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David Bach The Automatic Millionaire

David Bach, The Automatic Millionaire

Seven Ways to Be Home Equity Savvy

by David Bach

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Posted on Monday, August 13, 2007, 12:00AM

I'm often asked if it's a good move to pay down high-interest credit card debt using a lower-interest home equity loan or line of credit.

My short answer? No.

From Dream to Nightmare

According to the Mortgage Bankers Association, Americans had more than a trillion dollars in outstanding home equity loans in the first quarter of this year. It's estimated that one in every three homeowners borrowing against their home use the proceeds to pay down credit card debt.

While this may make sense on paper considering the interest savings and tax deductibility, in my opinion using home equity to pay off credit cards could result in a financial nightmare.

So here are seven tips to help you make smart decisions about using -- or not using -- the equity in your home:

1. Don't rely on home loans to pay credit card debt.

The primary difference between credit card debt and home equity loans is that the latter are "secured" loans. You've pledged your house as collateral against the amount you borrow. If you fall behind on your payments for any reason, you could potentially lose your home.

In my experience, when people borrow against their homes to eliminate credit card debt, they typically just slide right back into it -- at the same level or worse -- within two to three years. That's because even after wiping the slate clean, they don't change their spending habits. They max out their credit cards all over again and find themselves in an even deeper hole.

Is it possible to use your home equity to pay down debt and then stay out of debt? Of course, but generally those disciplined enough to pull this off don't let their credit cards run amok in the first place.

Instead, I suggest calling your credit card company today and asking to have your interest rate lowered. It's a simple phone call that takes all of five minutes. For more details, read my earlier columns "Five Steps for Ditching Credit Card Debt" and "What Credit Card Companies Don't Want You to Know," and check out the reader comments for more great tips on getting out of credit card debt without using your home equity.

2. Use home equity credit to build assets.

Besides a financial emergency, the most worthwhile reason to tap your home's equity is for the purchase of, or investment in, appreciating assets. Buy an income-producing property or a second home and you've got a great investment.

Adding onto or upgrading your present home can be another good use for your home equity, if done carefully. According to Remodeling magazine, remodeled kitchens and bathrooms usually hold their value the best.

However, I think remodeling should be done primarily so that you and your family can better enjoy your home, not simply to try and increase its value. There's always the possibility that the money you spend on home improvements won't be recouped.

In addition, investing in your business or financing the startup of a smart new business could change your life. But notice the word "smart": Many new businesses fail, so there are no guarantees. Still, this kind of investment is wiser than using home equity to pay for a credit card maxed out by unnecessary impulse purchases.

3. Learn how different home equity loans work.

There are two primary types of home equity financing:

• Home equity loan: Generally called a second mortgage, this type of loan allows you to borrow a set amount that you receive in a lump sum up front. You pay it back over a specified period (typically 10 or 15 years) in monthly repayments. The interest rate is usually higher than a first mortgage but lower than most credit cards, and fixed for the life of the loan.

•HELOC: This stands for "home equity line of credit," and generally works like a credit card. Your lender assigns you a maximum amount up to which you can borrow. You can use only what you need if and when you need it, up to the limit. Interest is typically variable, but usually lower than credit cards because the credit is secured by your home.

4. Know your interest rates and terms.

First, shop around for the best rates (check out Bankrate.com or LowerMyBills.com to compare lenders' rates). Then, see if your primary mortgage lender can offer you a deal. But make sure you understand how it works.

For instance, is the loan tied to the prime rate? Is it fixed or variable? Variable rates can hurt if rates keep going up. Determine when that variable rate adjusts and what your new payment amount will be when it does.

Read the fine print: Is there an origination fee (even if you don't use the loan)? Is there a property appraisal or application fee? Will you incur closing costs? Will your payment amount increase if you're ever late? And finally, are there fees if you pay the loan back early?

