Home Equity Loans & Lines of Credit
Figuring Your Home's Equity
Home equity is the difference between the fair market value of your home and the amount that you owe on the mortgage. It is the amount of money that you have invested in the house. For example,
|Fair market value||$100,000|
|Outstanding mortgage balance||-60,000|
|Home Equity||$ 40,000|
Home equity loans are not new. These loans have been offered by financial institutions for years. You might know them better as second mortgages. They became popular in the 1980's when financial institutions marketed home equity loans as a way to tap into the financial asset that homeowners had built up by paying down their mortgages. Consumers soon realized the benefits of borrowing on their homes' equity. They could pay for college costs, home improvements, bill consolidations, cars and financing new businesses or second homes at a lower cost than with other types of consumer loans.
Home Equity Products
A home equity loan provides a lump sum payment for a specified use, such as a home improvement. You sign a contract that states the amount and terms of the payments. You cannot borrow any further funds from this loan. Your house will be used for collateral. If you cannot make the payments, you could lose your home
Your first decision is whether you need a revolving line of credit or a one-time, closed-end loan. A revolving line of credit enables the homeowner to choose when and how to borrow against the equity in the home. In a closed end loan, the homeowner receives a lump sum for a particular purpose, such as remodeling or tuition.
Home Equity Line of Credit
A home equity line of credit gives you the right to draw on your funds, up to your personal credit limit. The financial institution will determine your actual credit line based on your income and financial obligations. You are given either special checks or a credit card. Then you can draw on your credit line until you reach your limit. Most financial institutions have a minimum draw when using the special checks, from $100 to $500. The credit card usually does not have a minimum draw. When you reach your limit, you cannot draw any more funds until you either pay off some of the balance or apply to increase your credit line. It is a cash reserve that can be used for any purpose. Generally with a credit line, if you borrow small sums over time or borrow and repay the balance within a reasonable time, you can expect to pay less interest than you would with a home equity loan.
A home equity line of credit gives you more flexibility and lower closing costs than home equity loans. When approved for a line of credit, you will receive either special checks or a credit card. You can use this revolving credit at any time and make payments only when there is a balance due. You will have not only a lower finance rate but a great emergency source of funds. Your house serves as collateral for either home equity product.
Home Equity Loan or Second Mortgage
A home equity loan or also known as a second mortgage loan is a closed-end loan that can have a fixed term, a fixed rate, and fixed monthly payments or it can carry an adjustable finance charge rate that fluctuates with a key index such as the prim rate. The loan proceeds are usually made available in a lump sum.
Home equity products provide a relatively low cost credit source because they are secured by your house. You have credit that is flexible enough to be available when and where you need it. You can use the credit as you please, with the understanding that your house is used as collateral. Tax laws allow the interest on home equity products to be fully deductible for most purposes.
Almost every bank and credit union offers home equity loans or lines of credit. Financial institutions negotiate a home equity loan just like a second mortgage. You have to pay off the loan or credit line when you sell the house. The bank will give you a lump sum amount and require that you make monthly payments for a specific period of time. The home equity loan is a possible option if you need a specific amount of money for a short period of time. An example would be a $40,000 home improvement project.
If you are considering a home equity loan or credit line, you must understand the advantages and disadvantages of each product. The right choice for you depends on how you answer the following questions:
- How much money do you need?
- When do you need it?
