CONSIDERING A HOME EQUITY LINE: WHAT YOU NEED TO KNOW
If
you are in the market for credit, a home equity plan is one of several
options that might be right for you. Before making a decision, however,
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 risks. 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 a home often is a consumer's most valuable
asset, many homeowners use home equity credit lines only for major
items, such as education, home improvements, or medical bills, and
choose not to use them for day-to-day expenses.
With a home equity line, you will be approved for a specific amount
of credit. Many lenders set the credit limit on a home equity line by
taking a percentage (say, 75%) of the home's appraised value and
subtracting from that the balance owed on the existing mortgage. For
example:
In determining your actual credit limit, the lender will also
consider your ability to repay the loan (principal and interest) 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 other 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) or 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. Remember, though, that the APR for a home equity line is
based on the interest rate alone and will not reflect closing costs and
other fees and charges, so you’ll need to compare these costs, as well
as the APRs, among lenders.
Variable interest rates
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). In such cases, the interest
rate you pay for the line of credit will change, mirroring changes 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. It is also important to note the amount of the
margin.
Lenders sometimes offer a temporarily discounted interest rate for
home equity lines--an "introductory" rate that is unusually low for a
short 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 the index drops.
Some lenders allow you to convert from a variable interest rate to a
fixed rate during the life of the plan, or let you convert all or a
portion of your line to a fixed-term installment loan.
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); and
- Closing costs, including fees for attorneys, title search,
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. And 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 a minimum monthly payment that includes a portion
of the principal (the amount you borrow) plus accrued interest. But,
unlike with typical installment loan agreements, the portion of your
payment 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 only 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 payment plan ends.
Regardless of the minimum required payment on your home equity line,
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% interest rate, your monthly
payments would be $83. If the rate rises over time to 15%, 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. This type of
loan provides you with a fixed amount of money, repayable over a fixed
period. In most cases, the payment schedule calls for equal payments
that 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.
What if the lender freezes or reduces your line of credit?Plans
generally permit lenders to freeze or reduce a credit line if the value
of the home "declines significantly" or, when the lender "reasonably
believes" that you will be unable to make your payments due to a
"material change" in your financial circumstances. If this happens, you
may want to:
- Talk with your lender. Find out what caused the lender to freeze or
reduce your credit line and what, if anything, you can do to restore it.
You may be able to provide additional information to restore your line
of credit, such as documentation showing that your house has retained
its value or that there has not been a "material change" in your
financial circumstances. You may want to get copies of your credit
reports (go to the Federal Trade Commission's website for information
about free copies) to make sure all the information in them is correct.
If your lender suggests getting a new appraisal, be sure you discuss
appraisal firms in advance so that you know they will accept the new
appraisal as valid.
- Shop around for another line of credit. If your lender does not
want to restore your line of credit, shop around to see what other
lenders have to offer. You may be able to pay off your original line of
credit and take out another one. Keep in mind, however, that you may
need to pay some of the same application fees you paid for your original
line of credit.
