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Home Equity Loan
With a home
equity loan, by
comparison, your lender will give you a lump sum and you're
typically charged a fixed intere
st rate and repay the loan in fixed monthly
installments. Home equity loans are best reserved for those times
when you need a set amount of cash, for example, to complete a home
improvement, start a business, or consolidate high-interest debt.
Line Of
Credit
A home equity line of credit is a flexible way to borrow
against the equity in your home. Once you open up a home equity line
with your lender (in a process similar to, but less involved than,
applying for a mortgage) you can borrow from it (up to a set amount)
when you decide you need to, and you'll only pay interest on the
money you borrow. As long as you don't borrow anything, you won't
owe any interest.
Most home equity lines come with variable interest rates,
though a few offer fixed rates. And these days, lenders offer many
ways for you to conveniently tap your available credit, most often
by writing checks or using credit cards linked to the line of
credit.
Tax impact
Generally, the money you borrow against your home, either
through a home equity loan or line of credit, is tax-deductible. The
IRS lets you write off up to $100,000 in interest you pay on these
loans (or up to $1 million if you use the money to fix up your
home).
Their tax deductibility and their decent
interest rates (as of early 2002, 5.2 percent on average for a
$10,000 home equity
line of
credit; 4.6 percent for a larger, $30,000 credit line) make home
equity lines of credit worth considering over many other types of
personal loans (which are not deductible).
Using the money wisely
Just because you have
easy access to a huge pot of credit doesn't mean
you should tap it freely. Take care to use your line
of credit responsibly; for example, to help cover your expenses if you
exhaust your emergency fund during an extend ed layoff. Resist the
urge to tap it for more frivolous reasons, like to
pay for a trip to Europe or to buy the entertainment
center you've always dreamed of.
Remember, any money you borrow is backed by your home. If you
run up big expenses that you're unable to pay back on time, you put
your house in jeopardy.And know this: Your stream of credit may not
last forever. Many lenders check your credit annually. While your
lender cannot accelerate the loan payments or change the terms, it
can suspend or reduce your borrowing privileges.
Lastly, with so many lenders competing to offer home equity
lines and loans these days, you need to be on your guard. The
Federal Trade Commission warns consumers that there are a number of
abusive tactics out there, including hiding loan terms and coercing
homeowners to accept home equity loans they can't reasonably afford.
For more on the warnings, visit the FTC's Web site.
Home Equity Line
versus Second Mortgage
|
|
Home Equity
Line |
Second
Mortgage |
|
Tax
Deductible |
Yes* |
Yes* |
|
Annual
Fee |
Yes (some lenders may
waive this) |
No |
|
Draw money when needed
|
Yes |
No |
|
Fixed
Rate |
No** |
Yes |
What you should know about HELOC
Home equity lines of
credit, also known as HELOC's, have become increasingly popular in
recent years. You can simply use the equity in your home to qualify
for a large amount of credit, which can be used when and how you
wish. Interest rates on HELOC's are usually relatively low and there
are certain tax benefits that are available to many homeowners. A
home equity product is often a good lending choice for many
borrowers. But, as with any loan, there are advantages and
disadvantages. You should know exactly what you are borrowing and
take the time to shop for the most favorable terms.
The main thing to keep in mind in regards to any loans against
your home equity is that if you default on the loan, you could lose
your home.
The Basics of HELOC
A home equity line of credit is a type of revolving credit. It is
a secured loan, using your home as collateral. Many consumers have
large investments in their homes which allow them to use the equity
to fund major items, such as college educations, home improvements
and medical bills. HELOC's are not recommended to fund day-to-day
expenses.
When you are approved for a HELOC, you are approved for a set
amount of credit. This is your credit limit - the maximum amount you
can borrow at one time. Most lenders will set your credit limit by
taking a percentage of the value of the home and subtracting the
balance owed on the first mortgage.
For example, many lenders will only let you have a total of 75%
of your home's value in mortgages. If your home is worth $100,000
and you owe $40,000, you will be able to take out a HELOC of
$35,000.
Your income, credit history and other debts will also be
considered in determining your credit line.
Most HELOC's have a fixed amount of time that the credit line
will be open, usually from seven to ten years. When the time period
is up, you may or may not be allowed to renew your credit line. If
you aren't, you will no longer be able to borrow additional money.
Many plans will ask for you to pay the loan in full at this time.
Some only ask for a partial payment or will refinance you into a
fixed equity loan.
Borrowers are usually given a credit card or checkbook to make
purchases using the line of credit. Many require that you borrow a
minimum amount each time you make a purchase. For example, you may
not be able to write a check for less than $300 at a time. Many
lenders require that you keep a minimum amount outstanding or that
you take an advance when you set up the HELOC.
Shopping for a HELOC
When thinking about applying for a HELOC, there are many factors
you should consider. There are many different plans out there, so it
is important to take the time to shop for the plan that best fits
your financial needs.
It is vital that you read the credit agreement carefully and
compare the terms and conditions of various HELOC's. Pay attention
to the APR and the costs and fees to establish the plan. The APR you
are quoted often does not include any closing costs or other
charges, so make sure you compare these costs as well.
