Two Kinds of Loan. There are basically two kinds of home equity loans, a home equity line of credit and a second mortgage. A home equity line of credit is a form of revolving credit (like a credit card) secured by your home, with a set maximum credit limit. You can usually borrow any amount up to your limit, any time the home equity loan is in effect, such as 5 years. These plans typically involve interest rates that change from time to time, so called "variable" interest rates, rather than fixed interest rates that stay the same over the entire duration of the loan. Terms for repayment and other features, such as the minimum amount that you can borrow from time to time, vary from plan to plan.
A traditional second mortgage loan also is a loan secured by your home, but provides you with a fixed sum immediately, repayable over a fixed period, usually in equal monthly installments. You usually would consider using a second mortgage if you need a specific sum immediately for a specific purpose, such as making an addition to your home. You can use either a home equity line or a second mortgage to consolidate your debts.
Costs. Costs for either type of loan can vary substantially from lender to lender. You need to be a Black Belt shopper to get the best deal. Be sure that the fees and other costs of the home equity loan are reasonable. You want to make sure you are in a much better financial position after the loan consolidation than before. It's important not to run up substantial credit card debt after the consolidation if you want a permanent improvement in your financial position.
There's an important financial feature of home equity loans you should consider. Debt on your home is different than unsecured consumer debt, such as credit card debt. While unsecured creditors can make life unpleasant for you, they can't take your home without a lot of hassle. They would have to sue you in court to get a judgement against you, record a lien on your home, then get the judgement lien enforced by selling the home. This is an expensive and time consuming procedure that unsecured creditors rarely undertake. A home equity lender, however, can take your home if you fall behind in payments simply by foreclosing on the home equity mortgage. Be sure you can make the loan repayments before you consider home equity financing. If your employment history is shaky or you anticipate incurring other heavy expenses soon, don't put your home as risk by turning your credit card debt into a home equity loan.
How To Make Your Interest Deductible
It's important that you qualify to get tax deductions for the interest you pay on your home equity loan. To do so the loan has to be "home equity indebtedness," which is a mortgage that meets two requirements.
First. The home equity loan must be secured by a mortgage on either your principal residence or a second home you select for purposes of getting the interest deduction. Your "principal residence" generally is where you live on a full time basis. Your second home generally qualifies if you use it for vacation or other personal purposes for a number of days during the year that exceeds the greater of 14 days or 10 percent of the number of days the residence is rented out at a fair rental.
Second. The total amount that may qualify as home equity indebtedness cannot exceed $100,000, or $50,000 in the case of a married individual filing a separate return.
There's a peculiar wrinkle to home equity indebtedness you should look out for if you are obtaining a so-called "high loan to value" loan. Home equity indebtedness can't exceed the difference between your total acquisition indebtedness and the fair market value of your home. This rule can clip your deduction if you borrow too heavily against your home. Check with your tax professional if you think this may be a problem for you.
Bottom Line. Often there's more than one way to implement a transaction. While the pre-tax results may be substantially the same regardless of which route is chosen, the after-tax results can be strikingly different if the tax saving route is taken. Credit card borrowing and auto loans are prime examples of where tax planning can help you make your home a bigger tax shelter.
WARNING. There are unscrupulous home equity lenders out there who push serial refinancings to the point where home equity is wiped out. The elderly are particularly vulnerable to these predators because they often have substantial equity in their homes but live on fixed incomes.
Regulators and consumer groups are well aware of these abusive lender practices but have limited means to stop them.