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Home Equity Line of Credit
By Kirk Haverkamp
Updated and reviewed Jul 10, 2013
There are infinite scenarios that may leave you in need of a quick infusion of cash. You may be seeking funds to buy a car or send your child to college, or you may be longing to renovate an aging kitchen or bathroom, or adapt new green technologies to your home. Ideally, you could fund these purchases with some type of emergency cash fund or savings account that you’ve been accumulating for this very occasion. But if you’re like most Americans, you don’t have that kind of cash sitting around in your account just waiting for you to need it.
If you’re a homeowner who has accumulated equity in your property, you may be able to tap into it for the cash you need with a home equity line of credit, which is also known as a HELOC. By doing this, you can take advantage of borrowing money at a relatively low interest rate, and get some tax benefits to boot that are not available with other kinds of loans.
HELOCS - The Basics
A HELOC is a second mortgage against your property. Unlike its sister, the home equity loan, which offers a fixed rate and a fixed term, a HELOC is akin to a giant credit card account that’s secured by your property. Once the HELOC is opened, you can withdraw as much cash as you need, up to your approved credit limit, and you’ll only pay interest on the amount you withdraw.
Lenders will generally extend a credit line up to 80 percent of your home’s available equity. To determine that amount for your individual situation, you’ll need to know the following numbers the appraised value of your home, and the amount remaining on your mortgage, if there is one.
If your home is worth $200,000, for example, and you owe $100,000 on your mortgage, the equity in your home is 100,000. Since most banks will generally allow you to borrow up to 80 percent of your outstanding equity, the maximum amount you could borrow in this scenario is $80,000. There are many other factors that will determine whether you will be approved for a HELOC, including your credit history, income, how much debt you have, and your other financial obligations. If you don’t pay your HELOC back in a timely manner, however, you could lose your home.
Paying it back
HELOCs come in two parts the draw period, and the repayment period. During the former, which is generally around 10 years, you can pull out the funds you need, up to your credit limit. The bank will provide you with separate checks or a credit card to facilitate your withdrawals. However, when that period ends, you could be required to pay back the entire indebtedness in full. Some banks may allow you to renew the credit line, or convert the loan into an amortizing adjustable-rate loan, which will be required to be paid back during a specified number of years. It’s important that you understand the terms of your loan before you agree to it, or you could be in for a big shock when the draw period is over, especially when the total amount of the borrowing is due and payable.
With a HELOC, the interest rate is adjustable. Therefore, the amount that you’ll pay each month will vary based on prevailing interest rates. The rate will be based on an index, generally the prime rate, that’s set by the Federal Reserve. When your lender gives you the HELOC rate, it will generally be quoted as this index, plus or minus a margin. If the prime rate is seven, for example, and the rate that your bank gives you is prime minus 1, you’ll be paying an interest rate of 6 percent for that month. The good news with a HELOC is that you’ll pay interest only on the amount you borrow, not on the entire line of credit.
In many HELOCs, the amount of principal that you’ll be required to pay each month is up to you, although there will always be some minimum payment of around $50 if there is an outstanding balance. You could choose not to pay any principal back until the end. But beware – if you choose this path, you may be hit with a huge payment that you won’t have when the time comes.
HELOCs are very desirable when interest rates are low or dropping, but they can be very unappealing in periods when interest rates are high.
Shopping for a HELOC
The process of looking for a HELOC is similar to shopping for a mortgage. You’ll be required to pay an application fee, which may or may not be refundable, depending on your particular lender -- so don’t forget to ask. You’ll also have to fork over funds for an appraisal, so the bank can determine the value of your home in the current real estate market. You may want to check with a local realtor, or with a website like Zillow.com, to get an estimate of the value of your property. If prices have dropped, you may not have enough required equity to make a HELOC worthwhile.
There may be other costs the bank can ask for, including closing costs, attorney fees, mortgage preparation, and filing expenses. Some banks charge annual membership and/or maintenance fees, or even a fee every time you make a transaction. But not all banks do, which is why it’s imperative that you shop around and make sure you’re getting the best deal available for you.
Begin your HELOC search with a bank that you’re currently doing business with, because many lenders give discounts to existing customers. In addition, if you have outstanding credit, many banks will waive all the closing costs altogether. And don’t forget to ask if your loan can be renewed or converted to a fixed-rate loan once the draw period is over. How your HELOC ends is just as important as how it begins.
