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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 this 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 loan could mean the loss of
is a Home Equity Line of Credit?
A home equity line 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 - meaning
the maximum amount you can borrow at any one time while you have the plan.
Many lenders set the credit limit on a home equity line by taking a percentage
(usually 75 percent) of the appraised value of the home and subtracting the balance
owed on the existing mortgage. For example:
Appraisal of home $100,000
Percentage x 75%
Percentage of appraised value $ 75,000
Less mortgage debt -$40,000
Potential credit line $35,000
In determining your actual
credit line, the lender also will consider your ability to repay, by looking at
your income, debts, and other financial obligations, as well as your credit history.
Home equity plans often
set a fixed time during which you can borrow money, such as 10 years. When this
period is up, the plan may allow you to renew the credit line. But in a plan that
does not allow renewals, you will not be able to borrow additional money once
the time has expired. Some plans may call for payment in full of any outstanding
balance. Others may permit you to repay over a fixed time, for example 10 years.
Once approved for the home
equity plan, usually you will be able to borrow up to your credit limit whenever
you want. Typically, you will be able to draw on your line by using special checks.
Under some plans, borrowers
can use a credit card or other means to borrow money and make purchases using
the line. However, there may be limitations on how you can 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 lenders also
may require that you take an initial advance when you first set up the line.
Should You Look for When Shopping for a Plan?
If you decide to apply for
a home equity line, look for the plan that best meets your particular needs. Look
carefully at the credit agreement and examine the terms and conditions of various
plans, including the annual percentage rate (APR) and the costs you'll pay to
establish the plan. The disclosed APR will not reflect the closing costs and other
fees and charges, so you'll need to compare these costs, as well as the APRs,
Rate Charges and Plan Features
Home equity plans typically
involve variable interest rates rather than fixed rates. A 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 will change,
mirroring fluctuations in the index. To figure the interest rate that you will
pay, most lenders add a margin, such as 2 percentage points, to the index value.
Because the cost of borrowing
is tied directly to the index rate, it is important to find out what index and
margin each lender uses, how often the index changes, and how high it has risen
in the past.
Sometimes lenders advertise a temporarily discounted rate for home equity lines
- a rate that is unusually low and often lasts only for an introductory period,
such as six months.
Variable rate plans secured by a dwelling must have a ceiling (or cap) on how
high your interest rate can climb over the life of the plan. Some variable-rate
plans limit how much your payment may increase, and also how low your interest
rate may fall if interest rates drop.
Some lenders may permit you to convert a variable rate to a fixed interest rate
during the life of the plan, or to convert all or a portion of your line to a
fixed-term installment loan.
Agreements generally will permit the lender to freeze or reduce your credit line
under certain circumstances. For example, some variable-rate plans may not allow
you to get additional funds during any period the interest rate reaches the cap.
to Obtain a Home Equity Line
Many of the costs in setting
up a home equity line of credit are similar to those you pay when you buy a home.
- A fee for a property appraisal,
which estimates the value of your home.
- An application fee, which
may not be refundable if you are turned down for 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 charges and closing costs would substantially
increase the cost of the funds borrowed. On the other hand, the lender's risk
is lower than for other forms of credit because your home serves as collateral.
Thus, annual percentage rates for home equity lines are generally lower than rates
for other types of credit. The interest you save could offset the initial costs
of obtaining the line. In addition, some lenders may waive a portion or all of
the closing costs.
Will You Repay Your Home Equity Plan?
Before entering into a plan,
consider how you will pay back any money you might borrow. Some plans set minimum
payments that cover a portion of the principal (the amount you borrow) plus accrued
interest. But, unlike the typical installment loan, the portion that goes toward
principal may not be enough to repay the debt by the end of the term. Other plans
may allow payments 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 entire sum when the plan ends.
Regardless of the minimum
payment required, you can pay more than the minimum and many lenders may give
you a choice of payment options. Consumers often will 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, aIl at once. You must be prepared to make this balloon payment by re- financing
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.
With a variable 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 initial payments would be $83 monthly. If the rate should rise over time
to 15 percent, your payments will increase to $125 per month.
