More and more lenders are
offering home equity lines of credit. By using the
equity in your home, you may qualify for a sizable amount of
credit, available for use when and how you please, at an
interest rate that is relatively low.
Furthermore, under the tax
law--depending on your specific situation--you may be allowed to
deduct the interest because the debt is secured by your home.
If you are in the market
for credit, a home equity plan may be right for you. Or perhaps
another form of credit would be better. Before making a
decision, you should weigh carefully the costs of a home equity
line against the benefits. Shop for the credit terms that best
meet your borrowing needs without posing undue financial risk.
And remember, failure to repay the amounts you’ve borrowed, plus
interest, could mean the loss of your home.
What
is a home equity line of credit?
A home equity line of
credit is a form of revolving credit in which your home serves
as collateral. Because the home is likely to be a consumer’s
largest asset, many homeowners use their credit lines only for
major items such as education, home improvements, or medical
bills and not for day-to-day expenses.
With a home equity line,
you will be approved for a specific amount of credit--your
credit limit, the maximum amount you may borrow at any one
time under the plan. Many lenders set the credit limit on a home
equity line by taking a percentage (say, 75 percent) of the
home’s appraised value and subtracting from that the balance
owed on the existing mortgage. For example:
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Appraised value of
home |
$100,000 |
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Percentage |
x 75% |
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Percentage of
appraised value |
= $ 75,000 |
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Less balance owed
on mortgage |
- $ 40,000 |
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Potential credit |
$ 35,000 |
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In determining your actual
credit limit, the lender will also consider your ability to
repay, by looking at your income, debts, and other financial
obligations as well as your credit history.
Many home equity plans set
a fixed period during which you can borrow money, such as 10
years. At the end of this "draw period," you may be allowed to
renew the credit line. If your plan does not allow renewals, you
will not be able to borrow additional money once the period has
ended. Some plans may call for payment in full of any
outstanding balance at the end of the period. Others may allow
repayment over a fixed period (the "repayment period"), for
example, 10 years.
Once approved for a home
equity line of credit, you will most likely be able to borrow up
to your credit limit whenever you want. Typically, you will use
special checks to draw on your line. Under some plans, borrowers
can use a credit card or other means to draw on the line.
There may be
limitations on how you use the line. Some plans may require you
to borrow a minimum amount each time you draw on the line (for
example, $300) and to keep a minimum amount outstanding. Some
plans may also require that you take an initial advance when the
line is set up.
What should you look for when shopping for a plan?
If you decide to apply
for a home equity line of credit, look for the plan that best
meets your particular needs. Read the credit agreement
carefully, and examine the terms and conditions of various
plans, including the
annual percentage rate (APR) and the costs of establishing
the plan. The APR for a home equity line is based on the
interest rate alone and will not reflect the closing costs and
other fees and charges, so you’ll need to compare these costs,
as well as the APRs..
Interest rate charges and related plan features
Home equity lines of credit typically involve variable rather
than fixed interest rates. The variable rate must be based on a
publicly available
index (such as the prime rate published in some major daily
newspapers or a U.S. Treasury bill rate); the interest rate for
borrowing under the home equity line changes, mirroring
fluctuations in the value of the index. Most lenders cite the
interest rate you will pay as the value of the index at a
particular time plus a
"margin," such as 2 percentage points. Because the cost of
borrowing is tied directly to the value of the index, it is
important to find out which index is used, how often the value
of the index changes, and how high it has risen in the past as
well as the amount of the margin.
Lenders sometimes offer a
temporarily discounted interest rate for home equity lines--a
rate that is unusually low and may last for only an introductory
period, such as 6 months.
Variable-rate plans
secured by a dwelling must, by law, have a ceiling (or
cap) on how much your interest rate may increase over the
life of the plan. Some variable-rate plans limit how much your
payment may increase and how low your interest rate may fall if
interest rates drop.
Some lenders allow you to
convert from a variable interest rate to a fixed rate during the
life of the plan, or to convert all or a portion of your line to
a fixed-term installment loan.
Plans generally permit
the lender to freeze or reduce your credit line under certain
circumstances. For example, some variable-rate plans may not
allow you to draw additional funds during a period in which the
interest rate reaches the cap.