Advantages of HELOCs
There are many other ways to borrow money from your home other than by using a HELOC, but they may not offer the same advantages. You could try a home equity loan, for example. In this case, you’d withdraw all the funds at once, and pay it back on a fixed schedule with a fixed interest rate, which means it wouldn’t have the same flexibility. You could also consider a mortgage refinance, but closing costs will be a lot more expensive.
A HELOC offers the following advantages when compared to other types of borrowing
- Low closing costs. As mentioned earlier, closing costs are low, relative to a mortgage refinance. And if you have outstanding credit, the bank may waive them altogether.
- Caps on rate increases. Your HELOC will have a maximum cap on how high it can climb, so even if interest rates rise, you have some protection. Check the lifetime cap before you agree to the loan, and make sure that you’ll be able to handle the monthly payment if it jumps to the maximum.
- No usage fees. Most banks will not charge you each time you draw from your HELOC. However, check with your bank, because some banks do, and you wouldn’t want to get stuck with a bank that charges fees for their HELOC, when you could have one that’s free of such costs.
- Pay back freedom. You can pay back the principal whenever you like. If you need a short-term loan, for example, to pay your taxes while you’re waiting for some money to come in, you could take a draw on your HELOC, pay interest for a short term, and then pay off the balance in full once you receive your funds.
- Tax advantages. You may be allowed to take a mortgage interest deduction for your HELOC of up to $100,000 of your borrowing. However, there are restrictions on how these funds are used, so it’s important that you consult your tax advisor to make sure that it’s appropriate for your particular situation.
Using your HELOC creatively
There are situations where using a HELOC makes obvious sense. If you have short-term financial needs, or you want to fund a renovation, or even if you need money for a vacation where you’re a few thousand dollars short, it makes sense to use a HELOC. But savvy homeowners have used their HELOCs in a variety of other ways that you may not have thought of, especially in times when the credit markets are tight, and it’s hard for people to borrow from banks.
If you’re considering funding a small start-up business, for example, a HELOC is an easy way to get access to money. Borrowing for a business that’s not established comes with a catch 22 – you need to show that your business is established in order for a bank to consider you a worthy candidate for a loan, but you can’t build your business without funds! But if you’re a homeowner with equity, a HELOC could help you solve this problem until the point when your business is successful, and the bank will deem you a worthy candidate for a loan.
Another way you can think outside the box when it comes to a HELOC is to use it for a bridge loan if you’re buying a house, but the sale of your current house hasn’t closed. A HELOC is a great candidate for a situation that demands temporary liquidity, because closing costs are low, paperwork is minimal, and it usually doesn’t take too long to get approval. You’ll also save money over a traditional bridge loan, because you only pay interest on the amount you borrow, as opposed to the entire sum that you’ve applied for. The big trick here is to apply for your HELOC before you list your property with a broker. Once the property is up for sale, most banks won’t give you a HELOC.
If you have a HELOC during a period where home prices are going in a downward spiral, your bank may freeze your credit line. This can occur if the value of your home significantly declines, or if there is a change in your financial circumstances. If this happens to you, you can take the following steps
- Try an appeal. Your first step would be to contact your bank, and learn the specific reason that they decided to freeze your credit line. They will also tell you what steps you need to take to get it reinstated. You may be able to get a new appraisal on your home, in order to show the bank that your home is retaining its value. If you decide to take this route, discuss it first with your bank, to ensure that they’ll accept the appraisal before you go out-of-pocket to pay for it. One problem with this path is that it can take a long time before you get all your paperwork to the bank, and it may be too late.
- Contact other banks. Just because your bank is tightening their purse strings doesn’t mean that other banks are. If you can get a new HELOC with another lender, you can pay off the old one and move forward. It may, however, mean another round of closing fees.
- If you get wind that your bank is beginning to freeze HELOCs, and you have more credit left on your line, you can withdraw the maximum amount or as much as you need. The only problem with this strategy is that you have to pay interest on the amount you withdraw.
Tips for finding your HELOC
If you’ve determined that a HELOC is right for you, here are some hints for making sure you find the one that’s the best deal.
