Question: I was wondering if you have a home equity loan and you want to sell your house, are you pretty much stuck in your home until the loan is paid off?
Or, when you sell your home, do you just have to make sure you get enough money out of the home sale to pay the home equity loan off? Unfortunately, we were not clear on this when we took out our home equity loan.
L.L., Lake Stevens
Answer: This is a very good question, especially in this time of declining home values.
Home equity loans and home equity lines of credit should be used very carefully. Remember, you’re talking about putting a second mortgage on your home. In the old days, taking out a second mortgage was considered a last resort, an act of financial desperation. Today, people casually use home equity loans to buy cars, pay off credit cards, take vacations and other somewhat questionable financial purposes.
One reason for the rush to home equity loans is the 1986 Tax Reform Act, which eliminated the tax deduction for interest on credit cards, car loans and most other consumer borrowing. The interest expense on home equity loans is one of the few remaining tax shelters left, so many people now use home equity loans to purchase cars rather than nondeductible auto loans. If you can handle the monthly payments, there’s nothing inherently wrong with that.
But as your letter points out, the home equity loan creates a lien on your property that must be paid off if you sell your home. As long as you have plenty of equity in your home (the difference between the home’s value and the total amount of loans against it) that’s not a problem.
But if you don’t net enough cash from the sale of your home to pay off your original and second mortgage, plus all the home selling expenses, you are going to be in trouble because you would literally have to bring cash to the closing table in order to sell your home.
This is becoming an increasingly serious financial risk for many people. As I have previously stated in this column, I expect home values to drop by an average of 10 percent to 20 percent this year.
If you are close to being “maxed out” on your home equity loan, you need to concentrate on paying it down so you don’t find yourself stuck in your home, as you put it.
Another risk of home equity loans is the threat of foreclosure. When you take out a car loan, if you don’t make your car payments, the lender will repossess your car. But with a home equity loan, if you don’t make your loan payments the lender can foreclose and take your home.
Home equity loans were originally intended to finance home improvements. That makes sense because improvements add value to your home, which increases the collateral for the loan. If you ran into financial difficulties that forced you to sell, the increased market value would typically cover the additional debt.
But you can’t necessarily count on that increase in value now, especially with the current slump in the housing market.
I advise people not to use their home equity loans any more than they absolutely have to because of the risk involved by shrinking equity. Be sure you have the financial resources to make the payments. And be aware of the consequences if you don’t.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206 or e-mail economy@heraldnet.com.
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