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?
What
should you look for when shopping for a plan?
Costs
of establishing and maintaining a home equity line
How
will you repay your home equity plan?
Lines
of credit vs. traditional second mortgage loans
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:
| |
Appraised value of home |
$100,000 |
|
| |
Percentage |
x 75% |
|
| |
Percentage of appraised value |
= $ 75,000 |
|
| |
Less
balance owed on mortgage |
- $ 40,000 |
|
| |
|
|
| |
Potential credit |
$ 35,000 |
|
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, among lenders.
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:
 |
A fee for a property appraisal to
estimate the value of your home |
|
An application
fee, which may not be refunded if you are turned down for
credit |
|
Up-front charges, such as one or more points
(one point equals 1 percent of the credit limit) |
|
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. Moreover, some lenders waive some or all of
the closing costs.
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:
|
The APR for a traditional second
mortgage loan takes into account the interest rate charged
plus points and other finance charges. |
|
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."
Single or multiple copies of the brochure are available without
charge. Order the brochure by telephone,
mail, or fax. Order online.
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