HELOC's usually have variable interest rates. This rate will be
based on a publicly available index, such as the prime rate which is
published in the Wall Street Journal. The interest rate will change
as the index changes. Most lenders charge a set number of percentage
points over the index - this is called the margin. For example, your
interest rate could be 1.75% plus the index rate. Pay attention to
what index and margin the lender uses and how often the index
changes. See how high the index has risen, so you will have a
worst-case scenario idea of how high your interest rate may go.
Many lenders offer teaser rates. These rates are discounted for a
certain amount of time, like an introductory period. After the
introductory period is up, the interest rate will reset to the index
plus loan margin.
HELOC's usually include a cap on how high the interest rate can
rise over the life of the loan. This protects the borrower from
sky-high interest rates. Many variable-rate plans will limit how
much the interest rate can increase and how much it can fall.
Many lenders will allow a borrower to convert from a variable
interest rate to a fixed rate during the life of the loan. Most will
allow you to convert the line from a HELOC to a fixed-term
installment loan.
Other types of loans will allow the lender to reduce your credit
line under certain circumstances. These loans sound restrictive, but
actually protect the borrower from borrowing more than they can
afford during periods of high interest. Some variable-rate HELOC's
will not allow a borrower to borrow any additional funds while the
interest rate is equal to the cap on the line.
The cost of a HELOC
When taking out a HELOC, you will probably feel as if you are
buying a home. Many of the costs are the same as when you take out
your primary mortgage. You will have to pay for a property appraisal
to determine the value of your home. There will be application fees,
points and closing costs. You may also be charged yearly membership
fees or maintenance fees as well as transaction fees each time you
use the credit line.
HELOC's often cost hundreds of dollars just to establish. If you
are only planning on using a small amount of the line or want to
have it "just in case," the costs could be a little too expensive.
On the other hand, the lender will usually offer you a lower
interest rate on a HELOC than found on other types of credit. The
interest saved often offsets any upfront costs. Many lenders do not
charge closing costs in order to draw in your business.
The responsibility behind a HELOC
You should never take out any type of loan without knowing how
you will pay back what you owe. Many plans will set minimum payments
that cover a portion of the principal and the accrued interest, much
like a credit card. Other plans only require you pay the interest
accrued. These plans usually leave borrowers still owing quite a bit
of principal, if not all of it, when the HELOC expires.
Most lenders will give you a choice of payment options. Many
consumers choose to pay down the principal regularly, just as with
other types of loans. For example, the simply pay as much as
necessary to pay off the loan within a set amount of time - like an
installment loan.
Keep in mind that in most cases when the plan ends, you have to
pay the entire balance owed. Yes, you may be able to refinance it or
take out a loan to cover the balance, but you don't know that for
sure. Situations change over time. You must be prepared to make the
payment. If you are unable to, you face losing your home.
Remember that with a variable interest rate, your monthly
payments will change over time. Your payment could increase
significantly in just a few years, or it could go down. That is the
risk of variable interest rate loans. Make sure that you aren't
borrowing more than you can pay back. Calculate what your payment
would be if the variable rate hit the loan cap and make sure that
you can afford that maximum payment.
When you sell your home, you will be required to pay of the HELOC
in full, just like a mortgage. If you are planning on selling your
home in the next couple of years, take the time to see if it makes
sense to pay the up-front costs of the HELOC. If you plan on using
the property as an investment, there are additional considerations.
Most lenders will not allow HELOC's on homes that will be rented out
or leased.
HELOC's versus second mortgages
A popular alternative to a HELOC is a traditional second mortgage
loan. A second mortgage, also known as a home equity loan, offers
additional security through a fixed payment over a fixed period of
time. The money is usually taken out as a loan in a lump sum. This
type of loan is a good choice for those who need a set amount of
money for a specific purpose, such as a remodeling project or home
improvements.
When comparing the two loan products, keep in mind that the APR
is calculated differently for a second mortgage. With a traditional
second mortgage, the APR includes the points and other finances
charges. A HELOC APR is a variable rate based on the periodic
interest rate. It will not include points and other costs.
Pay attention to the lender disclosure
Lenders are required by law to disclose the terms and costs of
HELOC's. These terms are required by the Truth in Lending Act. You
should be notified of the APR, miscellaneous charges, the payment
terms and the interest rate features. You can not be charged any
fees until you receive this information. Most lenders provide the
disclosure when you receive the application form. You will receive
additional disclosures before you close on the loan. If any terms
have changed - other than the variable rate - the lender must
reimburse you all fees if the change causes you to decide not to
borrow through them.
Above all, a HELOC is a loan that should not be entered into
lightly. It sounds great, but there is one big disadvantage. You are
putting your home at risk. If you default on your loan, you will
face losing your home. You have three days from the closing on the
HELOC to cancel the credit line. This gives you the right to change
your mind. You simply inform the lender in writing within the three
days after you sign on the loan. The creditor must cancel the loan
and return all fees paid in opening the account, including appraisal
fees and application fees.
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