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The Best Home Equity Line of Credit 101

By Tamon

If you are in the market or planning to hit the market for a credit, a home equity plan is one of several available options that you may want to consider. But, before making a decision or considering a home equity line of credit, you should weigh carefully the costs of getting it against the benefits. While there are more over hundreds of companies that provide this type of credit, you should conduct a thorough research and shop for the credit terms that best meet your borrowing objectives without posing undue financial risks. And remember, if you fail to repay the amounts you’ve borrowed, plus the interest, that could just mean losing of your home.

 

What is a Home Equity Line of Credit?

A home equity line of credit (Also known as a HELOC) is a form of revolving credit in which allows you to borrow funds on an as-needed basis against your home. Put another way, it’s a form of mortgage loan where your home serves as collateral. Because a home is often considered a consumer’s most valuable asset, many homeowners choose this form of credit only for major expenses, such as consolidating debt, home improvements, medical bills, buying a car, or education, and choose not to use them for day-to-day expenses.

With a home equity line of credit, you will be approved only for a specific amount of credit. Most credit lenders set the credit limit on a home equity line by taking a percentage, usually 75% of the home’s appraised value and subtracting from that the balance owed on the existing mortgage.

Consider a scenario where the appraised value of home $100,000. If the credit limit is 75%. Then the total credit worthiness will be 75% of $100,000 which is $75,000. This means that, the lender will be willing to loan a total of $75,000 against your house as the collateral. If you still have a mortgage loan on this house worth $25,000, this mortgage loan will be deducted from this amount. Therefore, the potential home equity line of credit would be $50,000

In determining your actual home equity credit limit, the lender will also have to consider your ability to repay the home equity loan, principal and interest, by looking at your credit history, debts, income, and other financial obligations.

Many home equity plans set a fixed period, such as 15 years during which you can borrow money. At the end of this period (draw period), you may be allowed to renew the home equity loan. However, if your plan does not provide for renewals, you will not be allowed to borrow additional money once the period has ended. Some plans may allow repayment over a fixed period, the repayment period, such as over 15 years while others may require you to make a full payment of any outstanding balance at the end of the period.

Once approved for a home equity loan, you will most likely be able to borrow up to your credit limit whenever you want, during the draw period. Typically, you will use special checks to draw on your line of credit. Some plans allow borrowers to draw with their credit card or other means.

There may be other limitations on how you use the line of credit. While some plans may require you to borrow a minimum amount, say $500, each time you draw on the line or keep a minimum amount outstanding, others may require that you take an initial advance when the home equity loan is set up.

 

Things to Consider When shopping for a HELOC

Once you have resolved to apply for a home equity line of credit, the next step is to search for the best home equity line of credit that meets your particular needs or objectives. Read the credit agreement carefully, and consider the conditions and the terms of various plans, including the costs of establishing the plan and the annual percentage rate (APR). Remember, that the APR for a home equity line of credit is based on the interest rate alone. It does not reflect or include other fees and charges such as closing costs. Therefore, make sure you take a proper consideration of these costs among lenders, as well as the APR rates.

 

Best Home Equity Line of Credit Rates: Variable interest rates

Home equity lines of credits are typically approved on a variable rather than fixed interest rates. The rate must be based on a publicly available index (such as the prime rate published in a U.S. Treasury bill rate or in some major daily newspapers). In such cases, the home equity lines of credit rates you pay will change, with respect to changes in the value of the index. Most lenders quote the interest rate you will pay as the value of the index at a particular time, usually the rate at the time of the approval, plus a “margin,” such as 2% points. Because the interest rate is tied directly to the value of the index, it is important to look at the index used, how high it has risen in the past, and how often its value changes. Also important to note is the amount of the margin.

Some lenders sometimes offer a temporarily discounted interest rate for home equity lines of credit, an “introductory” home equity rates that is unusually low for a short period, usually 6 months.

Variable rate plans secured by a dwelling must, by law, have a cap (or ceiling) on how much your interest rate may increase over the life of the plan. Some variable rate HELOC lenders limit how much your payment may increase and how low your interest rate may fall if the index drops.

Some lenders, including Bank of America, allow you the option to convert from a variable interest rate to a fixed rate during the life of the loan, or let you convert a portion or all of your outstanding variable-rate balance on your HELOC to a fixed-term installment loan. Payments make on the balance at a fixed interest rate are stable and predictable and can protect you from rising interest rates.

