A home equity loan essentially is a second mortgage loan that allows a homeowner to access the accumulated equity in the home. The loan may be set up as a traditional second mortgage or as a line of credit. The traditional loan provides a lump sum when the loan is closed, whereas the line of credit gives the borrower the right to draw cash over time as needed. The federal government allows homeowners to deduct all interest payments on such loans from their income taxes, but not on personal debts such as credit card interest. Borrowers may be able to reduce their after-tax cost of credit by converting nondeductible consumer loans to mortgage loans.

There are several limits on how much you can borrow on a home equity loan. Most lenders will not be willing to allow you to convert all of your equity. You may be restricted to a total debt of 80% of the value of the home. The lender may also require you to have sufficient income to qualify for the increased debt as well. State law may place further restrictions (for example, in Texas, you cannot get a home equity loan at all). Also, $100,000 of home equity debt above your acquisition debt is eligible for federal tax deductions of interest.

In order to take money out of your home, the amount of equity you own limits how much you can borrow. If the increased debt is more than 80% of the home's current value, you may not be able to borrow as much as you want unless you obtained mortgage insurance. If the value of your home has declined since you bought it, you may even have difficulty refinancing the loan at the same amount. You may want to have the home appraised before you apply for the loan.

Fees for a second mortgage may be more expensive than for the original loan. If you are applying for an existing loan, you may have to pay a prepayment penalty of as much as 1% of the old loan balance. Also, arranging a new loan may require payment of closing expenses, along with discount points, application fee, survey fees, and title insurance. Some of these costs may be waived if the loan is with the original lender. Second mortgages have closing costs as well. Currently, many lenders of home equity loans are reducing or waiving much of the closing costs for such loans.

REFINANCING

When interest rates drop, you may take out a new loan at the lower rate and pay off the old loan. In most cases, the new loan is just enough to pay off the old loan balance. You may want to include a little extra to cover the closing costs on the new loan. After the change, you will have lower monthly payments. Also, you may be able to structure the new loan to give you the same payments you currently have, but for a higher balance. The additional proceeds from the new loan could be used to pay off other debts.

It is difficult to guess when interest rates have dropped low enough for you to get a new loan. But there are certain guidelines that you can follow. First, you should not refinance unless the current rate is at least two percentage points below the rate you currently have. Second, you will want to reduce your monthly payments enough so that you can recover your refinancing costs before you sell the house. Third, if you calculate what your new principal and interest payment will be and compare it to your current payment (subtract the part going to escrow), you will determine your monthly savings. Fourth, dividing total refinancing costs by monthly savings indicates how many months it will take to recover costs.

CONVERSION LOANS

If you wish to increase your retirement income, you may wish to consider a home equity conversion loan. Elderly homeowners are allowed to mortgage their homes in such a way that lenders will provide monthly payments of supplemental income. The amount of income depends on whether you get a life annuity, which pays you as long as you live in the home, or a term annuity, which pays for a specified number of years. The balance of the loan is paid out of the proceeds when the home is sold.

TAX DEDUCTION

All interest paid on a mortgage loan used to buy a home is an itemized deduction for federal income taxes, up to a limit of $1,000,000 in loan principal. For a second mortgage or refinanced first mortgage, interest is deductible up to a limit of $100,000 over the amount of the loan used to purchase the home. These deductions apply to both first and second homes, and the property value must exceed the debts.

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