5. Get the tax deductions.

Just like with your first mortgage, the interest you pay on your home equity loan or HELOC may be tax deductible -- by up to $100,000 -- even if you're not using the loan for home-related expenses.

Your deduction may be limited if the combined amount of your first mortgage plus any home equity loans totals more than the property's actual value. For more information, check out IRS Publication 936.

6. Borrow no more than you need.

Ideally, I recommend keeping a minimum of 20 to 25 percent of equity in your home to ensure that you have a cushion should you ever find yourself in an emergency where you absolutely need to tap equity. This approach also grants you the peace of mind in knowing that you have some insulation against a declining real estate market.

To calculate your equity, simply take the current market value of your home and subtract all outstanding mortgages and home loans.

7. Don't use your home loans like an ATM.

Over the past several years, lenders have made it excessively easy to pull money out of your house. Many new first mortgages come with complementary pre-approvals for generous home equity lines, often equipped with fast-access tools such as checkbooks and ATM cards.

While these are great tools of convenience, be honest with yourself about whether you're responsible enough to handle the temptation.

The Ultimate Piggybank

Your home is very likely to be the foundation of your financial security. If you live off the equity in your home every three to five years by using it to pay off credit card debt, and then find yourself in a down real estate market like we're currently experiencing, you could wind up owing more on your home than it's worth.

This could lead to you being one of the millions who will lose their homes to foreclosure in the next few years. I don't want that to happen. So please be careful, and think twice before you borrow to pay down those credit cards.

Your home is the ultimate piggybank -- don't break into it unless it's a true emergency, or if doing so can truly help you live a richer life.

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48 Comments

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  • Yahoo! Finance User - Saturday, August 18, 2007, 10:28PM ET  Report Abuse

    • Overall: 3/5

    Different userid, same scam going on below my post. Google First Financial and a scam site is the first thing to pop up.

  • Fay - Saturday, August 18, 2007, 4:31PM ET  Report Abuse

    • Overall: 2/5

    David- YOU MISSED THE MOST IMPORTANT ONE THAT TIES IN WITH YOUR NUMBER 1- use a HELOC for an INTEREST CANCELLATION PROGRAM! That is exactly what we have done with the new program called the Money Merge Account using a HELOC. We will actually have our 30 year 1st mortgage AND our HELOC paid off in half the time! Plus, we had enough equity that we were able to pay off all of our other debts. We don't need any more credit cards or loans since now we have the cushion and emergency money from our HELOC. The nice thing about this also, is that there are no extra payments out of our pocket- it is using the bank's money and just re-structuring how we do our banking. I just learned that a similar program has been used in Australia for many years and they pay a lot less interest than Americans! If we had something like this a few years ago, we might not have all the mortgage issues going on and a lot less foreclosures! We went to this website www.u1stfinancial.net/johnfechik and filled out the free financial analysis to see if we qualified, they said you need a FICO score of about 640. An agent callled us and we got on the MMA and I absolutely LOVE it!

  • Angela C.G - Saturday, August 18, 2007, 11:51AM ET  Report Abuse

    • Overall: 4/5

    As a Real Estate Broker, I have seen time and again folks who pulled out an equity line & spent the money on everything but the house. I have not been able to even list many houses because the equity is upside down due to this, and the homeowners are left oweing more than the value of the house less commissions to sell it. Do NOT fall into this trap~!

  • Yahoo! Finance User - Saturday, August 18, 2007, 7:53AM ET  Report Abuse

    • Overall: 5/5

    3-1/2 Years ago I used my home equity to invest in two income properties. I have a five year plan to make these as profitable as I can. I have 1-1/2 years left with no regrets! It's one of the best financial moves I made other than for buying my first house instead of renting when I was young. I always listened to how other people became financially secure, then I responded with my own plan. I continue to listen, read and continue my education. I have more risk than other people, but I run these income properties as a business and not just an investement. David Bach is someone to listen and learn from.