 

Establishing and Maintenance Costs

Most of what you spend as costs or charges of setting up a home equity line of credit is similar to those you pay when you get a mortgage. These may include:

  • An application fee, which may not be refunded if you are turned down for credit
  • A fee for a house appraisal to estimate the value of your home
  • An up-front charges, such as one or more “points” (1 point equals 1 percent of the credit limit)
  • Closing costs, consisting of fees for title search, attorneys, property and title insurance, mortgage preparation and filing, and taxes.

Also, you may be required to pay certain fees during the loan period, such as a transaction fee every time you draw on the line of credit and an annual membership or maintenance fees.

Note that, the cost you pay for your home equity loan application may sum up to hundreds of dollars. And if you are also required to pay other charges such as the transaction fee, this may also sum up, especially if you draw only a small amount against your line of credit such that you carry out multiple transactions, you could find yourself paying thousands of dollars. Those initial charges would substantially increase the cost of the funds borrowed.

But, due to lower lender’s risk, as compare to other forms of credit, (since you have a collateral, your house backing your loan), the annual percentage home equity lines of credit rates are generally lower than rates for other types of credit. The interest you save could be enough to pay the costs of establishing and maintaining the line. Moreover, some lenders may even waive all or some of the closing costs.

 

Plan on Paying your HELOC

Before entering into a home equity line of credit, you must consider how you will pay back the loan. Some lenders require an upfront payment, while others expect a set amount within a minimum monthly payment that comprise of a portion of the principal (the amount you borrow) plus accrued interest. But, unlike with traditional installment loan agreements, the fraction of your payment that goes toward paying the principal may not be enough to repay the principal by the end of the term.

Other plans (known as “interest only” plan) allow payment of interest only during the life of the loan. This means that you pay nothing toward the principal loan you collected. For example, if you borrow $20,000, you will owe just that amount (with all interest paid) when the payment plan ends.

Regardless of the minimum required payment on your home equity line, you may decide to pay more and many lenders offer different payment options. Some borrowers may choose to pay down the principal regularly as they do with other loans. For instance, if you use your line to buy a car, you may want to pay it off as you would a typical car loan.

Whatever your payment choice during the life of the loan, whether you pay none, a little, or some of the principal amount of the home equity loan, when the loan period ends, you may be required to pay the entire balance owed, all at once. You may at such instance, consider refinancing your loan with the lender in order to make such huge or “balloon” payment. Refinancing simple mean obtaining a loan from the same or another lender, or by some other means. Remember, you could lose your home if you fail to make the balloon payment.

If your home equity loan has a variable interest rate, your monthly payments may change. For example, assume that you borrow $10,000 from a lender who require for interest-only payments. If we consider a typical home equity line of credit rates at 10%, your monthly payments would be $83. If the interest rate rises over time to 15%, your monthly payments will increase to $125. Similarly, if you payments choice consist of making payments that cover interest and some portion of the HELOC, your monthly payments may also increase, unless your agreement required that you make a fixed amount in payments throughout the plan period.

If you decide to sell your house, before the end of the loan payment period, you will probably be required to pay off your home equity line in full immediately. If you are planning to sell your home in the near future, consider whether it would be profitable to pay the up-front costs of setting up a home equity line of credit. Also remember that, some plans, under the terms of your agreement may prohibit renting your home.

 

Lender Freezing or Reducing your HELOC

Plans generally permit lenders to reduce or freeze a line of credit when the lender “reasonably believes” (with evidence) that you will be unable to make your payments due to some changes (material change) in your financial circumstances, or if the value of the home declines significantly during the loan repayment period. If this is the case, you (borrower) may want to:

Talk with your lender. Find out what prompted the lender to reduce or freeze your line of credit and what you can do to restore it (if anything). You may be require to provide additional information, such as documentation showing that there has not been a “material change” in your financial circumstances or  that your house has retained its value, in order to restore your line of credit. If you may have to get copies of your credit reports (from the Federal Trade Commission) to make sure all the information in them is correct. If your HELOC lender request a new appraisal, make sure you discuss Appraisal Company in advance so that you are certain they will accept the new appraisal as valid.

Shop around for another line of credit. As a last resort, if your lender does not want to restore your home equity line of credit, search around to see what other lenders have to offer. You may be able to get a refinancing (loan to pay off your original line of credit and take out another one). However, keep in mind that you may be required to pay some (if not all) of the same application fees you paid for your original line of credit.

