Getting the Most From Your Home Equity Line of Credit

Chris and Richard Paulson thought they had done all the right things in getting their daughter, Aimee, ready for college.

A home equity line of credit is a convenient and flexible way to use the equity in your home as collateral for borrowing. It works almost like a bank credit card, but it has much higher credit limits and much lower interest rates. A home equity line of credit also has many tax benefits. Like any home equity loan, your credit line is based on the equity in your home and your ability to repay. No matter how high your limit is, you pay interest only on the money in use. Once you have established your line of credit, you can draw from it by writing a special check.

Since a home equity line of credit is so easy to use, it is also easy to abuse. The Consumer Bankers Association has devised a list of six tips to consider when using your home equity line of credit. By following these tips, you can make wise use of your home equity.

  1. Home equity credit is best used for major expenditures such as home improvements, children's college expenses, or major medical or emergency expenses. It can also be used to consolidate other debts at a lower interest rate. Because the equity in your home represents a substantial source of savings, it should not be used to finance current consumption such as food, clothing, or entertainment.
  2. Don't borrow more than you can afford to repay over a reasonable period of time. For instance, if your use your line of credit to pay for a car, pay it off as soon as you would pay off a regular car loan, usually over a period of three to five years.
  3. Interest only payments are offered by some lenders, and may be appropriate when special circumstances may make it difficult or undesirable to pay down the principal, such as when children are in college. Generally, it's preferable to pay down principal to retire your debt. With some plans, interest-only payments lead to a balloon, when the unpaid balance is due. This may be appropriate only for those who can predict that they can pay off their loan--perhaps because they plan to sell their home--or who are willing to refinance at the rate prevailing in the future. Be sure your income will be sufficient to qualify you for refinancing.
  4. Total monthly payments on all types of loans should not exceed about 35 percent of your monthly before-tax income. Most lenders will help you determine how much debt you can afford.
  5. Most home equity loans have a variable-interest rate, meaning payment could fluctuate. Make sure you understand the terms and can afford the increase in the rate of interest if it should occur.
  6. Interest payments on home equity loans may be fully tax deductible. Consult a qualified tax specialist, as each homeowner's situation is different.

What You Should Know About Your Lender

Your lender isn't the only one who should ask questions. When it comes to a home equity line of credit, the questions you ask are just as important. As with any type of loan, it is essential to understand what you are getting into. Here are just a few of the questions you should ask any lender before making a final decision.

  1. Is a home equity line of credit most suitable for my needs, or would another kind of loan be more appropriate?
  2. What is the initial rate of interest? Is it fixed or variable? If it is variable, on what index is it base? How often can the rate change? What is the lifetime interest rate cap?
  3. What fees must I pay at the time of application and closing? Is there an annual fee?
  4. What will my minimum monthly payment be for each $10,000 in credit, and how much of the minimum payment will go to principal?
  5. If interest rates go up, will my minimum monthly payment go up with a variable rate loan? What increase in rate would cause my payment to go up?
  6. If I only make the minimum payment allowed, is it possible that my outstanding debt will increase? Will I still be paying down principal?
  7. Are there conditions under which I can reduce my monthly payment? Will I still be paying down principal?
  8. Under what conditions can the financial institution demand repayment or refinancing of my outstanding credit? Can any of the credit terms be changed without my approval?
  9. Do I have an option of converting my line of credit into a fixed term installment loan to pay it off? If so, at what interest rate, and over what period of time?
  10. If my income or amount of available equity increases in the future, can I have my line of credit increased? Will I have to pay new fees? Will I have to requalify?

The Point Behind Points

Lenders often charge an up front fee known as points to home equity loans and lines of credit. Each point is equal to 1 percent of the loan amount. For example, on a $25,000 line of credit, one point would be $250.

Points often have impact on your loan's Annual Percentage Rate (APR). When shopping for your home equity loan or line of credit, be sure to compare the APR and not just the contract interest rate. As the following table shows, for example, a loan of 9.5 percent with three points is equal to an APR of 9.85 percent and is, therefore, almost identical to a loan of 9.75 percent with one point (APR 9.87 percent). All lenders are obligated by regulation to disclose a loan's APR. Comparing the APR rather than the contract interest rate of a loan is, therefore, a good basis for comparing the costs of different loans.

Effective Rate on Home Equity Loans (25-year Amortization)*

  Points
Contract Interest Rate One Two Three Four Five
9 9.11 9.23 9.34 9.46 9.58
9.25 9.36 9.48 9.60 9.72 9.84
9.5 9.62 9.73 9.85 9.98 10.10
9.75 9.87 9.99 10.11 10.23 10.36
10 10.12 12.24 10.34 10.49 10.62
10.25 10.37 10.54 10.62 10.75 10.88
10.5 10.62 10.75 10.88 11.01 11.14
10.75 10.88 11.00 11.13 11.26 11.40
11 11.13 11.26 11.39 11.52 11.66

Source: U.S. League of Savings Institutions (now America's Community Bankers)

What Lenders Want to Know About You

Applying for a home equity loan or line of credit is similar to applying for any mortgage loan. The lender you choose will need to ask many questions and gather important data before your loan can be approved. You can make the loan-approved process as painless and swift as possible by doing some homework before you apply.