Even with payments that
cover interest plus some portion of the principal, there could be a similar increase
in your monthly payment, unless the agreement calls for keeping payments level
throughout the plan.
When you sell your home,
you probably will be required to pay off your home equity line in full. If you
are likely to sell your house in the near future, consider whether it makes sense
to pay the up-front costs of setting up an equity credit line. Also keep in mind
that leasing your home may be prohibited under the terms of your home equity agreement.
a Line of Credit and a Traditional Second Mortgage Loan
If you are thinking about
a home equity line of credit you also might want to consider a more traditional
second mortgage loan. This type of loan provides you with a fixed amount of money
repayable over a fixed period. Usually the payment schedule calls for equal payments
that will pay off the entire loan within that time. You might consider a traditional
second mortgage loan 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 the APR and other charges. You cannot, however, simply compare the APR for
a traditional mortgage loan with the APR for a home equity line because the APRs
are figured differently.
The APR for a traditional mortgage takes into account the interest rate charged
plus points and other finance charges.
The APR for a home equity line is based on the periodic interest rate alone. It
does not include points or other charges.
The 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 has changed before the plan
is opened (other than a variable-rate feature), the lender must return all fees
if you decide not to enter into the plan because of the changed term.
When you open a home equity
line, the transaction puts your home at risk. The Truth in Lending Act gives you
three 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 creditor
in writing within the three-day period. The creditor must then cancel the security
interest in your home and return all fees - including any application and appraisal
fees - paid in opening the account.
Annual membership or
participation fee - An amount that is charged annually for having the line
of credit available. It is charged regardless of whether or not you use the line
Annual percentage rate
(APR) - The cost of credit on a yearly basis expressed as a percentage.
Application fee -
Fees that are paid upon application. An application fee may include charges for
property appraisal and a credit report.
Balloon payment -
A lump-sum payment that you may be required to make under a plan when the plan
Cap - A limit on
how much the variable-interest rate can increase during the life of the plan.
Closing costs - Fees
paid at closing, including attorneys' fees, fees for preparing and filing a mortgage,
for taxes, title search, and insurance.
Credit limit - The
maximum amount that you can borrow under the home equity plan.
Equity - The difference
between the fair market value (appraised value) of your home and your outstanding
Index - The base
for rate changes that the lender uses to decide how much the annual percentage
rate will change over time.
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 to be charged.
Minimum payment -
The minimum amount that you must pay (usually monthly) on your account. In some
plans, the minimum payment may be "interest only." In other plans, the
minimum payment may include principal and interest.
Points - A point
is equal to one percent of the amount of your credit line. Points usually are
collected at closing, and are in addition to monthly interest.
- An interest that a lender takes in the borrower's property to assure 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.
to Go for Help
The following federal agencies
are responsible for enforcing the federal Truth in Lending Act, the law that governs
credit term disclosure for home equity lines. Any questions concerning compliance
with the act by a particular financial institution should be directed to its enforcement
State Member Banks of the
Federal Reserve System
Division of Consumer and Community Affairs
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, DC 20551 (202) 452-3946
Office of the Comptroller of the Currency
250 E Street, S.W.
Washington, DC 20219 (202) 874-4428
Federal Credit Unions
Office of Consumer Programs
National Credit Union Administration
1776 G Street, N.W.
Washington, DC 20456 (202) 682-9640
Federally Insured Non-Member
State-Chartered Banks and Savings Banks
Office of Consumer Affairs
Federal Deposit Insurance Corporation
550 Seventeenth Street, N.W.
Washington, DC 20429
(800) 424-5488; (202) 898-6005
TDD (800) 452-3151; (202) 898-6726
Federally Insured Savings
and Loan Institutions and Federally Chartered Savings Banks
Consumer Programs Division
Office of Thrift Supervision
1700 G Street, N.W., Fifth Floor
Washington, DC 20552
Division of Credit Practices
Bureau of Consumer Protection
Federal Trade Commission
601 Pennsylvania Avenue, N.W.
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