Home equity loans good for big goals, but not for casual cash

For many years, banks and savings-and-loans - and their customers - gained financial strength through home ownership. The banks made profits by lending money to build or buy homes, and the public acquired real estate, one of the most important keys to financial security. Now, because of tax reform, these banks, S&Ls, brokerages, and finance companies are heavily pushing a product that could take away that key from some homeowners.

Tax reform did not create the home equity loan, but by keeping the interest deduction for first and second mortgages while taking away the deduction for other consumer debt, Congress opened up the home equity loan to many good uses - and the possibility of many abuses.

``Home equity loans are good for people who want to use them for the right thing,'' says Paul R. McLaughlin, an accountant and financial adviser in Braintree, Mass. ``But the person who owes money to MasterCard, Visa, American Express, or whatever and uses these loans to consolidate bills is running a great risk.

``If you run into hard times and you can't pay your American Express or Visa, the chances of their coming after you and taking your house are slim to none. But if you consolidate them with a home equity loan [and then run into credit trouble], the chances of keeping the house are slim to none.''

This may be an overstatement, but it is a key to the debate over what could turn out to be the most controversial product to be pushed by the banks since banking deregulation. Americans have some $3 trillion in equity locked up in their homes, and lenders are working overtime to see how they can get a piece of it.

What some are calling a loophole in the tax law preserves the interest deduction on home loans and on home equity loans, or second mortgages, as long as the total debt does not exceed the purchase price, plus the cost of any improvements.

Let's say you bought a house a few years ago for $100,000, making a 20 percent down payment. Since then, you've put $15,000 worth of improvements in the place. The equity you can tap for any purpose is $35,000: the down payment plus improvements. Most banks will lend you up to 75 or 80 percent of that amount, or $26,250 to $28,000.

You can raise the base above $35,000 if the money is used for educational or medical expenses. So if the value of this home has appreciated to $130,000, you could borrow up to 80 percent of that higher figure for school or medical costs.

While there are dangers, these loans have several advantages. They give you quick access to a large pool of money at reasonable rates, more flexibility in repaying the loan, and a tax deduction.

Before considering a home equity loan, however, think about how you're going to use the money. It should be reserved for important goals, like home improvements, retiring expensive debt, your children's - or your own - education, or starting a business. It should not be considered a pool of money that's ``handy'' for whatever comes along.

Also, think about how you're going to pay the money back. If you can fit the extra debt into your monthly budget, fine. Or if the loan helps lead to a more valuable home or a new profession that will eventually generate the money to pay off the debt quickly, that makes sense, too.

But unlike home mortgages, which have long-term fixed rates or adjustable rates with caps, most home equity loans have no caps to prevent the interest rate from rising beyond your means. If the interest rate rises, so do your payments, perhaps hundreds of dollars a month.

How that rate is adjusted is also important. While adjustments on first mortgages are usually keyed to a widely watched index such as the prime rate or Treasury bills, some lenders tie home equity loans to their own certificates of deposit, or to whatever rate bank officials set.

When you're comparing rates, watch for ``teasers'' that are several points below what other banks are charging. These rates may be in effect for only the first three months, which is fine, as long as the long-term rate doesn't surge past the competition's. A bank may also offer to waive many of the closing costs to get your loan. Again, that's good, if the long-term costs of the loan are reasonable. Lenders must disclose the annual percentage rate for the life of the loan; this is your basis for comparison.

``In a free market and free economy, there's a need for consumers to learn the lesson of caveat emptor,'' says George Schuepert, a partner and banking consultant at Coopers & Lybrand, the accounting firm. ``But the lenders have to show some responsibility, too.''

Many home equity loans aren't single lumps of money but lines of credit that can be tapped as needed, usually by writing a check. You can also tie your home equity to your credit card. Here, any outstanding balance on your credit card is taken from your home equity loan. So a credit card statement will always show the maximum available credit.

Although your credit card balance doesn't change, the equity in your home is going down, notes John C. Pollock, editor of the Bank Credit Card Observer newsletter. ``You could owe so much that when it comes time to sell your house, your profit may be reduced substantially,'' he says.

Though lending institutions will be pushing home equity loans especially hard after the first of the year, remember that the consumer interest deduction is being phased out, not eliminated, as of that date. Next year, 65 percent of consumer interest will still be deductible; 40 percent will be deductible in 1988; 20 percent in 1989; and 10 percent in 1990.

This means you don't have to rush out and get a home equity loan and get rid of all other consumer debt immediately. For most moderate-income taxpayers, losing 35 percent of the interest deduction won't make enough difference to risk getting a loan that's too expensive or too risky.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway St., Boston, MA 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.