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?
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 expired. 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, 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) 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?
Variable interest rates
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 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
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 costs 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 the 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?
Regardless of the minimum payment required on your home equity line, you may choose to pay more, and any lenders may 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 the 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 house 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
Disclosures from lenders.
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:
Annual membership or participation fee. An annual charge for access to a financial product such as a line of credit, credit card, or account. The fee is charged regardless of whether or not the product is used.
Annual percentage rate (APR). The cost of credit, expressed as a yearly rate. For closed-end credit, such as car loans or mortgages, the APR includes the interest rate points, broker fees, and other credit charges that the borrower is required to pay. An APR, or an equivalent rate, is not used in leasing agreements.
Application fee. Fees charged when you apply for a loan or other credit. These fees may include charges for property appraisal and a credit report.
Balloon payment. A large extra payment that may be charged at the end or a mortgage loan or lease.
Cap (interest rate). A limit on the amount that your interest rate can increase. Two types of interest-rate caps exit. Periodic adjustment caps limit the interest-rate increase from one adjustment period to the next. Lifetime caps limit the interest-rate increase over the life of the loan. By law, all adjustable-rate mortgages have an overall cap.
Closing or settlement costs. Fees paid when you close (or settle) on a loan. These fees may include application fees, title examination, abstract of title, title insurance, and property survey fees; fees for preparing deeds, mortgages, and settlement documents; attorneys’ fees; recording fees; estimated costs of taxes and insurance; and notary, appraisal, and credit report fees. Under the Real Estate Settlement Procedures Act, the borrower receives a good faith estimate of closing costs within three days of application. The good faith estimate lists each expected cost as an amount or a range.
Credit limit. The maximum amount that may be borrowed on a credit card or under a home equity line of credit plan.
Equity. The difference between the fair market value of your home and the outstanding balance on your mortgage plus any outstanding home equity loans.
Index. The economic indicator used to calculate interest-rate adjustments for adjustable-rate mortgages or other adjustable-rate loans. The index rate can increase or decrease at any time. See also Selected Index Rates for ARMs over an 11-year Period (www.federalreserve.gov/pubs/arms/arms_english.htm) for examples of common indexes that have changed in the past.
Interest rate. The percentage rate used to determine the cost of borrowing money, stated usually as a percentage of the principal loan amount and as an annual rate.
Margin. The number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.
Minimum payment. The lowest amount that you must pay (usually monthly) to keep your account in good standing. Under some plans, the minimum payment may cover interest only; under others, it may include both principal and interest.
Points (also called discount points). One point is equal to 1 percent of the principal amount of a mortgage loan. For example, if a mortgage is $200,000, one point equals $2,000. Lenders frequently charge points in both fixed-rate and adjustable-rate mortgages to cover loan origination costs or to provide additional compensation to the lender or broker. These points usually are paid at closing and may be paid by the borrower or the home seller, or may be split between them. In some cases, the money needed to pay points can be borrowed (incorporated in the loan amount), but doing so will increase the loan amount and the total costs. Discount points (also called discount fees) are points that you voluntarily choose to pay in return for a lower interest rate.
Security interest. If stated in your credit agreement, a creditor’s, lessor’s or assignee’s legal right to your property (such as your home, stocks, or bonds) that secures payment of your obligation under the credit agreement.
Transaction fee. Fee charged each time a withdrawal or other specified transactions is made on a line of credit, such as a balance transfer fee or a cash advance fee.
Variable rate. An interest rate that changes periodically in relation to an index, such as the prime rate. Payments may increase or decrease accordingly.
State-chartered bank membersof the Federal Reserve System
National banks and national-bank-owned mortgage companies1
Federally chartered credit unions2
Federally insured state-chartered banks that are not members of the Federal Reserve System
Savings and loan associations3
Mortgage companies and other lenders
1 Banks with “National” in their names of “N.A.” after the name
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What You Should Know About Home Equity Lines of Credit