Is Equity Loan the Way to Consolidate Debts?

QUESTION: Because of extremely fortunate circumstances when buying our first house (a rent-to-own option from an out-of-state landlord, a low appraisal and skyrocketing real estate), my wife and I closed escrow last August with nearly $25,000 in equity.

House prices have since taken another substantial jump and comparable remodeled homes are now nearly double what we paid. We plan to expand the kitchen this spring and add a second bathroom in the fall.

My wife and I have student loans of about $15,000 each--she’s been paying for about four years on a consolidated 9% note ($190 a month), and I’ve been paying for about six months at 8% ($250 a month). Our mortgage payments stand at $650 a month and, besides the student loans, our only other substantial debt is $150 in car payments with a year to pay off.

My wife is in her early 30s, I’m in my mid-30s and our combined income is about $70,000, but this should drop to about $45,000 next year when my wife goes part time to have a baby.

We have been considering taking out a home-equity loan to pay off these loans and apply any additional amount toward a new vehicle. Of course, there are some drawbacks: We put the house at more risk and we won’t have as much equity to put into another house when the time comes. On the plus side: We rid ourselves of a tremendous burden in the form of student loans, while taking advantage of what seems to be the last tax benefit. Still, we have some doubts.

ANSWER: Don’t fret. I don’t see anything wrong with your plan. The essential ingredient is in place: You know what you’re doing, you understand the risk in a home-equity loan and you’re taking it out for a solid reason. You’re not taking it out to improve your temporary standard of living or for some frivolous purpose. Make sure that you take out such an equity loan for no more than you actually need to pay off the student loans and for the new car. (Incidentally, where are the funds coming from for the proposed remodeling?)

Read and understand everything you sign--what the interest rate (probably variable) is; on what index it is based; what fees are involved; is there an annual fee; how often can the rate change, and what is the lifetime interest rate cap? While some home-equity loans are offered on an interest-only basis (appropriate in some cases), I suggest picking one where the principal is paid down, as on any amortized debt.

Remember too total monthly payments on all types of loans you have outstanding shouldn’t exceed 35% of your monthly before-tax income. Even with your lower anticipated income next year, it sounds like a practical move for you in your present situation.

Used prudently, the home equity loan has become a popular way to raise money for improvements and major purchases. There’s one catch: There has to be equity to tap. It builds up at a snail’s pace unless you have accelerated principal payments on your mortgage -- as explained in our leaflet, “Free and Clear: Getting the Mortgage Monkey Off Your Back.” Send a long, stamped, self-addressed envelope and $2 to cover costs to Don Campbell, P.O. Box 80260, Phoenix, Ariz. 85060.

Campbell, a retired Times staff writer, now is a Phoenix-based free-lance writer. Questions can be sent to him at P.O. Box 80260, Phoenix, Ariz. 85060.