Home Equity LoansThe Home Equity Loan ProcessThe equity in your home can be a valuable source of cash.
Now that you are more knowledgeable about the workings of an equity loan and you are ready to begin evaluating them, there are steps that you should take in order to make the process a smooth one.
The process consists of:
- Gathering information from potential lenders regarding rates, fees and loan types and
- Determining which loan makes the most financial sense for you.
To evaluate which loan makes the most financial sense you’ll need to:
- Compare the loan fees and costs among your different loan choices.
- Evaluate if you should pay points -- see the section "The Point of Points" and do a rate versus point comparison.
- Determine if the interest is tax deductible. See the section "What You Can Deduct on Your Tax Return".
- Determine the after-tax cost of borrowing. If the interest is tax deductible, it reduces the net cost of borrowing. See the section "Total Cost of Borrowing".
HOT TIP!: Shop for the best deal. Getting a good interest rate with a minimum of closing costs is your first objective. Choose the loan with the lowest overall cost of borrowing.
Procedure Checklist
You’ve decided to apply for an equity loan. Here are the procedures you need to follow:
- Fill out an application.
- Ask your lender if fees can be included in the loan amount.
- Get an appraisal.
- Determine what is tax deductible.
We will walk through each of these procedures in detail in the following sections.
The Application Process
Once you select a package that makes financial sense, it’s time to apply for the loan. The application fee can range anywhere from about $150 to $450. It’s also a good idea to get pre-qualified for the loan. Ask the lender before submitting the application if there is a pre-qualification program. The loan officer will tell you what you need to do to get this done; it could save you a hassle once you have submitted your application with the fee.
If you choose to get a home-equity loan with your current lender because they can give you the best deal, you could save money on the fees. And, the process can be smoother since the lender already has information about you. You also may not need to get a new appraisal on your home when you apply for a home-equity loan with your current lender. However, this could be a rare occurrence in these days of fluctuating real estate values.
A full-blown credit history is not usually required to obtain a home-equity loan. The lender will usually just check your existing credit file and do a simplified income verification. It is important that your mortgage payment record be in good shape.
Fees
Did you know that you may be able to include most if not all costs of obtaining a home-equity loan in the new loan? Each lender has its own rules, so be sure to ask your lender how it handles the fees. Including the costs in the loan makes it that much easier to go through the process because you won’t be required to come up with a lot of out-of-pocket cash. The most significant cost that you can include in the loan amount is the points. Instead of paying them outright, you can finance them with the principal amount. Just remember, there’s no such thing as a free lunch! Taking out a bigger loan will mean higher monthly payments.
Thanks to bank regulators, lenders must provide people who take out a home equity loan with a reasonable estimate of settlement costs and fees associated with the loan, this is called a "Good Faith Estimate". They must do this within three business days after receiving your application.
Appraisals
As the name home-equity loan suggests, you must have sufficient equity in your home before you can tap into it! As we said earlier, lenders are not usually willing to lend you more than 75 to 80 percent of the value of your property (some lenders may lend you more than that depending on their lending policies, so it's a good idea to shop around), minus your outstanding mortgage balance. Here’s an example.
Let’s say your home recently appraised for $155,000. Your mortgage balance is $109,000. You could qualify to take out an equity loan or line of credit of approximately $7,250.
Value of the home
|
$155,000
|
75% of the value
|
$116,250
|
Minus: Principal balance remaining
|
-109,000
|
Amount you can borrow
|
$7,250
| If your home happens to appraise lower than you expect, you may have to wait for the real estate market to improve and your mortgage principal balance to decrease (through your mortgage payments) before being able to get the amount of money you need.
What Can You Deduct On Your Tax Return?
There are some special tax rules with regard to what costs can be deducted in connection with an equity loan or credit line. Let’s see what tax breaks you’ll get from Uncle Sam.
Interest
The beauty of home-equity loans and lines of credit is that the interest, on debt up to $100,000, is tax deductible no matter what you use the money for.
CAUTION!: If you are married filing separately, the limit is reduced to $50,000.
If you borrow against the equity in your home to make major capital improvements to the home, the interest on up to $1,000,000 of debt (counting both your existing first mortgage and the home-equity loan) is tax deductible.
CAUTION!: If you are married filing separately, the limit is reduced to $500,000.
Points
There are two different ways that the IRS treats home-equity points.
- If you are borrowing to make capital improvements to your home, the points are fully deductible in the year you borrow. Now, this gets tricky if only a portion of the loan is used for the improvements. If this is the case, only the portion of the points related to the improvements is deductible in the year you borrow. The remaining points are required to be deducted equally each year over the term of the loan or the line of credit.
- If you are borrowing for any other reason, the points must be deducted equally each year over the term of the loan or the line of credit.
- If you pay off your loan early, the points become deductible immediately.
This information should serve as a guide for you--to give you an idea of what’s tax deductible and what’s not. You should call your tax advisor to clarify anything you don’t understand and to verify that the information is still valid under current law. Keep in mind that tax laws are always subject to change, and that the information provided here could change at any time, so don’t take it for granted!
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