Wednesday, May 16, 2007

Home equity loans: Are you kidding?

I hate home equity loans. A few people are going to argue with me on this one, but let me offer a little perspective first. I see a home (at least, your primary residence) as a home, not an investment. There is nothing that could convince me to sacrifice the security that I have in my home. To me, equity is security. The more equity I have, the more security I have. That is why my personal goal is to become debt free including my mortgage. I want to own my home free and clear. Unfortunately, thanks to the laws of our government (the same government that years ago encouraged banks to sign subprime loans in order to increase home ownership and diversity) allows them to take my home away for nonpayment of taxes whether I own it or not.

That said, it is easy to presume that we never really own our home (well, we don't) we just lease it from someone else. We lease it from a bank at a high cost, we lease it from the government at a low cost. But let's focus on our relationship with the bank here.

Let's say I buy a home and finance $100,000. I pay for 5 years and have around $30,000 in equity (thanks to the principle I've been paying and the appreciation on the home). Now I decide to take the bank up on its offer (aren't they so generous?) to take out an additional home equity loan. I now owe $125,000. I'm still paying interest, I now have two loans so I'm paying more interest, and I've now borrowed more against my home than I bought it for in the first place half a decade ago.

And what do these home equity loans do? If I take the advertisements at the bank as any indication, they go towards home improvements, vacations, debt consolidation.

Home Improvements: Very few home improvements are going to provide a 100+% return. Worse, now that I've financed this home improvement, I have to gain a much higher return to get my money's worth. When I go to sell the house, that improvement simply isn't going to give back what I put into it in the initial payment and the interest thereafter. It's simply not an investment to improve on your house. If you want to do any improvements, you must save for it. You (hopefully) intend to stay in your home for many, many years. It isn't going anywhere, and you have plenty of time to save. Plus, your savings draw interest for you, instead of just making your home improvement that much more expensive.

Vacations: Do I even need to touch on this? It's very simple. Never finance a consumable! This includes gas, food, entertainment, and vacations. You continue to pay interest on the balance for many years after the initial purchase is long gone. What kind of crazy financial plan is that? If you must finance, at least keep it to physical things that retain value and can be sold if you need to pay off your loan.

Debt Consolidation: This is a fine goal, but there are so many different avenues for debt consolidation, I just don't think low-interest equity loans are the answer. You can get a low interest credit card or credit union loan instead. If you are in so much debt that you are considering consolidating, the last thing you want to do is pull out the equity in your home. It could lead to a financial disaster should you ever be forced in a position where you have to sell, and if you do need to do something drastic - like declare bankruptcy - it is still possible to keep your home through the process, something that is much less likely if you cannot afford the payments.

A home purchase should be considered final at the time of closing. Any further decisions regarding the home loan should be focused on reducing the overall principle and total interest that you pay out of the loan. Note, I did not say that changes should be made to lower your monthly payment. That may sound good in your head, but anything that reduces your interest liability and principle is going to reduce your monthly. If your monthly is reduced without those two, it is likely a loan that is going to land you in a financial black hole.

None of this applies to investment properties, which you hopefully won't be living in. But a home is a huge purchase, and you spend a huge amount of money getting into it and financing it. Long-term, any risk to that property is just a bad idea.

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