Are Home Equity Loans a Viable Financial Strategy?

Summer 2011 CSANews Issue 79  |  Posted date : Jul 08, 2011.Back to list

Things To Consider Before You Take Out a Home Equity Loan

Have you seen the commercials about "home equity loans" or "reverse mortgages?" You know, the ones that explain how a home equity loan can give you cash without dipping into your savings. Is this another case of something too good to be true? Or is it a viable strategy for boosting your income during retirement?

The answer to that question depends largely on your personal circumstances. One thing that's certain, however, is that these commercials don't tell you everything you need to know in order to make an informed decision about whether a home equity loan or reverse mortgage would be a good idea for you.

With that in mind, here are the facts about what a home equity loan is, what it isn't, and what it can do for you.

What is a home equity loan?

A home equity loan describes the process of converting a portion of the equity in your home into cash. There are a variety of ways to structure such a loan but, essentially, the strategy works much like a conventional mortgage, except in reverse (hence the popular term "reverse mortgage"). Instead of you paying a bank to buy somebody else's house, the bank pays you to buy a portion of your house. That payment could be structured as a one-time lump sum, or as a series of monthly payments, or as an "on demand" line of credit against which you make withdrawals when you need to (a "home equity line of credit").

Most of the time, such borrowing is structured as a "no payment" loan, in which borrowers don't need to make any payments as long as they remain in the home. As the owner of the property, you retain possession of the home and you only pay loan principal and accrued interest when you move (or when you pass away). Most institutions also require borrowers to follow other common-sense provisions, such as paying property taxes on time, making necessary repairs, etc.

You can see how such a strategy can be very useful, particularly for those who have few assets other than their homes. If you bought your home decades ago, you've likely built up a good deal of equity - equity which you can't access without selling the entire home. A home equity loan solves that problem. By taking out a home equity loan, you can convert a portion of your most significant asset into cash, while retaining full ownership.

Another bonus - unlike a traditional loan, you generally don't need to pass any income test to qualify for a home equity loan. Your home is usually all of the collateral that's needed. And because it's a loan, reverse mortgages typically have no affect on your eligibility for Old Age Security or other government benefits.

An expensive strategy

As good as all of this sounds, a home equity loan can actually be a very expensive way to borrow money. If you're not careful, it can also eat away the equity which you've built over decades. In addition, there are often fees and other costs to account for - property appraisal, administration fees, closing costs and so on.

Here's an example of how a home equity loan can quickly become very expensive. Most home equity loans will only allow you to borrow between 10% and  40% of the value of your home. The exact percentage will be based on your life expectancy; the more valuable your home and the older you are, the lower the loan interest rate and the more you can borrow.

So, assume that your home is worth $500,000 and you qualify for a loan of 40%, or $200,000. At a 6.75% rate of interest, your loan balance will double in about 11 years. You'll now owe about $400,000, or about 80% of what your home was worth at the time you took out the loan. If your home increases in value by more than 6.75% a year, you'll be fine. But if it doesn't, it's theoretically possible that the loan value will one day exceed the value of your home. Ouch.

Beware of rising interest rates

Perhaps the most dangerous thing about home equity loans is their exposure to rising interest rates. This is a particular problem with home equity lines of credit. Because these loans are typically structured with "floating" rates - that is, the interest you get charged moves up and down with the bank's prime lending rate - a hike in interest rates can make a big impact on the interest that you pay.

This has become an even more serious issue over the past several months. All signs point to the Bank of Canada raising interest rates in the months to come; the only questions are by how much and how quickly. For those with locked-in debt (a mortgage, a car loan, etc.), rising interest rates are of little consequence, at least until the term of the loan expires. For those with floating-rate debt such as home equity lines of credit, however, rising interest rates can be the fast ticket to insolvency.

Home equity loans as a debt-reduction strategy

One common use for a home equity loan is to consolidate multiple, higher-interest debts into a single loan. In fact, data from the U.S.-based Consumer Banking Association suggests that debt consolidation is the most common use for these types of loans, by a wide margin (see chart below).

On paper, this strategy makes a lot of sense. Instead of paying credit card debt at sky-high rates (often 18% or more per year), you take out a lower-interest home equity loan and use the proceeds to pay off your credit card. Such a move could save you hundreds, even thousands in interest over the lifetime of your loan.

There's only one problem: getting out of debt is more about changing your spending behaviour than it is about getting a lower-interest rate. Moving high-interest debt into a lower-interest loan is all well and good but, unless you make a commitment to changing the spending behaviour that led you into debt in the first place, all you've managed to do is shuffle debt from one account to the other.

Getting the best deal

Should you decide to apply for a home equity loan, you'll need to know how to get the best deal possible from your bank or other lending institution. Here are some tips:

Shop around

Home equity loans is a competitive business. Fees, rates and terms can vary widely, depending on the with which institution you're talking. So shop around for the best deal, and don't be afraid to tell one lender what the guy across the street is offering. Your job is to get the best deal, not to make friends.

Be careful about fees and other costs

Application and appraisal fees are standard at some lending institutions but, if you have a good credit history, you should be able to get them waived.

Understand early-payment options

Some home equity lenders stipulate hefty penalties for paying the loan balance off before the loan term ends. Obviously, that's in the lender's best interest, not yours. Don't be afraid to take your business elsewhere if you can't get such provisions dropped.

Give yourself some wiggle room

Try to keep an "equity cushion" of about 20% of your home's value. If your mortgage and other home equity borrowing exceeds 80% of the home's value, chances are that you'll pay higher interest rates on your loan.

If you don't understand it, ask a third party

Home equity loans can be complicated, and some of the terms and conditions can be difficult to understand. If you're unclear about something, take your offer to a trusted third party for review - a financial advisor, a lawyer or an accountant would be a good choice. The extra step could end up saving you a lot of headaches down the road.

Other options

If you're interested in unlocking some of your home equity to generate additional income, there are alternatives to a reverse mortgage.

If there's a specific purchase that you have in mind, make sure to check out other lending avenues before you settle on a home equity loan. For example, you'd be surprised at how inexpensive car loans can be. Many auto manufacturers routinely offer low- or zero-interest loans - that's a lot better than anything you'll get on a home equity loan.

If ongoing income is a priority, an annuity or a conservative, systematic withdrawal plan from your investment portfolio might both be options. 

Depending on your individual circumstances, a "leaseback" (in which you sell your home then lease it back from the buyer for life) might be a viable strategy.

While home equity loans can certainly make sense for some people, there are definitely cheaper ways in which to secure your retirement income. Before you consider a home equity loan or reverse mortgage, be sure to talk to a financial professional. Chances are that there are alternatives which are worth exploring.