Costs
of establishing and maintaining a home equity line
Many of the costs of
setting up a home equity line of credit are similar to those you
pay when you buy a home. For example:
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A fee for a
property appraisal to estimate the value of your home
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An
application fee, which may not be refunded if you
are turned down for credit |
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Up-front charges, such as one or more
points (one point equals 1 percent of the credit
limit) |
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Closing costs, including fees for attorneys, title
search, and mortgage preparation and filing; property
and title insurance; and taxes. |
In addition, you may be
subject to certain fees during the plan period, such as annual
membership or maintenance fees and a transaction fee every time
you draw on the credit line.
You could find yourself
paying hundreds of dollars to establish the plan. If you were to
draw only a small amount against your credit line, those initial
charges would substantially increase the cost of the funds
borrowed. On the other hand, because the lender’s risk is lower
than for other forms of credit, as your home serves as
collateral, annual percentage rates for home equity lines are
generally lower than rates for other types of credit. The
interest you save could offset the costs of establishing and
maintaining the line.
How
will you repay your home equity plan?
Before entering into a plan, consider how you will pay back the
money you borrow. Some plans set minimum payments that cover a
portion of the principal (the amount you borrow) plus accrued
interest. But (unlike with the typical installment loan) the
portion that goes toward principal may not be enough to repay
the principal by the end of the term. Other plans may allow
payment of interest alone during the life of the plan, which
means that you pay nothing toward the principal. If you borrow
$10,000, you will owe that amount when the plan ends.
Regardless of the minimum
required payment, you may choose to pay more, and many lenders
offer a choice of payment options. Many consumers choose to pay
down the principal regularly as they do with other loans. For
example, if you use your line to buy a boat, you may want to pay
it off as you would a typical boat loan.
Whatever your payment
arrangements during the life of the plan--whether you pay some,
a little, or none of the principal amount of the loan--when the
plan ends you may have to pay the entire balance owed, all at
once. You must be prepared to make this
"balloon payment" by refinancing it with the lender, by
obtaining a loan from another lender, or by some other means. If
you are unable to make the balloon payment, you could lose your
home.
If your plan has a
variable interest rate, your monthly payments may change.
Assume, for example, that you borrow $10,000 under a plan that
calls for interest-only payments. At a 10 percent interest rate,
your monthly payments would be $83. If the rate rises over time
to 15 percent, your monthly payments will increase to $125.
Similarly, if you are making payments that cover interest plus
some portion of the principal, your monthly payments may
increase, unless your agreement calls for keeping payments the
same throughout the plan period.
If you sell your home,
you will probably be required to pay off your home equity line
in full immediately. If you are likely to sell your home in the
near future, consider whether it makes sense to pay the up-front
costs of setting up a line of credit. Also keep in mind that
renting your home may be prohibited under the terms of your
agreement.
Lines
of credit vs. traditional second mortgage loans
If you are thinking
about a home equity line of credit, you might also want to
consider a traditional second mortgage loan. A second mortgage
provides you with a fixed amount of money repayable over a fixed
period. In most cases the payment schedule calls for equal
payments that will pay off the entire loan within the loan
period. You might consider a second mortgage instead of a home
equity line if, for example, you need a set amount for a
specific purpose, such as an addition to your home.
In deciding which type of
loan best suits your needs, consider the costs under the two
alternatives. Look at both the APR and other charges. Do not,
however, simply compare the APRs, because the APRs on the two
types of loans are figured differently:
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The APR for a
traditional second mortgage loan takes into account the
interest rate charged plus points and other finance
charges. |
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The APR for a home equity line of credit is based on the
periodic interest rate alone. It does not include points
or other charges. |
Disclosures from lenders
The federal Truth in Lending Act requires lenders to disclose
the important terms and costs of their home equity plans,
including the APR, miscellaneous charges, the payment terms, and
information about any variable-rate feature. And in general,
neither the lender nor anyone else may charge a fee until after
you have received this information. You usually get these
disclosures when you receive an application form, and you will
get additional disclosures before the plan is opened. If any
term (other than a variable-rate feature) changes before the
plan is opened, the lender must return all fees if you decide
not to enter into the plan because of the change.
When you open a home
equity line, the transaction puts your home at risk. If the home
involved is your principal dwelling, the Truth in Lending Act
gives you 3 days from the day the account was opened to cancel
the credit line. This right allows you to change your mind for
any reason. You simply inform the lender in writing within the
3-day period. The lender must then cancel its security interest
in your home and return all fees--including any application and
appraisal fees--paid to open the account.
The information on this
site is adapted from the brochure "What You Should Know about
Home Equity Lines of Credit." To order your free brochure,
please feel free to send us an
email requesting one.
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