As mortgage rates have hit 40-year lows, refinancing has been all the rage. But experts such as financial adviser James R. Cotto say consumers also should seriously consider consolidating debt through home equity loans.
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Cotto, the managing director of Cotto & Padovani, isn't in favor of betting it all on the ranch, so to speak. But with credit cards sporting annual interest rates as high as 21% and home equity loans charging in the neighborhood of 3.75% to 6%, Cotto believes that consolidating debt through a home equity loan or a second mortgage makes tons of sense. Plus, he notes, you can write off interest on a home equity or second mortgage loan, which you can't do with the interest you pay on credit cards.
Here, Cotto runs some numbers to make the case for swapping expensive "plastic" debt for a loan against the value of your home. The sad but true fact is that many Americans are loaded up with credit card bills.
For homeowners, Cotto lays out a plan to make the best of a bad situation.
TSC: Is it really a smart thing for people to consolidate their debt through home equity loans -- and are a lot of people doing it?
Absolutely. Mortgages are still just above their lowest rates in 40 years. Statewide in New York, that's about 6.75% with a 1% closing point. People around the country who are refinancing are finding this out, because this is an historical event. And the same logic applies to taking out home equity loans.
TSC: Revolving credit card interest rates really vary, but generally, how much are credit card companies charging folks these days?
Some credit card companies initiate their cards at very, very low rates -- 1.9%, 2.9% -- and older credit cards were charging 14% to 21%. But on average, you are seeing anywhere from 8.5% up to 21%. That's very substantial, and it's not tax efficient.
TSC: How, then, can someone with multiple credit cards with substantial balances consolidate those bills?
One way is through mortgage refinancing or home equity loans. If you had a home, you could refinance your first mortgage or take out a home equity loan -- or even refinance with a home equity loan on top of that.
For a person living in New York with four credit cards charging annual interest rates of even a relatively modest 9%, with first mortgages running at 6.75% with one point in New York and home equity loans running 1% below the 4.75% prime, you can see the benefit right there --
you can get a third of your payments back in taxes. That's attractive.
Bottom line is, you're looking at borrowing tax-effectively at about 3.25%, 3.3% ... which is far more attractive than a credit card rate of 9%. And we're not even talking about those cards with the exorbitant 21% rates.
TSC: What's the difference between a home equity loan and a home line of credit?
A home equity loan and a home line of credit are one and the same. They're synonymous. And the benefit of a home equity loan is you're not paying until you draw down on it. And once you pay it back, you are able to draw down on it again. So, it's exactly like a line of credit. In fact, I advise people to have home equity loans set up for "just in case" purposes -- for the possibility of losing your job or maybe seeing your income fall, for example. They're a safety net.
TSC: On a fully mortgaged home originally bought for $200,000, how much home equity could a homeowner expect to get?
It depends on the borrower's creditworthiness and the loan-to-value ratio, which is the difference between the price of the house and the balance on the existing mortgage.
Let's say you purchased a house valued at $200,000, with $100,000 left to pay on it. That means you have a 50% loan-to-value ratio. Let's say that house is now worth $220,000. Depending on the financial institution, the borrower may be able to draw up to a maximum of 80% of the current value of their house. In this case, 80% of the current value is $176,000. Less the $100,000 existing loan balance, this homeowner could potentially take out a $76,000 home equity loan.
TSC: In comparison to the high rates credit card companies charge, home equity loans appear to make sense. But given the fact that there are so many people out of work right now and that we are stilil in or are just coming out of a recession, is taking out a loan against your home, of all things, a prudent thing to do?
I would never suggest borrowing more than you can afford to pay back. But if you're already extended, you might as well be borrowing as efficiently as possible. If you are borrowing with a 9% mortgage and you can reduce that to 6.75%, you should consider doing that.
Conversely, if you have a 7%, 30-year fixed mortgage and you've got $25,000 in other mortgages and car payments that average 10%, I would advise paying them off with a home equity loan.
TSC: Is there any downside to consolidating debt, besides your rule of thumb about not going in over your head and taking on more debt than you can handle?
The only downside would be to do it when there isn't a need to do it, when it's less than a 1% difference. You have to run the numbers, especially because there are other costs associated with doing a refinancing -- closing costs, points, attorney fees, appraisals, mortgage recording tax, title lien searches. You also have to consider your time frame; if you are planning on selling the house within a year, why would you go through the whole ordeal of refinancing?
TSC: How can a person find out all of these fees?
Right from the financial institution or your financial adviser. They should be able to help you determine at least an estimate of all of these fees. Then, you either run the numbers on your own or ask your financial adviser if the numbers work, and how long it will take you to recoup all of these costs.
TSC: How quickly should a person repay a home equity loan?
Since it's an interest-only payment, you are only servicing the interest. ... The bigger question is, "When do you reduce your debt?" And the answer is: When you have the capability; when you have the cash flow. But while many of my clients are high net worth and don't carry large or revolving credit card balances, many do have second vacation homes, and there are those that like the tax write-offs.
TSC: Which is better, a second mortgage or a home equity loan?
A second mortgage is an interest and principal loan that's usually for a 15-year period, at a rate that's typically 1% to 2% higher than the first mortgage. Depending on your creditworthiness and loan-to-value ratio, it's probably 8% to 10%. So I would probably opt for the home equity loan.