- Shop carefully. Your first step is to call a variety of different lenders, and check online sites, to get information. Make a list so that you can compare what each bank offers side-by-side. Take a piece of paper, and get ready to compare. The first section should include the basic features of each loan. Make columns for the annual percentage rate, the index used (and current value), the amount of the margin, the frequency that the rate adjusts, and the interest-rate cap. You’ll also want to compare the draw period and the repayment period, and the initial fees, including ones for the appraisal, application, and closing costs. Finally, list all the possible repayment terms, including when the period ends, if there’s a balloon payment, and if a renewal or refinancing will be made available by the lender.
- Don’t be afraid to haggle. If one lender offers a good rate with closing fees, but another offers no closing fees, don’t be afraid to ask your preferred lender for a better deal. They may say no, but if you don’t ask, you don’t even give yourself a chance.
- Watch out for teaser rates. Some lenders will advertise HELOCs with very low rates, or fixed rates, just to draw you in, or “tease” you to become a customer. However, after a certain period of time, those rates will revert back to their higher counterparts. Make sure that the rates you are being quoted are for the entire term of the loan.
- Get the draw information. Since each bank has its own policy, make sure that you fully understand how each bank operates. If you need money quickly, you might want to withdraw funds during the closing, since it may be a few weeks before you get your checks or the credit card that’s connected to your account.
- Stay conscious. Make sure that you can handle the payments, even if the interest rate hits its cap. Discipline is essential when you have a HELOC. If you withdraw the total amount, you won’t have any more credit available. And worse, if you have a huge outstanding balance when the draw period ends, you may need to pay it all at once. If you don’t have the funds on hand – and it’s likely you don’t if you’re applying for a HELOC – you may need to do a mortgage refinance or take out another HELOC. If you’re in a tough lending environment, this may not be possible, and you run the risk of losing your home.
Versatility of HELOCs
Your home's equity can be one of the best ways to find capital when funds are scarce. And the best way to tap into this equity is with a home equity line of credit (HELOC), which gives you the flexibility of a credit card and the tax-deductions of a mortgage. Since a HELOC allows you to draw funds for myriad reasons, it has become the Swiss Army Knife of financial instruments.
One credit line, many uses
Popular reasons to tap a home's equity include home improvement, debt consolidation, a second home purchase, vacations, and college tuition. Many small business owners will opt to use a HELOC instead of applying for business loans, because the process is easier and less expensive.
In recent years, debt consolidation has proven to be an extremely popular use for the HELOC. It can drastically reduce a borrower's monthly payment by offering lower interest rates than credit cards. On the flip side of the coin, people who are debt-free often use the HELOC to buy a car, taking advantage of the tax-deductibility of the interest payments.
Rainy day fund
It's a basic rule of thumb to keep three to six months of living expenses stowed away in a liquid account as a rainy day fund. Even though it's a great savings habit, consumers are forsaking savings, and using a HELOC as a source for emergency funds. If you choose this route, make sure the lender you select doesn't charge a fee just to keep the line of credit open. Just because you have a rainy day fund doesn't mean the institution should rain on your parade.
HELOCs can be fee-free. Avoid a lender who wants to charge you for writing checks or proposes exorbitant closing costs. Some lenders might require an appraisal; but there are plenty of lenders who will waive the appraisal fee. The cost of writing checks should also be free of charge.
Convert to a fixed-rate loan whenever you want
Since HELOCs are tied to short-term interest rates, they may rise suddenly. If they do, you may find that a fixed-rate home equity loan can save you money in interest payments over the long-term. If you choose to convert, expect a higher monthly payment. There may also be additional closing costs, so do the math to see if this move is right for you.
These features, as well as caps on interest rate increases and no prepayment fees, are all versatile benefits that underscore the HELOC's Swiss Army Knife reputation. About the only thing you can't do with it is whittle, or use it to spoon up beans by the campfire. Short of those tangible benefits, the HELOC could be the versatile borrowing tool for just about anything you need.
HELOCs Find The Hidden Fees
Life is all about taking the good with the bad. With a home equity line of credit (HELOC), just make sure that your mortgage has more good than bad when you're comparing potential lenders.