Terms You Need To Know
As you comparison shop before you sign a home equity loan or line of credit contract, review the following terms:
Amortization — Principal is paid down over the life of the loan Principal is paid down over the life of the loan
Annual membership or participation fees — Fee that is charged annually for use of the line of credit, whether or not you use the credit — Fee that is charged annually for use of the line of credit, whether or not you use the credit
Annual Percentage Rate (APR) — The cost of credit on a yearly basis expressed as a percentage — The cost of credit on a yearly basis expressed as a percentage
Application fee — Fees paid with the application forms, such as for property appraisal or a credit report — Fees paid with the application forms, such as for property appraisal or a credit report
Balloon payment — A lump sum amount that is required as the final payment — A lump sum amount that is required as the final payment
Cap — A limit on how much the variable interest rate can increase — A limit on how much the variable interest rate can increase
Closing costs — Fees paid at the closing, such as preparing and filing the mortgage, taxes, title search and insurance papers — Fees paid at the closing, such as preparing and filing the mortgage, taxes, title search and insurance papers
Credit limit — The maximum amount you can borrow — The maximum amount you can borrow
Equity — The difference between the fair market value or appraised value and the outstanding mortgaged amount — The difference between the fair market value or appraised value and the outstanding mortgaged amount
Index — The base for rate changes that the lender will use to decide how the much the APR will change during the term of the line of credit — The base for rate changes that the lender will use to decide how the much the APR will change during the term of the line of credit
Margin — The number of percentage points the lender adds to the index rate to determine the APR — The number of percentage points the lender adds to the index rate to determine the APR
Minimum payment — The minimum amount that you must pay on your account, usually monthly — The minimum amount that you must pay on your account, usually monthly
Points — A point is the value of one percent of the amount of your credit line and is paid at closing — A point is the value of one percent of the amount of your credit line and is paid at closing
Right of Rescission — Allows the borrower 3 full business days to cancel the transaction — Allows the borrower 3 full business days to cancel the transaction
Security interest — An interest that a lender takes in the borrower's property to assure repayment — An interest that a lender takes in the borrower's property to assure repayment
Transaction fee — A charge each time you use your credit line — A charge each time you use your credit line
Variable rate — An interest rate that will change periodically in response to an index — An interest rate that will change periodically in response to an index
How Lenders Decide How Much You Can Borrow
Financial institutions determine the amount of your home equity loan or credit line by taking a percentage of the appraised value of the home and subtracting the balance of the mortgage. For example:
|Appraised value of home||$80,000|
|Percentage rate set by lender||80%|
|Percentage of appraised value||$64,000 (80,000 X .80)|
|Maximum Loan or Line of Credit||$44,000 (64,000 minus 20,000)|
The lender will also evaluate your ability to repay this loan by looking at your income, financial responsibilities and credit record. You normally will not want to borrow any more than you really need because your house is generally your largest single investment. You will want to be careful not to put it in jeopardy.
You should beware of offers to loan you 125% of the value of your home. When you take out this type of loan, you own more on your house than it is worth on the present market. These types of loans are based on the assumption that your home will continue to increase in value. These types of loan also usually have a higher rate of interest. If you plan to move or refinance in the next five to ten years, you should not consider this type of loan.
Choosing A Home Equity Product
The following factors should be considered as you decide which home equity product best suits your needs:
Interest Rates. The most expensive cost of any home equity product is interest. The interest rates on both home equity products are generally similar. Know the interest rates and APR's to compare a loan with a credit line. Home equity loans are available with either fixed or variable rates.
- A fixed rate loan means the that rate is established in the contract and will not change. You have the security of knowing the exact amount that must be paid each month. Home equity credit lines usually have variable interest rates, however a few offer fixed rates.
- A variable rate loan means that the interest rate can change in response to a designated economic indicator, such as the prime rate. With a variable rate, an increase in interest rates affects the monthly payment. Either the amount of the monthly payment goes up or the term of the loan is increased. The financial institution can help you chart out what would happen to your payment at different interest rates.
APR. The Truth in Lending Act's Regulation Z requires that lenders disclose the Annual Percentage Rate (APR) in all home equity products. The APR includes all the costs of credit, such as interest rate, points or other finance charges. This regulation makes it much easier for you to compare the different home equity products.
Other Financing Costs. Three common costs include application fees, points, and closing costs. These costs will make a big difference in the total cost of your loan. Application fees cover the cost of processing your application, such as appraisal or title fees and credit check. These costs are somewhere between $25 to $300. Some financial institutions do not charge application fees but they do include these charges in the closing costs.