  • Yahoo! Finance User - Wednesday, August 15, 2007, 10:36PM ET  Report Abuse

    • Overall: 4/5

    I wish that home equity could not be tapped as easily as it currently is!!! The vast majority of people get themselves into financial pickles by relying on home equity to fund a short budget.

  • Yahoo! Finance User - Wednesday, August 15, 2007, 12:52PM ET  Report Abuse

    • Overall: 5/5

    Great article, if only I read this years ago.

  • Ann - Wednesday, August 15, 2007, 9:34AM ET  Report Abuse

    • Overall: 5/5

    Very Good advice for all homeowners. The business of pushing home equity loans on consumers has grown tremendously over the past 10 years and homeowners need to be cautious as to when and if they take a home equity loan.

  • Yahoo! Finance User - Wednesday, August 15, 2007, 12:13AM ET  Report Abuse

    • Overall: 5/5

    To all the negative feedbackers- People who have high credit card bills and carry balances will piss away the home equity $ too! They suck with $ and will blow it all and save 0. Dave is trying to help prevent this. PS: For all the "this is too basic for me" people", when you have 5 mill in the bank, you can leave that comment!

  • Michael H - Tuesday, August 14, 2007, 11:56PM ET  Report Abuse

    • Overall: 4/5

    I have a friend who did a refinancing and rolled up his credit card into it. Since refinancing started the mortgage process all over again, he's going to be paying that credit card debt off over 30 years. So I don't know if this was such a good deal, even if he did get a lower interest rate. I'm also worried that he will indeed "need" another home equity loan or refinancing. Unfortunately, he is the type of person who thinks things are always going to work in his favor....and when they don't he just lies to himself about it. There are a lot of people out there like my friend, unfortunately.

  • Yahoo! Finance User - Tuesday, August 14, 2007, 11:43PM ET  Report Abuse

    • Overall: 1/5

    Not paying off a debt having interest rate over 20% with a home equity loan of much lower rate? It is a really stupid advice.

  • Larry - Tuesday, August 14, 2007, 8:34PM ET  Report Abuse

    • Overall: 2/5

    The author gives some good advice when he talks about not using your home equity line like an ATM and making sure you take advantage of tax benefits. However, he is mistaken in saying that home equity loans or lines should not be used to consolidate credit card debt. Here's why: If someone has a mortgage and credit card debt and the payments on the credit card become hard to keep up with, what's the likelihood that that person will default on their mortgage and lose their home? On the other hand, if you consolidate that credit card debt with a home equity line, your payments typically decrease and so does the amount you pay in interest every month. This clearly helps you pay down the debt faster and actually save your home. The author says that people with bad spending habits are just going to abuse their home's equity. But what's to stop them from digging a deeper hole by taking on even more credit card debt? Lastly, the last thing a debt junkie should be thinking about is buying an investment property if they are struggling with credit card debt.

  • Joe - Tuesday, August 14, 2007, 8:22PM ET  Report Abuse

    • Overall: 2/5

    ok

  • Marty - Tuesday, August 14, 2007, 8:04PM ET  Report Abuse

    • Overall: 4/5

    Good sound advice.

  • J_E_S - Tuesday, August 14, 2007, 7:49PM ET  Report Abuse

    • Overall: 4/5

    As an economics professor, I found this column to be sound, helpful advice for this work-a-day world.

  • Beer Baron - Tuesday, August 14, 2007, 7:28PM ET  Report Abuse

    • Overall: 5/5

    Thanks for the Bachtastic schooling.

  • Cesar - Tuesday, August 14, 2007, 6:56PM ET  Report Abuse

    • Overall: 5/5

    Your article explained very clearly how refinancing works, I enjoyed reading it.

  • joseph - Tuesday, August 14, 2007, 6:28PM ET  Report Abuse

    • Overall: 5/5

    It's pure commonsense, but many Americans seem to not understand simple frugality. Thanks for an excellent article.

  • george - Tuesday, August 14, 2007, 5:55PM ET  Report Abuse

    • Overall: 5/5

    Bach is the Man!