Some of the questions you are asked will seem basic: full name, current address, former address, marital status, number of dependents, and so on.

Other questions may be a bit more personal. Nonetheless, you should be prepared to answer them. Some of the questions you may have to answer include:

  • Are there any outstanding judgments against you?
  • Have you declared bankruptcy within the past seven years?
  • Have you had property foreclosed upon or are you a party to a lawsuit?

The most important consideration for any lender is whether or not you will be able to meet your loan payments. To make a decision, the lender will need certain documentation. Be prepared for the following:

  1. Credit verification and appraisal. When you apply for a home equity loan or line of credit, you will have to sign a credit verification form and order a credit report. This usually costs about $50. Since the credit report the lender receives has such a tremendous impact on the loan-approval process, it is a good idea to obtain a copy from a credit reporting agency before you apply for a home equity loan or line of credit. It costs a small fee, but you will be able to see if the information on your credit history is current and up-to-date. If you find any mistakes, clear them up before you apply for your home equity loan or line of credit.
  2. You cannot determine your equity without knowing the current market value of your home. Therefore, your lender will also require $200 to $300 for an appraisal of your property. This fee is usually paid at the time you apply.
  3. Your lender will also ask you to sign an employment verification form. This form will be sent to your current and previous employers of the past two years. Ask the appropriate personnel to return this form promptly in order to speed up this process.
  4. You will also need proof of your income. Be prepared to show a copy of your most recent pay stub showing taxes, Social Security, insurance, and W-2 withholding statements for the last two years. When you are calculating your income it may be possible to include overtime, bonuses, commissions, dividends and interest, net rental income, alimony, child support, and the separate maintenance income you may give or get. If you are self-employed, you may need other information and documents as well.
  5. Your lender will also need to have a record of your assets. Therefore, you will need the account numbers of all checking and savings accounts, as well as the names and addresses of the financial institutions. You may be asked to sign Verification of Deposit forms to send to these institutions. You will also be asked to list the cash or market value of your assets on your application.
  6. Financial institutions also need to know what your liabilities are. These include any installment debts, including charge accounts. Your lender will need to know the creditor's name, address, phone number, and your account number and outstanding balance.

Tax Advantages

Tapping your home equity makes good sense tax-wise. The Tax Reform Act of 1986 phased out the deductibility of personal loan interest. But, thanks to the 1987 Tax Act, homeowners with home equity loans and lines of credit can still deduct the interest from their federal income tax returns on up to $100,000 of home equity borrowing ($50,000 for married couples filing separate returns). The message is clear: if you're interested in tax savings, your home may be the best bargain around.

Glossary


Acquisition Indebtedness -- Debt incurred in acquiring or constructing your principal residence or second home plus debt incurred for the purpose of making substantial home improvements.

Annual Percentage Rate (APR) -- The cost of credit consumers pay, expressed as a simple annual percentage. It takes into account interest, points, and the loan origination fee.

Appraisal -- The estimated value of property.

Balloon Payment -- A final payment on installment debt that is much larger than the regular monthly payments.

Debt Consolidation -- Obtaining one loan to repay multiple debts.

Home Equity -- The difference between the current market value of a home and the claims against it.

Index -- A statistical composite used by lenders to establish variable loan rates. An index measures changes in the economy or financial markets.

Lifetime Interest Rate Cap -- An amount, usually given in percentage points, that limits how high or low a variable rate loan can change during the life of the loan.

Line of Credit -- The funds a lender is willing to make available to a borrower. The borrower may use all, a portion of, or none at all.

Points -- An upfront fee charged by many lenders. One point is equal to one percent of the loan principal.

Prime Rate -- The interest rate banks charge to their most creditworthy customers.

Refinance -- Prepaying the balance mortgage by replacing it with a new one.

Test Your Home Equity I.Q.


True of False




1. 
Total monthly payments on all types of loans should not exceed  about 45% of your monthly before-tax income.


2. 
A home equity credit line is based on the equity in your home and your ability to repay.


3. 
You usually access your line of credit with a bank credit card.


4. 
The most important consideration for any lender is your ability to meet loan payments.


5. 
Each point charged for your loan is equal to one percent of the loan principal.


6. 
Points have no affect on a loan's Annual Percentage Rate.


7. 
A home equity line of credit is very flexible.


8. 
Interest payments on home equity loans may be fully deductible.

Answers


1 False; 2 True; 3 False; 4 True; 5 True; 6 False; 7 True; 8 True

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