- Points are service fees that are added on to all home equity loans and a few home equity lines. They are figured on the total amount of the loan or credit line and are paid at closing. One point equals one percent of the loan amount or credit line, for example, for a $40,000 loan or equity line of credit, one point would equal $400. You need to know how many points are added on to the costs. Some lenders add or subtract points for a lower or higher interest rate.
- Closing costs cover appraisal, title, recording and insurance fees. Financial institution fees vary, so compare lenders. Request an itemization of the closing fees at least one week before the closing to avoid surprises. Estimate 2 to 5% of the home equity product for closing costs.
Tax Deductible. The loan or credit line is tax deductible if it will improve your home or property, with specific limitations and exclusions.
Term. Home equity loans can run from 3 to 20 years, while credit lines typically run for 5 to 20 years. When you reach your credit limit, you must stop borrowing and start repaying. The financial institutions generally give you 10 to 20 years to repay the debt. A line of credit may be divided into borrowing and repayment periods. Some lenders will give you the option to take lower payments with a final balloon payment. You should agree to a balloon payment only if you know that you will sell your house before the end of the repayment period or know that you will be able to pay the balance of the debt before the end of the repayment period.
Right of Rescission. This right is part of the Truth in Lending Act and gives you three days from the day the account was opened to cancel the home equity product for any reason. However, you must inform the lender in writing within the three-day period and the lender must return all fees paid to open the account.
Foreclosure. With either a home equity loan or credit line, when the debt is in default, the lender can foreclose on your house and property. The foreclosure process varies from state to state, but generally takes from 2 to 18 months. The foreclosure process on a home equity loan or line of credit differs from foreclosure on a first mortgage. The home equity products would be repaid after the first mortgage is paid in full.
Terms And Conditions
When shopping for any home equity product, read the application information and contract carefully because the rates, terms and conditions will vary from lender to lender. Some of the following terms and conditions may not be suited to your needs or could add extra costs to your home equity product.
Introductory or Teaser Rates. Because of competition in the marketplace, some lenders offer what are called "teaser rates". This would be rates lower than the prime rate, usually one to two points, for a short period of time, usually 6 months.
Caps. The cap will specify the maximum percentage that a rate can increase. Caps are a very good way to protect yourself from high interest rates.
Index. Variable interest rates are tied to an index. The index is an independent rate upon which the changes in your loan rate will be based. The most common indexes used are the prime rate or Treasury bill rate. It is helpful to know how often the index changes and how high it has risen in the past as a possible indicator of future rate changes.
Zero Closing Costs. When the financial institution offers zero closing costs, you could be responsible for all these costs, around $200 to $300, if you close your line or sell your house within a year.
Convertible Loans. This feature is for home equity products with variable interest rates. Consumers tend to be concerned about having little control over the interest rates. In response to this concern, some financial institutions offer convertibility features. For example, it may be possible for borrowers to adjust rates on both fixed rate home equity loans and variable rate lines of credit. You could be offered a "teaser rate" for the first 6 months; such as the prime rate minus two points. After 6 months if the prime rate goes down, so does your rate. If the rate goes up, you have the option of converting your loan or line into a fixed rate loan at the going rate. Another option allows consumers with a fixed rate loan at a high rate to convert their loan for no extra charges, one time, when the rates go down.
Loans Within Lines. Some lenders allow consumers to separate their credit line into as many as three fixed rate loans with terms from 15 to 25 years. The interest rate will become the going rate for fixed-rate loans on the day you change.
Margin. The margin is included in the APR and is the index plus one to three percentage points. Each percentage point adds to the total cost of credit, so look for fewer points.
Repayment Features. Find out if there is a payback feature that would allow you to either refinance or extend your debt for another period of time.
Transaction Fee. These fees may be charged every time you draw on the credit line or if you do not use your credit line during a 12 month period.
Application Fee. These fees would cover the initial costs of application, such as property appraisals and credit reports.
Cancellation Fee. If you pay the entire balance of the loan or credit line during the first 12 or 24 months, you could be required to pay this fee.
