loans and each one has its own list of pros and cons. In order to find the ideal loan for you, it's wise to evaluate your current situation and become familiar with each type of loan and mortgage.
The most common misconception about FHA loans is that the Federal Housing Administration lends the money. The fact is the FHA simply insures the loan in case of default and the loan must be given out by an FHA approved lending institution. First-time homebuyers often choose this type of loan and while the interest rates are competitive with other types of loans, they may have higher loan-to-value ratios. An FHA loan is best for someone who doesn't have perfect credit and individuals who need low down payments and low closing costs.
The Department of Veterans Affairs has a division that guarantees loans for veterans to purchase or build a home. In order to take advantage of the VA loan, an individual must meet certain requirements to receive a VA certificate. The VA loan allows a veteran or spouse to purchase or build a home with a small down payment or none at all. As with the FHA loan, the Department of Veterans Affairs doesn't lend the money. They simply insure the loan.
A conventional loan is considered to be a secured loan. The loan-to-value ratio is most often one of the lowest, with a ratio that is generally less than 80 percent of the value of the home. With this type of loan, the borrower is often required to make a down payment of at least 20 percent. The conventional loan is best for buyers who can put down at least a 20 percent down payment.
The Adjustable Rate Mortgage is a loan that will have a fixed interest rate for a specified amount of time and then the interest rate will be adjusted according to an objective economic indicator. The loan will have a margin of how much the interest rate can be adjusted, as well as how often. This type of loan is best for someone who is not planning to be in their home long-term. An ARM allows for lower interest rates and a lower payment at the beginning of the loan term.
The Sub-prime lender is one who will approve financing for individuals who have been turned down by traditional lenders, most often due to a low credit score. Because of the higher risk, the borrower must pay a higher interest rate on the loan. The Sub-prime loan should only be used by buyers who have been turned down by mainstream lenders since the borrower will end up paying thousands of dollars more on this type of loan.
No Down Payment
There are several types of loans that will allow for no down payment from the borrower. These often include FHA loans, VA loans, as well as Sub-prime and Conventional. However, when no down payment is given, the interest rates will often reflect this by being a little higher.
Private Mortgage Insurance is an insurance the borrower purchases in order to secure the loan with the lender. It will usually only protect the top portion of the loan in case of default. This is best to be obtained when a borrower has a lower down payment. Once the top portion (for example, the top 30 percent of the loan) is paid, the PMI is cancelled.
Equity Line of Credit
This type of loan is a re-usable line of credit that is secured by your original mortgage. The payments on this type of loan will vary as the credit line rates may be adjusted every month. This loan is best for those individuals who do not need all of the cash up front, as you can withdraw only the amount you need and pay only the interest on what money you have withdrawn.
Home Improvement Loans
These loans are best for borrowers who need money to improve their home. They're often available at a fixed interest rate and are tax-deductible. These loans are great for major home improvements and will allow you to pay off your loan over a longer period of time.
The No-Documentation loan is best for those individuals who may have a difficult time proving their income. Often, these are available with either a fixed or adjustable rate, as well as an interest-only loan.
Before approaching lenders, draw up a detailed budget for your remodeling plans. To calculate an accurate estimate, first decide what projects you’ll need to hire a contractor for and which ones you’ll do yourself. On contracted work, start with a firm bid and add 10% for "surprises." On work you’ll do yourself, draw up a detailed list of materials and costs (including equipment rental) and add 15-20% for "surprises."
How much you can borrow depends on your credit rating, income, and the loan-to-value ratio of your remodeling plans. The LTV ratio is a percentage of the appraisal value of your home and is normally capped at 80%, minus the balance of your mortgage.
Now you’re ready to start thinking about the type of loan you want. You can refinance your existing mortgage, or take on an entirely new loan. Consider these various possibilities.
Home Equity Loan As with regular mortgages, the interest on these is deductible. Terms are normally 15-30 years, with a fixed interest rate. However, interest rates tend to be a little higher than with regular mortgages.
Home Equity Line of Credit This type of mortgage is similar to a credit card. Your lender will give you a set amount which you can borrow, and you can draw funds when you need them and pay interest only on the amount of money you have used. Some programs have a minimum withdrawal amount and most have variable interest rates. Most require repayment in full within ten years. If you decide on this type of loan shop carefully – some lenders will grab your attention with low initial interest rates and then increase it substantially later on.
FHA 203(k) Mortgage These are FHA-insured loans which let you refinance your first mortgage and combine it with your remodeling costs into a new mortgage. This type of mortgage bases the loan on the value of your home after improvements are made, which increases the amount you can borrow.
Energy-Efficient Mortgage (EEM) An EEM is a special type of mortgage which allows you to finance remodeling work that increases your home’s energy efficiency. If you decide to finance some of your remodeling with an EEM, your monthly energy savings are used to finance the energy upgrades. To qualify, your improvements must be cost-effective. This means the monthly savings on your utility bills as a result of the improvements must be greater than the monthly repayment of the energy mortgage, and also that your total savings must be greater than your total costs, including maintenance costs. If you decide to finance part of your remodeling with an EEM, you must apply for both loans at the same time, as you cannot add an EEM after the regular loan has been granted. Once your EEM has been approved, you have between 90 and 180 days to make the improvements.
Selecting a Contractor
The idea of the 40-year mortgage has been around in America since the 1980s, when interest rates reached record highs of over 18%. With those massive interest rates, the affordability of monthly mortgage payments was a big problem. Increasing the terms of the mortgage to 40 years rather than 30 lowered monthly payments, making mortgages affordable for more people.
Even so, this type of mortgage didn't achieve much popularity until 2005, when Fannie Mae announced a pilot program to test-market a 40- year mortgage in America. In 2006, with housing affordability becoming an issue once again, approximately 5% of new mortgages are 40-year fixed-rate mortgages.
40-year mortgages offer lower monthly repayments for those who can't afford a 30 year mortgage. For example, a loan of $100,000 at 8.5% for 30 years will mean monthly repayments of $769. Financing the same purchase with a 40 year loan would mean monthly repayments of $733. It may not seem like a lot, but for a family with a tight budget, it can mean the difference between continuing to rent, and being able to own their own home.
What Are the Disadvantages of a 40-Year Mortgage?
While monthly repayments are lower on a 40-year mortgage, over the life of the loan, you'll end up paying significantly more in interest than you would with a 30 year loan. Taking that $100,000 loan as an example, with an 8.5% interest rate, the cost of borrowing for 30 years is $276,840. With a 40-year loan, the figure jumps up to $351,840 - which means that 40-year loan is costing you $75,000 more than a 30-year loan would. And it's not even that simple. 40-year loans usually carry a higher interest rate than 30-year loans, because the extended term means that lenders carry more risk.
Another significant problem with the 40-year mortgage is that building equity in the property takes a lot longer. Mortgages are front-loaded in terms of paying interest, and payments on a 40-year loan are almost all interest at the start. And because it takes longer to build equity, it means your costs are higher - for example, if you have private mortgage insurance, you'll be paying it for a lot longer than with a 30-year loan, because you must pay the insurance until you have at least 20% equity in the property.
And if housing prices go down, you're at even greater risk. Suddenly, you owe more than the house is worth, and you've got too little equity in the house to make refinancing a good option.
In short, a 40-year loan may not be the best idea, unless you're planning to refinance or move within five to seven years. If you can't afford a 30-year mortgage, in some circumstances it might be better to continue renting and save for a larger down-payment to reduce interest, rather than going for a mortgage with a longer term.