What You Should Know About
Lines of Credit
When Your Home Is On the
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 line could mean the
loss of your home.
What 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 (say, 75%) of the appraised
value of the home and subtracting the balance owed on the existing mortgage.
Appraisal of home . . . .
. . . . . . . . . . .$100,000
Percentage . . . . . . .
. . . . . . . . . . . . . . . . . * 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
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 use the line.
Some plans may require you
to borrow a minimum amount each time you draw on the line (for example,
$300.00) 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.
What 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
Interest 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
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
Variable rate plans secured
by a dwelling may 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
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.
Costs to Obtain a Home
Many of the costs in 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 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
How 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 bank 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.
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
Also keep in mind that leasing
your home may be prohibited under the terms of your home equity agreement.
Comparing 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.
Disclosures from Lenders
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
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.
Commonly Used Terms
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.
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 ends.
Cap. A limit
on how much the variable-interest rate can increase during the life of
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.
difference between the fair market value (appraised value) of your home
and your outstanding mortgage balance.
base for rate changes that the lender used 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.
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.
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.
Security 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.
Ask your lender to help
fill out this check list.
annual percentage rate
annual percentage rate
and current value
of rate adjustments
of discount (if any)
Length of plan
During the draw period
and principal payments
When the draw period
of balance by lender
* Courtesy of The Federal Reserve