Q&A on Home Loans

Q: I read a column about how much interest you could save by paying a home mortgage off early. Would you give the same advice to someone who has student loan payments? I have approximately $10,000 remaining on my student loans. Payments are to run until 2007, and I pay a total of $225 a month. Does it make sense to reduce my principal by adding to my monthly payments?

A: One of the reasons it makes sense to prepay a mortgage is that you build equity in the home. If you need the money that you prepaid later, you can borrow it back. But you can't do that with a student loan.

Additionally, student loans come at a low rate and are highly flexible. You can, for instance, get payment deferrals if you are out of work or want to go back to school. So, generally, I tell people to pay off every other debt first--and contribute to their 401(k) and/or start an automatic savings plan--before paying off these loans. You can save a bit of interest by prepaying a student loan, but the savings is usually not significant enough to make up for losing all that flexibility.

***

Q: My home is worth $135,000 and I do not have a mortgage on it. In fact, I paid off a 25-year loan in 22 years by making extra monthly payments. I do not intend to move. My children are grown and all college costs have been paid. I expect to retire within the next 10 years.

My wife and I are contemplating purchasing a new car and making some needed home improvements that we expect to cost $40,000 to $45,000. Financial experts say home equity loans are an excellent source of cash for major expenses such as these. I know the interest is deductible, but I worry about putting my house on the line. Would it be feasible to obtain an auto loan and a home improvement loan and not put my home up? Or should I get the home equity loan so I could deduct the interest? No matter what type of loan I pursue, I do not want it to be for more than 60 months.

A: On a purely economic basis, the home equity loan is the best deal. It's likely to have a lower interest rate than other consumer debt and the interest is tax-deductible, making the effective rate even lower. But, because you are nervous, you ought to run through all of your worst-case scenarios. What would happen if you lost your job or got seriously ill? Do you have health insurance and disability insurance? What would happen if you or your wife (if she is also a wage-earner) died? Would you still have enough income to pay the loan? Do you have life insurance to pick up the slack?

If you have sufficient insurance to tide you over in an emergency, get the home equity loan and know that you have little to worry about. If you don't have enough insurance, you can get a personal line of credit and a car loan. (Home improvement loans generally put your house on the line, too.) These are likely to cost more than a home equity loan and the interest is not deductible, but you'll have fewer worries about losing your house.