Annual Membership or Participation Fees. A yearly fee charged just to use the credit line. They can be negotiated.
Conditions That Would Make The Home Equity Product Frozen or Due. Situations, such as losing your job or a good credit rating, which would permit the lender to freeze or reduce your credit line.
Similarities And Differences
The following chart summarizes similarities and differences between the two home equity products. In addition, the Home Equity Product Comparison Worksheet included in this mini-lesson can be used to compare costs and features of two home equity products, based on local costs and options available to you.
|Home Equity Loan||Home Equity Line Of Credit|
|Lump sum loan amount||Flexible spending amounts, options vary with each financial institution|
|Generally fixed interest rate, some variable rates||Generally variable interest rates, fixed|
|Costs include a credit check, appraisal, recording and application fees and points||Costs include a credit check, appraisal, recording and application fees, plus fees such as annual and transaction fees. (usually no points)|
|Tax deductible interest||Tax deductible interest|
|Fixed time period||Flexible time period|
|Principal is paid down over the life of the loan||Variety of borrowing and repayment options|
|Right of rescission||Right of rescission|
|Foreclosure for nonpayment||Foreclosure for nonpayment|
Tips For Evaluating Home Equity Lines Of Credit
The credit plan should be carefully scrutinized when:
- Virtually all of the amount of credit is extended at the outset.
- The loan is non-amortizing or is barely amortizing at the scheduled minimum payments, making the replenishing feature largely illusory.
- The creditor refinanced a closed-end loan into open-end or open-end into open-end (especially telling if the refinance is performed by the same creditor).
- The contract contains a prepayment penalty clause.
- The contract contains a call provision with or without a balloon payment.
- The contract contains a no draw provision or a term-limited draw provision coupled with a non-amortizing payment period in the contract.
- There are substantive limitations (usury, other consumer protections, HOEPA) which the creditor can try to evade by calling the credit "open end."
When comparing home equity loan offers, ask:
- What is the minimum monthly payment?
- Is there a maximum?
- What is the annual percentage rate?
- If the interest rate is adjustable, how much can it increase at one time?
- Is there a maximum rate?
Early Warning Signs
Avoid any lender who:
- Tells you, or requires you to falsify information on the loan application. For example, the lender tells you to say your loan is primarily for business purposes when it's not.
- Pressures you into applying for a loan or applying for more money than you need.
- Pressures you into accepting monthly payments you can't make.
- Fails to provide required loan disclosures or tells you not to read them.
- Misrepresents the kind of credit you're getting. For example, calling a one-time loan a line of credit.
- Promises one set of terms when you apply and gives you another set of terms to sign-with no legitimate explanation for the change.
- Tells you to sign blank forms-the lender says they'll fill them in later.
- Says you can't have copies of documents that you've signed.
Are Home Equity Products Right For You
A home equity loan or line of credit may not be an appropriate financial tool for every homeowner. Because home equity products are second mortgages, they are due in full when you sell your home. These products may not be the best choice if you plan to sell your home in the near future. Some people use a home equity product to fix up a home to increase its value before they sell it.
If your home is now worth more than when you purchased it, home equity products could help you turn that increase into usable credit. Be sure that you can afford the increase in payments and the closing costs. Your house is on the line if you default.
REMEMBER- YOU CAN CANCEL A HOME EQUITY LOAN FOR ANY REASON IN WRITING WITHIN THREE BUSINESS DAYS OF THE DATE THE LOAN WAS CLOSED.
For More Information
Regulation Z which implements the Truth in Lending Act, requires creditors to provide a brochure When Your Home Is on the Line: What You Should Know About Home Equity Lines of Credit, or a suitable substitute, to consumers when an application form is provided for a home equity line of credit. The brochure is available on the Federal Reserve Board's Web Site.
See Mortgage Calculator Web Site on "Should I Consolidate Debt into a Home Equity Loan?"
View the Home Ownership and Equity Protection Act.