  • Ray the loan officer - Tuesday, August 14, 2007, 5:23PM ET  Report Abuse

    • Overall: 3/5

    The basic advise is good for a credit novice. I doubt your readers are novices to credit and home equity in general. I do not agree with you promoting LowerMyBills.com as a good source for information. I've been a loan officer for almost 10 years and my experience with LowerMyBills.com has been very very very bad. Most of the companies in their network hire anyone who can talk a good talk. Most of the loan officers have less than 2 years of experience and many of them don't even own a home (young college drop outs). If a consumer wants to deal with a shady broker and novice loan officers than I do advise them using LowerMyBills.com. A better source would be LendingTree.com. That website at least holds the lenders accountable for poor service and kicks lenders off of the network after repeated bad service.

  • don - Tuesday, August 14, 2007, 4:32PM ET  Report Abuse

    • Overall: 5/5

    Your advice is sound. The reasons to use home equity are few. I have used in the past for home improvements that worked out well. My most frequent use is for new auto purchase every four years. I like the tax deduction. I am seventy years and have a lot of equity.

  • Yahoo! Finance User - Tuesday, August 14, 2007, 4:01PM ET  Report Abuse

    • Overall: 5/5

    Good advice, even if it is a bit too basic for the more "advanced" readers. David Bach shares the simple truth: the road to financial security is not hopelessly complicated (contrary to what some reviewers here would have us believe.) The principles are simple. The hard part is keeping the focus on the destination, and staying on track, and not being distracted from our goals.

  • Big Wavee - Tuesday, August 14, 2007, 3:38PM ET  Report Abuse

    • Overall: 3/5

    Very basic information, however, Americans needs this kind of stuff right now. There are many Americans who use a HELOC (or even worse a HEL that is drawing interest against them) to finance the purchase of unnecessary consumer goods and services -- that boat, beamer, second home, vacation, jewlery, etc.. This is way America is doomed to expereince a very messy credit crunch and millions of foreclosures in the future. All of this so-called "growth" in the economy is a joke that was financed in large part from people up to their eyeballs in debt -- whether in the form of credit cards, equity loans, or other borrowing. Oh.... and I forgot to mention that while other countries in the western industrialized world are spending their tax money on infrastructure (bridges, mass transportations systems) and universal health care -- America is too busy playing cop to the world and spending billions of tax dollars to promote "democracy" in Iraq (which is making it impossible to win the war on terror in the long run because it serves a a recruiting tool for Bin Laden). A better strategy would have been to focus on Afghanistan and leave the middle east alone. Bottom line: America is falling and soon will be a "has been" on the economic superpower scene unless changes are made soon! China and India are rising in economic power beyond even the most bullish expectations! Russia is emerging and Europe's strong currency is making America seem like a banana republic!

  • Rob - Tuesday, August 14, 2007, 2:26PM ET  Report Abuse

    • Overall: 1/5

    Extremely basic information. Appealing title although the substance is for people who have poor credit scores and believe credit is an asset. My advice to Daivd... spice up your advice and intrigue us with your wisdom!!

  • Go Dawgs - Tuesday, August 14, 2007, 2:11PM ET  Report Abuse

    • Overall: 1/5

    #2 is insane. Especially given the realities of the credit and home binge. Build assets? Please David, tell me how you define an "asset?" People should live in their house - not "treat it as an ATM" or some other magic money tree - now, due to greed and ignorance, the U.S. housing market and the Bush administrations complicity in allowing Freddie Mae and Fannie Mac to buy and bundle exotic loans, the entire world economy may grind to depression. I have always thought this guy's title "The Automatic Millionaire" was always silly and his advice fitting for a fifth grader who rides around with his parents looking for houses on the weekends. Not a serious thinker - but, he has certainly become an Automatic Millionaire by selling pedestrian advice to those with the dream of getting something for nothing... Oh well. Best of luck Yahoo! readers - my advise - keep your cash on hand, liquidate your stocks while you still can and for those who are in a situation of near foreclosure on "investment" properties - do yourself a huge favor - save your cash and hand the keys back to your joint venture partner (aka the bank). Good luck.

