A smart use of home equity?

Been looking twice at those attractive-sounding offers to "consolidate" your debt?

Paying off high-interest credit-card debt with a home-equity loan can help financially troubled families make ends meet. And in some cases the interest on a home-equity loan may help reduce income tax.

Home-equity loans are certainly popular.

The Federal Reserve reports that outstanding consumer debt exceeds $1 trillion. Of that amount, SMR Research Corp. reports that in 1998 $525 billion was home-equity debt and $450 billion was credit-card debt. According to the Consumer Bankers Association 1998 Home Equity Lending Survey, consumers have nearly 80 percent of the appraised value of their homes in loans or potential loans. That's up seven percentage points from the CBA's 1997 study.

Lenders today allow homeowners to borrow up to 100 percent, and even 125 percent, of the value of their homes to consolidate debt. The 125 percent loans present problems. "We feel these loans are very risky and not in the best interest of the customer," says Ken Fazio, vice president at Champion Mortgage in New York.

Consider what a 125 percent loan means when you sell your house: With a 125 percent loan taken on a house valued at $200,000, you would have to bring $50,000 to the closing before even considering the cost of the sale.

Also, home-equity loans are not treated the same way as credit-card debt in the event of a bankruptcy. While credit-card balances may be wiped out, homeowners must continue to pay on the home-equity loan or face possible foreclosure.

According to the National Home Equity Association: "About 2 percent of home-equity borrowers default on loans and end up in foreclosure proceedings. This figure compares to 1 percent for prime loans and 3 percent for government-guaranteed mortgage loans."

Home-equity loans are made in two ways. The first option is a fixed term and fixed amount. Typically these mortgages are made for periods of 5 to 20 years. Each payment is the same, and the loan is paid off at the end of the term.

For example, you borrow $20,000 for 10 years at a fixed rate, and at the end of 10 years the loan is paid off.

The second alternative is a line of credit secured by your house. The line of credit can increase and decrease just as a credit-card balance does. The monthly payment is usually based on 1.5 percent to 2.5 percent of the outstanding balance. As with a credit card, this balance can go on almost indefinitely as long as the borrower pays the interest and a small amount of the loan principal each month.

Many lenders will terminate the line of credit after 10 years and require that the balance be paid off over the next 10 years. Also, lines of credit usually have adjustable rates of interest. So in a time of rising interest rates, you'll pay more every time the prime rate increases.

Another problem: Consumers who take out home-equity loans to consolidate credit-card debt often run up their cards again. One study showed that 70 percent of households using equity loans to consolidate debt had new credit-card balances at the end of a year.

To prevent such behavior, some lenders will go to the extent of paying off credit cards with checks sent directly to the credit-card companies. Some even require that the cards be cut up at the loan closing.

Finally, the tax deductibility of home-equity loan interest sounds enticing but may not always benefit average borrowers.

According to a recent study by the National Home Equity Association, the typical nonprime borrower is 48 years old with an annual income of $34,000. And most of these loans are taken to consolidate high-interest debt or finance a child's college education.

For most borrowers in this income-tax bracket, the standard deduction would exceed any benefit gained from itemizing interest expense. In order for a homeowner to take the mortgage-interest deduction, the homeowner must have enough itemized deductions to total an amount greater than his particular standard deductions.

Tax laws also limit the amount of loan interest by a formula that only allows interest on loans up to 100 percent of the fair market value of your home. Thus, the portion of a loan that exceeds the 100 percent figure - such as with a 125 percent loan - is unlikely to qualify for a tax break.

(c) Copyright 2000. The Christian Science Publishing Society