The devil is in the details. For mortgage lenders, so is the profit. With the home equity line of credit (HELOC), there are a number of ways a lender can make money that may not be immediately apparent to a borrower. These details are generally woven into a loan's fine print, so you'll need to watch out for them when you're HELOC shopping.
The primary way a lender makes money on a HELOC is by charging a margin. The margin is the amount that's added to the prime rate to determine your mortgage rate. The lender may offer a HELOC with an introductory rate that's much lower than the prime rate plus the margin. But after the initial period-generally six months to a year-a lender will adjust the rate upward, even if the prime rate hasn't changed. They may continue to base the interest on the prime, but they'll likely have built in a margin, and you may not know exactly what the margin will be unless you inquire directly about it.
When you're shopping for a HELOC, always ask about the margin. Factor this in as you collect quotes from a number of different parties.
To TIL the truth
With every mortgage, a lender is required to disclose a Truth in Lending (TIL) statement. The TIL discloses the exact cost of the loan. For many homeowners, this is an excellent way to determine precisely how much your mortgage will cost you. For HELOC borrowers, the issue is slightly cloudy. The TIL makes no disclosure of margins. You can't rely on the document for an apples-to-apples comparison, so don't trust it. You'll need to ask the lender directly about it.
See no evil
Lenders are notorious for sliding in a few fees here and there, with many of them occurring the year after you've closed the loan. For example, a lender may entice you into closing on a loan by not including any closing or appraisal costs. However, the next year, you may discover on a statement that you've been charged an annual fee. Be sure that you know all the fees before you make a move.
These types of devilish details tend to leave a bad taste in borrowers' mouths. To be fair, this is how lenders make their money. You can expect to pay some sort of costs during the course of the loan. Just be sure to check in all the known places where fees and hidden costs tend to hide. Find them, and you'll find a way to get yourself a more affordable HELOC.
Lower Your HELOC Rate
A home equity line of credit can be a great tool for consolidating high interest credit card debt, or financing a long-overdue home improvement project. Get the lowest rate possible, and then bank the savings over time.
A home equity line of credit (HELOC) is easy to establish, requires very little red tape, and generally carries no monthly fees, except for payments made on the money you borrow. Best of all, when you don't need to borrow, the credit line just sits there waiting for you to use it. What's more, you don't have to pay any interest until you actually withdraw the funds. In other words, a HELOC has all the convenient features you enjoy with a typical credit card. Many banks and financial institutions will even issue you a card that resembles a credit or ATM card, or simple checking account style checks. You can then use them whenever you want to access your equity.
The big difference between a home equity line of credit and a consumer credit card is the interest rate. HELOCs usually charge only a portion of what you might expect to pay for a credit card, because HELOC rates are only slightly higher than the rates charged for mortgages. While credit card interest can easily soar into double digits-and climb into the 25 or 30 percent stratosphere if you make a late payment or commit some other minor account infraction-HELOCs are relatively stable. With a HELOC, for example, you don't run the risk of borrowing over your limit. If you approach your credit ceiling, the HELOC automatically refuses you additional funds. But as soon as you pay down your debt, your available cash kicks in again, replenishing your supply of equity financing.
Tips for lowering rates
To really take advantage of the features of a HELOC, shop around for the lowest possible rate. Then, when you transfer your consumer debt to your HELOC, you'll capture a greater percentage of savings.
To get the cheapest rates, follow these tips before applying
Pay off debts, clean up your credit report, and raise your credit score.
Spread it around. Find out how much lenders add to the prime rate to determine your interest rate. The prime will fluctuate, but the "spread" charged by lenders determines your bottom line. Get the lowest spread possible.
Don't max out your HELOC. Borrow a little, then pay it off and borrow more, instead of biting off a huge chunk that you'll have trouble repaying.
Over time, each percentage point can translate into hard cash that would otherwise have been lost. Managing your finances with a HELOC can add up to thousands of dollars in savings over time. Those savings are compounded by tax benefits-unlike credit card debt, which is not tax deductible, most home equity loan debt carries valuable year-end deductions.
Six Advantages of HELOCs
If you were a typical kid, you hated homework. But as an adult, you now understand that doing your homework can pay off financially-especially when you learn about the advantages of a home equity line of credit.