  • Yahoo! Finance User - Tuesday, August 14, 2007, 1:59PM ET  Report Abuse

    • Overall: 3/5

    All good points in the article. The problem is the people that can most use the advice are not online researching it. If you're not savvy financially why would you be here? Same reason I'm not reading the tabloids! Then you have us goof balls rating the article and either complaining about our situations or saying how easy it is to be a financial guru. We all love financial information...now if we can get all the Lindsey Lohan's to frequent the site we'd really be able to put America's resources to good use!

  • scott - Tuesday, August 14, 2007, 1:52PM ET  Report Abuse

    • Overall: 1/5

    This is typical advice for people who are not responsible with their money. They will never improve their situation because they are irresponsible. No amount of money or advice is going to help those folks. Darwin, anyone? Depending on one's tax situation, deductible debt is almost always better than non-deductible debt. If someone doesn't have the discipline to pay off the credit card every month, then yes, they are at risk of losing their house if they don't pay the bill. So what else is new? Just because someone owns a gun doesn't mean they HAVE to use it. He makes the assumption that real estate is an investment that is worth tapping the equity. So, in effect, he's saying that real estate cannot decline in value. Another poor piece of advice. New business start-up? Another high-risk venture. Finally, he says only to tap the equity in case of an emergency. So, you've lost your job and now you go to the bank to get "your equity." The bank asks you how you are going to pay back the loan, since you don't have a job. Whose equity is it? That's right, the bank. Good luck, just when you need it, you can't have it. Some emergency fund. Best advice: park the equity somewhere safe, liquid, and preferably, tax favored. Contrary to the financial porn these idiots spew to the masses, the best place to park the money is in conservative, cash value life insurance policies -- safe, liquid, and tax-favored. Here's a question for all of you experts: what rate of return does home equity earn? Give up? Zero. That's right, nil, zilch, nada. The house will appreciate / depreciate whether there is an encumbrance or not. The market doesn't care if the house is paid off or fully financed. So why trap the equity in the home, with no liquidity, no use, no control, and no return? No wonder Americans are in trouble. Advice from so-called experts like Mr. Bach.

  • Jesse - Tuesday, August 14, 2007, 1:44PM ET  Report Abuse

    • Overall: 3/5

    there are no universal rules for best use of HE loans. if you can't use good sense, go ODOD and buy nothing except for cash. yes, it is doable.

  • jw - Tuesday, August 14, 2007, 1:43PM ET  Report Abuse

    • Overall: 3/5

    Unfourtunatly Home Equity lines and loans are available to cash illiterate giving writers something to write about. Everyone should have an HELOC with Zero drawn on it just for emergencys and credit cards should NEVER carry a balance. and last but not least NEVER spend more than what comes in. These three simple steps and you can live on 1/2 the income as the people around you carring balances, taking home equity loans, buying the flat screen TV's on payment plans and Leasing that Beamer. My cars are both paid for in full, my mortgages (30 year fixed and MTA) were all paid off in 5-8 years. Why? Cause I did not spend over my head. And I do not make 6 figures.

  • Yahoo! Finance User - Tuesday, August 14, 2007, 1:16PM ET  Report Abuse

    • Overall: 2/5

    If he would have stopped at #1, it would be 5 stars. He talks about not using your home as an ATM, but then lists several ways to use it as an ATM. IT IS YOUR HOUSE, don't put it at risk by borrowing more against it. If you can't buy new kitchen cabinets or a new bathroom with cash, wait and save.

  • Yahoo! Finance User - Tuesday, August 14, 2007, 12:14PM ET  Report Abuse

    • Overall: 5/5

    I hope articles like this reach the people who need them most.

Showing comments 6-35 of 48<< PreviousNext >>

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