Q. Two years ago, we obtained a home equity loan. Our monthly mortgage payment was amortized over a 30-year payment, which meant that a portion of the payments were being credited toward interest and the remainder to reduce the outstanding balance.

Recently, we obtained a new home equity loan from the same institution. This time we were informed that we did not have to pay more than the interest each month. Does this mean that the principal would never be reduced? We plan to pay the same amount we have been paying in the past, so as to reduce – and ultimately pay off the loan. Is this a wise decision?

A. If your loan was with a credit card company, I would be outraged. Credit card companies conveniently tell the card holder on each monthly statement the minimum balance required to be paid for that month. Any too many consumers believe that this is all that they can pay. The result: the outstanding balance either goes up – or stays the same – thereby reaping big interest payment benefits to the credit card company.

But with a home equity loan, each consumer has to look to his or her own situation before deciding whether paying interest only is a good deal or not.

First, a brief explanation of terms:

Home Equity Loan This is a creation of banking institutions which started in the l990's. Let us assume that you have a home (or a condominium) that is currently worth $200,000. The outstanding balance on your first mortgage is $125,000. Thus, in this example, you have $75,000 in equity (value) in your house.

Most banks which offer home equity loans will lend you up to 80 or 90 percent of this equity, or between $60, 000 up to $67,500. You will sign a promissory note and the payment will be secured by a deed of trust. Make no mistake about a home equity loan: it is a second mortgage (deed of trust) on your property.

What is interesting about a home equity loan, however, is that you do not have to borrow the full amount of the loan. You basically have a check book from the lender, and when you need cash, you write a check. You only have to pay interest on the money you borrow. I believe that every homeowner should take advantage of a home equity loan, since it is a protection against those “rainy day” disasters which periodically crop up in every household.

Interest Only Loan Under this type of arrangement, the borrower only has to pay interest on the amount of the money which has been borrowed. The principal balance stays the same.

Let’s look at this example. You want to borrow $60,000, and the interest rate is 5.5 percent. If you were to have this loan fully amortized over a 30 year period, the monthly payment would be $340.68.

The monthly interest on a $60,000 loan in our example will be $275 (60,000 x 5.5% / 12). Thus, the difference between the interest payment and the monthly payment is $65.68 (340.68 - 275). You have now reduced your loan balance down to $59,934.32. As you can see, although the interest portion of your monthly mortgage is quite high, at least you have started to reduce the loan. After about seven years, the principal portion of the monthly payment will start to be higher than the interest portion, and at the end of 30 years, the loan will be paid in full.

If, for example, you decide to make a larger monthly payment (and advise the lender that you are making an extra principal payment) you will reduce your loan even faster. A rule of thumb is that if you make one extra monthly payment each year, you will reduce a 30-year loan down to approximately 22 years.

Getting back to your question, you ask if it is wise to make additional payments. That depends on your own personal situation. How long do you plan to keep the house? If you plan to sell it within a few years, why bother to make additional payments? When the house is sold, the entire $60,000 home equity loan will be paid out of the sales proceeds.

Do you have other uses for this extra money? Currently, banks are generally paying less than one percent interest on savings accounts. It certainly does not pay to put that extra money in such a low interest account; you might be better off reducing your outstanding loan balance.

Do you have children who will be heading off for college in the near future? As we all know, college education is expensive, and getting more so each and every year. Why not take this extra principal and put it in a college education fund? In recent years, Congress has authorized some very creative programs to assist parents with their future college education tuition payments.

What’s your overall financial situation? Have you discussed your retirement plans with a competent financial advisor? I have too many clients who are house rich, and cash poor. They own their expensive house, free and clear of any mortgage debt, but do not have enough money to pay the real estate taxes, insurance and the upkeep of the property. Perhaps you should consider using this extra money for some solid investment – add to your 401(k) or IRA plan, buy long-term treasury bonds, or even consider investing in a good (but conservative) stock or mutual fund.

Although I seriously doubt that properties will continue to increase at the phenomenal rates we have seen in the last couple of years, I suspect that future appreciation will be in the range of 3 - 5 percent per year. Thus, regardless of the equity you have in your home, it will continue to appreciate. If you put all of your money into your home, and end up with 100 percent equity, this is, in my opinion, dead equity. You might find better uses for this extra money, and have two or more investments working for you, instead of only your home appreciation.

Are you making a wise decision by paying down your home equity loan? That’s something that only you can decide – but only after you do your homework and review your personal financial situation.

Published: July 14, 2003

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