If Home Equity Loan Is Tough to Get, It May Be a Sign You Should Forgo It

Q: My husband and I are in the process of securing a $32,000 home equity loan through an out-of-state lender at an interest rate of 12.5%. How does one know what are fair and equitable costs for a home equity loan? The lender is telling us that the processing costs will be about $5,000. Does that sound reasonable? The payments are going to be affordable for us. Also, other lenders wouldn’t do the loan because they felt we didn’t have enough equity in our home, or they thought our credit rating fell a little short.

A: If you were my sister, I’d tell you to cancel that loan right now.

Paying $5,000 to get a $32,000 loan is outrageous. Paying a 12.5% interest rate on a home equity loan isn’t much better.

Visit any major bank Web site or Bankrate.com and you can find the rates and fees charged to borrowers with good credit. Many home equity loans now carry interest rates of about 9.3%, and reputable lenders charge these customers no more than 1% to 2% of the loan in fees and processing costs. You would be paying nearly 16% in fees.

If your credit is bad enough that those are the best terms you can get, then you have no business taking out another loan. You should be concentrating on paying down your current debt, rather than taking on more. You can improve your credit rating by always paying your debts on time, by not running up your credit cards and by not taking out new loans until the old ones are paid off.

You also shouldn’t be tapping all your equity unless you’re in extremely dire straits. Having at least 20% equity in your home gives you a comfortable cushion in case of emergency.

Many people see home equity loans and debt consolidation loans as magic pills that will end their problems with high-interest debt. In fact, these loans can be just the opposite, particularly when accompanied by exorbitant fees and interest rates. You’ll just be digging yourself in deeper and making yourself a slave to debt payments while putting your future financial freedom at grave risk.

Best Way to Invest for a Child?

Q: People at work collected more than $1,400 for a woman whose daughter was killed in a car accident. She wants to use it for her 9-year-old grandson’s college savings--probably all the kid will have. What’s the best vehicle for investing this money? An education IRA?

A: For most people, education IRAs are more hassle than they’re worth.

Education IRAs offer tax-deferred growth and tax-free withdrawals when the money is used for qualified education expenses, but contributions are limited to $500 a year per child. Tapping an education IRA for college expenses also prevents you from using Hope Scholarship or Lifetime Learning credits that year. These valuable credits allow you to slice up to $1,500 off your tax bill. (For more information, visit https://www.latimes.com/taxes.)

If your co-worker needs a tax-deferred way to save for college, she might investigate state-based college savings plans. These plans allow you to invest money tax-deferred for a college education, and the money--when withdrawn for college expenses--is taxed at the student’s tax rate. (There’s even some talk of making the withdrawals tax-free, but Congress has yet to tackle the issue.) The money can be used for any U.S. college, not just those in your state.

College savings plans offer both more and less control than other savings vehicles. Unlike custodial accounts, the child doesn’t get the money at a certain age. The person who contributes the money controls who gets it, and can even withdraw it (but must pay penalties). If Junior turns out to be a wastrel, the contributor can shift the account to benefit another family member.

Now for the bad news: Once they’ve picked a college savings plan, contributors don’t get to say how the money is invested. Typically the state, or an investment manager hired by the state, determines that. California offers several plans, including one that’s 100% invested in the stock market and another that automatically reduces stock exposure as the child nears college age. But once you choose a plan, you’re stuck with it.

You can shop around, of course. If you don’t like the program or investment manager your state offers, you can check out other states’ plans; some are open to nonresidents.

Finally, these plans offer some intriguing estate-planning benefits. Well-off grandparents, listen up: You can contribute up to $50,000 in one year to a grandchild’s college savings plan without triggering gift tax concerns, as long as you make no other gifts in the next four years. That can move a chunk of change out of your estate, without completely giving up control of the money.

Want to know more? Check out the College Savings Plan Network, a clearinghouse for information on the various state plans, at https://www.collegesavings.org. Or call (877) CSPN-4YOU ([877] 277-6496).

For information on California’s plan, visit https://www.scholarshare.com, or call (877) 728-4338.

There are also a few books about the plans, including Joseph F. Hurley’s “The Best Way to Save for College” (BonaCom Publications, 2000).

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Send questions to liz.pulliam@latimes.com or mail to Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012. She regrets that she cannot respond personally to queries.