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.
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