 

Benefits of HELOC

Getting a loan may not seem a wise financial decision on the surface however; home equity lines of credit offer a variety of financial benefits to borrowers. Most HELOC lenders make funds are available just after a maximum of four working days after you sign your loan documents. This fund is put at your disposal during the entire draw period of your loan, thus, you can access if at will or even transfer funds.

 

Debt Consolidation

By using a home equity line of credit to pay off higher-interest debts, you may be able to pay off the debt more slowly without struggling merely to keep up with rising interest charges. And while HELOC typically carry higher interest rates as compare to an original mortgage loan, the rates are generally much lower than those charged by credit card providers and short-term personal loan companies. Bear in mind, though, that because your home is the collateral for the HELOC loan, failure to make payments can cause you to lose your home.

 

Interest Only Payments

Although making payments against charges on your HELOC is essential to paying down the balance, most home equity line of credit lenders don’t require borrowers to pay on the principal each month. This is a huge benefit particularly to those who are in a financial bind because you can opt to pay only the interest charges until your finances recover. This is an option most other lenders don’t allow.

 

Tax Deductible

The IRS regulations allow borrowers to claim the interest paid on a home equity line of credit as a tax deduction. The size of your home equity line of credit debt must be less than $50,000 ($100,000 for married couples filing jointly) to qualify. This is not true for other forms of revolving credit, such as credit cards, which do not allow borrowers to receive a tax break on their interest charges.

 

Better Credit

When you start making payments on your home equity line of credit, the account will appear on your credit report. According to the most lenders, the most prominent factor that influences your credit scores is your payment history with creditors. By making timely payments on your home equity line of credit, you can increase your credit score. Spending up to and more than 70 percent of your line of credit’s spending limit will also help you improve your credit rating.

 

Low closing costs

Most lenders charge a low closing cost on the home equity line of credit. Some lenders may even waive them altogether, particularly if you have good credit score (if you keep a good faith with your loan payments).

Low interest rates

Because they're secured by your home equity, the best home equity line of credit rates are lower rates than unsecured loans such as personal loans and credit cards. And as an adjustable-rate loans, they can give you a lower rate than a standard home equity loan. However, these rates can vary over time.

Financial flexibility

A home equity line of credit lets you borrow the amounts you need and when you need it most. This loan type also allows you to only pay interest on what you've actually borrowed. For example, if your lender approves a HELOC loan of $50,000 and you actually spend just $30,000, you will be required to pay interest on the $30,000 and not on the $50,000 approved loan. This makes them useful for covering on-going expenses over a period of time.

No restrictions on use of funds

When you get approval for a home equity line of credit, how you use it is solely a matter of your preference or needs. You are not required to justify your plans for using your loans as it’s the case with most other types of loans. However, you most play with caution in the way you use your HELOC loans since you're backing them up with your house.

Caps on rate increases

The best home equity line of credit will have a maximum cap (ceiling level) on how high it can get, so even if interest rates increases, you have some protection. Verify the lifetime cap before you decide to the loan, and make sure that you’ll be able to comfortably handle the monthly payment even when it jumps to the maximum.

No usage fees

Most home equity line of credit lenders do not charge a fee for drawing funds and others charge just a minimal fee.  Therefore, you have to check this with your lender to be sure you will be able to handle the additional charges before closing the deal.

Repayment freedom

Most home equity line of credit lenders gives you the privilege to decide your payment choice. For example, if you need a short-term loan, to pay your taxes while you’re waiting for some money to come in, you could take a draw on your home equity line of credit, settle interest for a short term, and later pay off the balance once you receive your funds.

 

Some of the risks of HELOCs

While a home equity line of credit may provide you with a good number of benefits, there are some risks with this loan type. Most disturbing of all is the fact that your home will be on the line if you don't repay the HELOC. Some lenders may also prevent you from renting the home, thereby limiting your possible source of income. Para venture, you’re unable to make your payments due to some changes (material change) to your financial circumstances, and your lenders may be forced to reduce or freeze a line of credit without any notice. This may end you with no money at your disposal and with an impending loan to pay. If you use a HELOC to pay off other debts, there is a more change that you will still need funds to pay off the HELOC. This will only mean drowning yourself into deeper debts.  When the draw period ends and the repayment period begin, the minimum monthly payment can get too high to afford the payment (cause by variable interest rate).

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