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When Your Home is On the Line
What You Should Know About Home Equity Lines of Credit
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?
What should you look for?
How will you repay your home equity plan?
Lines of credit vs. traditional second mortgage loans
Disclosures from lenders
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 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 material in this page is adapted from the
brochure "When Your Home Is on the Line", published by the
Federal Reserve Board.
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