Debt has a lousy reputation. It's often associated with financial pain and strain. But when this bane of your existence exists in the form of a second mortgage, it allows you to purchase some of the good things in life, including a new car, a home renovation, or a set of plane tickets for a vacation.
As much as we like to grumble about it, debt can sometimes be a blessing. And if we choose the right kind of second mortgage, such as a home equity line of credit (HELOC), borrowing money doesn't have to cost you an arm and a leg. Here's why
1. No closing costs
If your credit is good, you won't pay any closing costs on your loan. That means no application fee, and no closing or appraisal costs. If a lender tries to charge you for these things, take your business elsewhere.
2. No fees when using your HELOC
It's common practice for most checking accounts to tack on usage or check-writing fees. HELOCs are different. You should never have to pay any kind of account maintenance or check-writing fees.
3. Low interest rate
The rate on your HELOC is variable and based on the prime rate, which is relatively low by interest rate standards. When you factor in the loan's tax deductibility, you have access to relatively inexpensive money.
4. Caps on rate increases
Even if the prime rate jumps, your HELOC should have a cap on how high it can climb on a quarterly basis. Most loans will move up in increments of 0.5 percent or less. Stick with a HELOC that has a lifetime rate cap that's within your budget. You never know what the market will do, so it's best to be prepared.
5. Converting to a fixed-rate product
Jumps in the prime rate over the past year have made the fixed-term, fixed-rate home equity loan more attractive. Most HELOCs allow you to convert to the home equity loan whenever you'd like.
6. Pay it off when you like
You should also have the ability to pay off your HELOC whenever you'd like. Talk to a loan officer before you close the mortgage, and be certain that there are no fees for paying off your loan early.
Lenders understand that their second mortgages must be attractive to borrowers to compete in the marketplace. That's why they've equipped loan products like the HELOC with so many benefits. If you've got good credit, you should be able to take advantage of all the HELOC benefits, and make a bitter pill, like debt, a little easier to swallow.
Five HELOC Risks
With relatively low interest rates and tax-deductible interest, home equity lines of credit (HELOCs) have always been considered the best choice when it comes to home improvement loans. But while they might be the top lending tool for homeowners, HELOCs have their fair share of risks. The phrase "one size fits all" might apply to ski caps and umbrellas; but it has no place in the world of financial instruments. A terrific opportunity for one individual might spell trouble for another. A home equity line of credit (HELOC) is a perfect example. It has many tangible benefits, but the loan needs to be used in the appropriate situation; otherwise, the risks may outweigh the rewards. Here are five examples why one size doesn't fit all when it comes to home equity loans.
1. Low payments, little equity gained
A HELOC has a very attractive feature-the minimum monthly payment need only cover interest costs. A loan amount of $30,000, for example, might only require a minimum payment of $200. This allows you to float the balance from month to month. Over the long haul, however, if you make only the minimum payment, you'll never pay off any principal, and the loan will never go away.
2. Interest rates rise
Interest rates on HELOCs are usually based on the prime rate, which tends to hover in the single-digit range. A HELOC's loan rate is variable, however, and usually rises when the Federal Reserve increases rates to stem inflation. These increases can come quickly and may climb 2 percent or more. As a result, that low minimum payment will increase.
3. Hammered by hidden fees
Lenders lose money when borrowers refinance loans with another institution. To keep their loans in-house, lenders will tack on early-termination fees. These can be either a set fee, or a percentage of the loan balance. Before you take out the loan, look for a lender who doesn't impose these types of fees.
4. Losing home value
Another risk is that your home may decrease in value while you're borrowing more money. When it comes time to sell the house or refinance the loan, you may find that the equity that you had counted on has suddenly disappeared. Avoid this problem by making sure that the total amount of your home loans doesn't equal more than 80 percent of the house's market value.
5. Borrowing unwisely
A HELOC works well if you're borrowing for home improvements or to launch a business. Those types of investments can appreciate over time. If you're borrowing to finance a trip to Hawaii, the memory of a great vacation will eventually fade away with your suntan, but your debt will stay with you until the last cent is repaid.
HELOCs have plenty of upside; but every homeowner's situation is different. As with any financial tool, you need to consider all the potential risks, as well as the rewards. A HELOC is a great option-just make sure it's the right one for you.
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