Home Equity Loan
What is a home equity line of credit?
A home equity line of credit 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 maximum amount you may borrow
at any one time under the plan. Many lenders set the credit limit
on a home equity line by taking a percentage (say, 75 percent) of
the home's appraised value and subtracting from that the balance
owed on the existing mortgage. For example,
In determining your actual credit limit, the lender will also consider
your ability to repay, 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 ended. 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 (the "repayment 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) and to 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?
If you decide to apply for a home equity line of credit, look for
the plan that best meets your particular needs. Read the credit
agreement carefully, and examine the terms and conditions of various
plans, including the annual percentage rate (APR) and the costs
of establishing the plan. The APR for a home equity line is based
on the interest rate alone and will not reflect the closing costs
and other fees and charges, so you'll need to compare these costs,
as well as the APRs, among lenders.
Interest rate charges and related plan features
Home equity lines of credit typically involve variable rather than
fixed interest rates. The 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
for borrowing under the home equity line changes, mirroring fluctuations
in the value of the index. Most lenders cite the interest rate you
will pay as the value of the index at a particular time plus a "margin,"
such as 2 percentage points. Because the cost of borrowing is tied
directly to the value of the index, it is important to find out
which index is used, how often the value of the index changes, and
how high it has risen in the past as well as the amount of the margin.
Lenders sometimes offer a temporarily discounted interest rate for
home equity lines--a rate that is unusually low and may last for
only an introductory 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 interest rate may fall if interest
Some lenders allow you to convert from a variable interest rate
to a fixed rate during the life of the plan, or to convert all or
a portion of your line to a fixed-term installment loan.
Plans generally permit the lender to freeze or reduce your credit
line under certain circumstances. For example, some variable-rate
plans may not allow you to draw additional funds during a period
in which the interest rate reaches the cap.
Costs of establishing and maintaining a home equity line
Many of the costs of 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 to estimate the value of your
- An application fee, which may not be refunded if you are turned
down for credit.
- Up-front charges, such as one or more points (one point equals
1 percent of the credit limit).
- Closing costs, including fees for attorneys, title search, and
mortgage preparation and filing; property and title insurance;
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. If you were to draw only a small amount against your credit
line, those initial charges would substantially increase the cost
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 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?
Before entering into a plan, consider how you will pay back the
money you borrow. Some plans set minimum payments that cover a portion
of the principal (the amount you borrow) plus accrued interest.
But (unlike with the typical installment loan) the portion that
goes toward principal may not be enough to repay the principal by
the end of the term. Other plans may allow payment 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 amount when
the plan ends.
Regardless of the minimum required payment, you may choose to pay
more, and many lenders 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 percent interest
rate, your monthly payments would be $83. If the rate rises over
time to 15 percent, 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
your agreement calls for keeping payments the same throughout the
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 home 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.
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