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Home Equity

Types of Home Equity Loans

Fundamentally, there are two types of home equity loans.

• Home Equity Line: When you get a home equity line, you obtain the right to draw money, whenever you want, over a certain period of time. You only pay interest on the amount you borrow. You may borrow, pay off and borrow again against the line of credit. You typically access the line with a check or credit card.
• Second Mortgage (home equity loan): When you get a second mortgage, you obtain a lump sum of money. The interest rate and monthly payments are fixed.

Before deciding which type of loan you want, consider how you'll use the money. If you need funds for a single expense, such as a room addition, remodeling, etc., you'll want to strongly consider a fixed-rate, second mortgage. You receive one lump sum at the beginning of the loan term. You pay it back in equal, monthly installments.

The certainty of a fixed interest rate and equal monthly payments make the fixed-rate, second loan very attractive. Will this type of loan be less expensive compared to an adjustable rate, home equity line? There is no way to know with certainty. One would have to be able to predict interest rates with accuracy. Consider one of the reasons why adjustable rate loans were invented:  to shift interest rate risk from the lender to the borrower. When market interest rates rise above the interest rate on your fixed-rate mortgage, the lender is effectively losing money on your mortgage and you're getting a bargain. Lenders wanted a way to protect themselves from this situation--thus the adjustable-rate mortgage.

If you need periodic amounts of money over time, for a child's education tuition, for example, a home equity line may be ideal. You can borrow only the amount you need, when you need it. These loans carry adjustable (ARM) rates, but some banks allow you to convert a portion of your loan to a fixed-rate second. You may pay a premium for the convenience of an equity line, including a transaction fee for each draw and an annual fee if you draw or not.

Deciding in advance which type of loan is best for you helps when comparing the expense of various loans. Since the APR for a fixed-rate second is calculated differently compared to a home equity line, APR comparisons can be difficult when comparing a fixed-rate second to a home equity line. APRs of fixed-rate seconds account for points and other closing charges.  APRs for home equity lines don't account for points and other closing costs. When comparing the same types of loans (apples to apples), APRs are much more meaningful.

* Interest may be fully deductible. Consult your tax advisor regarding your particular situation.
** Under certain circumstances, some loan programs let you convert part of your home equity line to a fixed-rate, home equity loan.

What is a Home Equity Line 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 particular 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 loan 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. 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. The credit limit is the maximum amount you can borrow at any one time while you have the loan.

Many lenders set the credit limit on a home equity line by taking a percentage (say, 75 percent) of the appraised value of the home and subtracting the balance owed on the existing mortgage. For example:

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 ten 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 ten years.

Once approved for your home equity loan, you should be able to borrow up to your credit limit whenever you wish. Typically, you will be able to draw on your line by using special checks.

Using a special credit card or other means, some plans allow borrowers to make purchases, in addition to borrowing money. 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) and to keep a minimum amount outstanding. Some lenders may require that you take an initial advance when you first set up the line.

Closing Costs

Many of the costs of obtaining a home equity line of credit may look familiar to you. From the lender's standpoint, there isn't much difference between a purchase money mortgage, home equity loan, or home equity line. The standard services will be required to protect the lender's interest. Potential services and their associated fees include:

• Property appraisal.
• Loan application. The fee may not be refundable if you are turned down for credit.
• Loan origination fees (points). One point equals 1 percent of the credit limit.
• Attorney, title and escrow, mortgage document preparation, recording documents, property and title insurance.
• Annual membership or maintenance fees.
• Transaction fee for drawing on the credit line.

Repayment

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 immediately pay the entire outstanding balance. 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 calling for interest-only payments. At a 10 percent interest rate, your initial monthly payments would be eighty-three dollars. If the rate should rise over time to 15 percent, your monthly payments would increase to $125. 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 allowed 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.

Home Equity Loan Checklist