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.
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,
Appraisal of home
Percentage
Percentage of appraised value
Less mortgage debt
Potential credit line |
$100,000
x75%
$75,000
$40,000
$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.
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.
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.
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, which estimates the value of your home.
- An application fee, which may not be refundable if you turn down the credit.
- Up-front charges, such as one or more points (one point equals one percent of the credit limit).
- Other closing costs, which include fees for attorneys, title search, mortgage preparation and filing, property and title insurance, as well as taxes.
- Certain fees during the plan, for example, some plans impose yearly membership or maintenance fees.
- You also may be charged 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.
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.
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 mortgage takes into account the interest rate charged plus points and other charges.
- The APR of a home equity line is based on the periodic interest rate alone. It does not include points or other charges.
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.
Annual membership or maintenance fee
An annual charge for having the line of credit available. Charged regardless of whether or not the line is used.
Annual percentage rate (APR)
The cost of credit on a yearly basis expressed as a percentage.
Application fee
Fees that are paid upon application. May include charges for property appraisal and a credit report.
Balloon payment
A lump-sum payment that may be required when the plan ends.
Cap
A limit on how much the variable interest rate may increase during the life of the plan.
Closing costs
Fees paid at closing, including attorneys fees, fees for preparing and filing a mortgage, fees for title search, taxes, and insurance.
Credit limit
The maximum amount that may be borrowed under the home equity plan.
Equity
The difference between the fair market value (appraised valued) of the home and the outstanding mortgage balance.
Index
Published rate that serves as a base for the interest rate charged on a home equity line and also as the base for rate changes used by the lender.
Interest rate
The periodic charge, expressed as a percentage, for use of credit.
Margin
The number of percentage points the lender adds to the index rate to determine the annual percentage rate.
Minimum payment
The minimum amount that you must pay (usually monthly) on your account. Under some plans, the minimum payment may cover interest only; under others, it may include both principal and interest.
Points
One point is equal to 1 percent of the amount of the credit line. Points must usually be paid at closing and are in addition to monthly interest.
Security interest
An interest that a lender takes in the borrower's property to ensure repayment of a debt.
Transaction fee
A fee charged each time you draw on your credit line.
Variable rate
An interest rate that changes periodically in relation to an index. Payments may increase or decrease accordingly.
Where to Go for Help
The following federal agencies are responsible for enforcing the federal Truth in Lending Act, the law that governs disclosure of terms for home equity lines of credit. Questions concerning compliance with the act by a particular financial institution should be directed to the institution's enforcement agency.
State Banks that Are Members of the Federal Reserve System
Division of Consumer and Community Affairs
Mail Stop 801
Federal Reserve Board
Washington DC 20551
(202) 452-3693
www.federalreserve.gov
National Banks
Office of the Comptroller of the Currency
Customer Assistance Unit
1301 McKinney St.
Suite 3710
Houston, TX 77010
(800) 613-6743
www.occ.treas.gov
Federal Credit Unions
National Credit Union Administration
Office of Public and Congressional Affairs
1775 Duke St.
Alexandria, VA 22314
(703) 518-6330
www.ncua.gov
Federally Insured Non-Member State-Chartered Banks and Savings Banks
Federal Deposit Insurance Corporation
Office of Compliance and Consumer Affairs
550 17th Street, NW
Room PA-1730, 7th Floor
Washington, DC 20429
(202) 942-3100 or
(800) 934-FDIC
www.fdic.gov
Federally Insured Savings and Loan Institutions and Federally Chartered Savings Banks
Office of Thrift Supervision
Consumer Programs
1700 G Street, NW, 6thFloor
Washington, DC 20552
(202) 906-6237 or
(800) 842-6929
www.ots.treas.gov
Mortgage Companies and Other Lenders
Federal Trade Commission
Consumer Response Center
600 Pennsylvania Avenue, NW
Washington, DC 20580
(202) 326-3758 or
(877) FTC-HELP
www.ftc.gov
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