Breaking the Home Equity Piggybank

For the vast majority of people “home sweet home” is their most valuable asset. Borrowing against a home can free up cash for many purposes that would otherwise be out of reach. Enter home equity loans and home equity lines of credit (HELOCs), both ways to access home equity without the homeowner having to sell. Home equity loans and HELOCs are essentially second mortgages that are secured by the home as collateral.

To calculate equity, subtract the amount you owe on your mortgage from your current property value. Generally, lenders will let you borrow up to 85% of your home equity, depending on your credit score and history, employment history, and monthly income and monthly debts. However, if you default on payments for either a home equity loan or a HELOC, the lender can foreclose on the property. That said, tapping into your home equity can be a sound strategy to raise cash for large purchases if and when you need it.

The rundown on home equity loans:

  • Lump sum
  • Fixed interest rate
  • Conventional loan structure separated into interest and principal
  • Monthly payments are predictable and don’t change.
  • Monthly payments are for a set period.
  • Monthly payments are made in addition to mortgage payments.

The rundown on home equity lines of credit:

  • Revolving credit line, money is withdrawn as needed (like a credit card).
  • Variable interest rate often begins at lower rate than home equity loans.
  • Conventional loan structure separated into interest and principal or interest-only payments
  • Monthly payments adjust up or down based on a benchmark interest rate.
  • Rising interest rates can increase payment.
  • You only pay interest on the money you withdraw, not the total credit available.
  • Some lenders allow partial or full conversion to fixed rate home equity loans.
  • The typical borrowing period is 10 years followed by a repayment period of 10 or 20 years.
  • During the borrowing period, you have to make minimum monthly payments on the amount you owe..
  • Once the borrowing period ends, you have to repay the remaining balance, like a conventional loan..
  • Interest may be tax-deductible.
  • You can make additional principal payments.
  • You can refinance.

Which option is right for you? Home equity loans could potentially be better for people who have an upcoming one-time expense with a known cost. For example, this might include home improvement projects, a down payment on another property, wedding expenses, emergency expenses, even credit card debt consolation. Home equity loans could also benefit people who want to avoid overspending. On the other hand, HELOCs could potentially be better for people who have upcoming variable or periodic expenses and would benefit from access to a revolving line of credit. For example, this might include home improvement projects, college expenses, medical bills, long-term care expenses, or a new business venture. As with most financial planning questions, the answer to this question depends on each homeowner’s unique circumstances, so this is a great question to discuss with a financial advisor.

To Lend or Not to Lend – That is the Question

There are times when lending one’s ear to a friend or family member going through a difficult time just isn’t enough. What they need the most is an infusion of cash. Should you or shouldn’t you reach into your pocket and help them out with a good-faith loan? While this intrepid financial planner cannot advise on relationship dynamics and how they might be detrimentally affected with a personal loan, I can tell you how to protect yourself if you do decide to go ahead with one.

Draw Up a Promissory Note
Despite everyone’s best intentions at the outset, a handshake is not enough to seal the deal. The best thing each party can do is protect themselves with a written contract called a promissory note. Basically, the promissory note is a document wherein the borrower promises to pay the lender back. It should state the loan amount, the interest charged, the repayment plan, the per diem for any late payments, and be signed by both parties. Once you have agreed on the interest rate, you can use an online calculator to calculate the amount of each payment over the term of the loan. Regarding repayment, you can arrange a lump sum payment (most common), an installment payment plan, or even a balloon payment plan (rare). Each party’s signature makes the promissory note an unbiased document that can be used as a gentle reminder, a means of exerting pressure, or evidence that will hold up in court (heaven forbid it comes to that).

Also, consider what would happen if you were to die before the loan is repaid. Depending on the amount loaned, you may want to add a line to the promissory note that stipulates that the borrower will either pay your estate back any amount still owed, or receive a decreased inheritance based on the amount still owed. This can protect other family members who will receive their inheritance out of your estate and prevent conflict between beneficiaries.

If there is serious concern about repayment, an added layer of protection would be to have the promissory note notarized, which would officially recognize the document and give you increased legal standing in court, although it is not necessary. However, if there is serious concern about repayment, perhaps the loan is not the best option anyway.

Charge a Favorable Rate
If you make a personal loan, the IRS requires you to charge a minimum interest rate, called the Applicable Federal Rate (AFR), to avoid potential income tax and gift tax consequences. The interest you collect is then reported as interest income on your tax return. The AFR is less than what borrowers would have to pay for a bank loan, but more than what lenders could earn from CDs or money market accounts. The AFR you must charge depends on the term of the loan:

Short-term (< 3 years)
Mid-term (3 – 9 years)
Long-term (9+ years)

What if it makes you feel Scrooge-like and ungenerous to charge the borrower interest? You might consider that the function of interest is to fairly compensate the lender for using money that could have been earning interest elsewhere. By lending that money to your borrower, you give up the opportunity cost. That said, you can still go ahead with an interest-free loan if that is most comfortable.

What happens then? If you make an interest-free loan and the IRS discovers it, they can impute the interest and require you to report it on your tax return. The uncharged interest can be treated as a tax-free gift to the borrower as long as it’s under the gift tax annual exclusion amount for the year (it’s $14,000 in 2016). Otherwise, any uncharged interest over the gift tax annual exclusion amount will need to be reported on your tax return. However, only a handful of people ever pay gift taxes in the end. This is because any amount over the gift tax annual exclusion amount reported on your tax return is added to your lifetime exclusion amount free of Federal estate tax (which is a whopping $5.34 million in 2016).

Let Go
With the promissory note in place, let go of any attachment you might have to the borrower’s use of the money. You have made a careful effort to set up an agreement where you are the bank and this should free you (and the borrower) of any emotional tangles or obligations that belong outside of the loan agreement. Ideally, both parties can compartmentalize the loan and resume their normal relationship with one other.