When Home Equity Loans Are the Wrong Choice
Many people, including the writer, have made wrong choices about home equity. Those around us often encourage these wrong choices and the financial systems make them easier than ever. Here are some ways that I’ve inflicted damage on my home equity.
Pay off credit-card debt with a home equity loan
If you are a homeowner with some home equity, then I know you do not need to look for opportunities to borrow against that equity. They are in your mailbox almost every day. One of the often-touted reasons to get a home equity loan is to pay off credit card debt. It sounds so sweet to set up a line of credit, and then use a check or debit card to access that cash. Good-bye credit card debt, cause the check is in the mail! Many financial experts would be there licking the stamp for you.
This plan works out well on paper, but not in real life unless you cut up the credit card and close the account. Nearly two thirds of the people who secure a home equity loan for this reason go on to generate more credit card debt. In the final analysis you have more debt, and by the way, your home equity is reduced. People who attempt to do a debt consolidation using a home equity loan tend to do it over and over. The eventual end of the cycle is that your home is at risk.
To date I have fought the urge to accept one of the home equity loan offers. However, I have been able to reduce my home equity by refinancing my mortgage with a cash-out option. This is just a different path to the same pit.
Borrow from your 401(k) account
Did you know that most company 401(k) plans have an option for the employee to borrow against their own retirement funds? You generally cannot withdraw the money unless you have a specific hardship case, and even then you will pay taxes and penalties. But you can borrow that money, and here is the cherry on the sundae – the interest you pay goes back into your account. The company will have a small service fee for managing this loan, but you are so excited about paying yourself the interest – who cares! Seems to be a much more sound decision than a home equity loan.
Your 401(k) account is a significant piece of your equity for the future. At some point your 401(k) account will couple with your established home equity as your major resources for the future. A poorly managed 401(k) account may force you to tap into your home equity sooner than desired, or in a way that you did not plan. The 401(k) loans I’ve had in the past are paid off, and I’m glad of that. What are the negatives of these loans? First if you loose your job or get fired, you will have to pay back the loan balance in a short amount of time (maybe you could get a home equity loan). Secondly, even though you ‘saved’ interest off the money, there is a good chance that the money would have earned more if you had left it alone.
Stretch your budget to buy that house
My wife and I have purchased three homes and every time we have been wrongly advised by a hundred people on this issue. When you are looking at how much house you can afford, the common line of advice has been that you have to stretch and get the most house possible. Cash will be tight at first, but then the family income will rise and eventually you will see that it was the right decision to stretch. Besides, the realtor seems to respect you more for having the wisdom to stretch that budget. Well, this expert can tell you “Hogwash!” It just isn’t so! It used to be that a decently performing professional could expect an annual raise of 6% to 10%. Now, that same professional might see 3% increase over a 14 to16 month period. That leaves no room to pay for a too-big mortgage, along with the other additional expenses life brings. By the way, every time a tax levy passes (school, children’s services, the zoo, road repair, libraries and any government programs) your property tax on that house increases.
When we bought our current house we fell into this quagmire. Being stretched, we took the margin out of our budget. When we moved, we were paying about $275 per month for gasoline for two vehicles. As the price of gasoline went to $3 per gallon and our need for local driving increased, that same bill has gone to over $600 OUCH! These kinds of situations make a home equity loan awful tempting.
Bottom line – do not set yourself up to be house broke by going for the maximum house. Remember, the multi-step process of moving to a smaller home is expensive, and will bite a chunk out of your home equity. Wrong move!
