Myth: Home Equity loans are cheap, efficient, and safe ways of pulling equity out of your home on a “as needed” basis.

Truth: Home Equity loans are glorified credit cards that are very expensive in the monthly payment, and some have hidden call features that can leave you with a bill you can not pay except with the foreclosure of your home.

Home Equity loans are the new rage. The Home Equity Line of credit is the new chic, sophisticated way of avoiding taxes by turning your car loans and credit card loans into tax deductible payments. Because these loans are secured, tax deductible debts, they are at faily moderate interest rates. Even better, Home Equity Lines of Credit (HELOC) aren’t the old, undesirable “second mortgage” that people who could not pay their bills had to get on their home.

None of these statements could be further from the truth!

HELOC’s are nothing better, and a whole lot worse, than a traditional second mortgage on your home. Their interest rates appear to be low but are usually adjustable. Instead of a fixed amortizing payment HELOC’s pay like a credit card, a percentage of the balance. HELOC’s have little or no closing costs for the same reason a credit card has little or no closing cost, they are so profitable for the bank (and expensive for you) that no closing costs are necessary. The final and most devastating characteristic of a HELOC is that they usually have a call feature! You might ask, “What is a call feature?”

A call feature is an agreement made by you, that the bank can call the entire balance of the HELOC due upon 30 day notice. Failure to pay the entire balance when called would constitute default of the note and your home could be subject to foreclosure. Why might a bank call a note due? If they needed capital they could call the note due. If you lose your job and they are afraid your situation will deteriorate they could call it due. If you have a bad pay history but have not defaulted they could call the note due. A call feature is a safety valve for the bank. It is all benefit for them and no benefit for you.

Let’s talk about the payback plan of a HELOC. HELOC’s usually require the borrower to pay the bank 1% to 3% of the balance every month. Usually the 1% payments are on interest only accounts and the 3% payments are on amortized accounts. If you borrowed $20,000 on a HELOC, your payment would be as little as $200 per month on an interest only loan or as much as $600 per month if it was an amortizing loan. Compare that to a standard fixed amortizing loan at a comparable interest rate: $329 per month. The truth is that the Opportunity Cost of the very high monthly payment is nearly double the extra tax deductible interest paid on a standard second mortgage (See article on Opportunity Cost).

HELOC’s are nothing more than a marketing tool that suckers in clients because of what they believe to be true. People believe closing costs are expensive, so on HELOC’s the bank hides the cost in high payments. People believe that having a Second mortgage is bad, so the banks changed the name to a Home Equity Line of Credit because it sounds better (same thing). People believe they can use a HELOC for liquidity but they don’t know that when they need it most (as would be the case if you lose your job) the bank can, and will, close it. People believe that fixed second mortgage rates are high, so banks offer low adjustable rates that can change on little notice and have no real interest rate caps. People believe that HELOC’s are a safe alternative to second mortgages, and they don’t know that they have signed up for a foreclosure clause that Banks refer to as a Call Option.

Fixed amortizing second mortgages are a far better choice because they have better terms. Their payment is lower and fixed. They have no Call Option. They have closing costs but they are netted from the proceeds and recovered in the lower monthly costs. They give you the money up front so they can not be revoked or closed in an emergency. And the only way you lose your home is by not paying the payment.

Don’t be fooled by a marketing scheme! Home Equity Lines of Credit are bad business dressed up in lots of attractive fluff. Fixed amortizing second mortgages are the way to go.

Article authored by John E. Harris, Moneyworks4u