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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.

Home Equity Line versus Second Mortgage
Home Equity Line Second Mortgage
Tax Deductible Yes* Yes*
Annual Fee Yes (some lenders may waive this) No
Draw money when needed Yes No
Fixed Rate No** Yes

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:


Appraisal of home
$100,000
Percentage
x75%
Percentage of appraised value
$75,000
Less mortgage debt
-$40,000
Potential credit line
$35,000

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.

Shopping for a Home Equity Line

Is a home equity line what you need?

Before you apply for a home equity line of credit (HELOC), make sure it's the type of loan you want. If you need relatively small amounts of money over time, such as for school tuition, a HELOC may be right for you. If you need a lump sum for a particular purpose, such as building a room addition, a home equity loan would probably be better.

Carefully compare plans

Carefully compare several plans. Examine terms and conditions, annual percentage rates (APR), annual and initial transaction (set up) costs, indices, margins and caps. Some lenders may not charge setup or annual fees, but may charge a higher interest rate in return.

There may be an introductory, or "teaser" rate offered. This is a temporary rate which will have little beneficial value over the life of your loan. Since most HELOCs are variable rate loans, the rate you pay is the sum of the index plus the margin. Indices are expressed as rates and include Prime and T-Bill rates. The margin is explicitly stated in your loan documents and is also expressed as a percentage. For example, if your loan were tied to the Prime rate with a 2% margin, and the Prime rate were 8%, you'd pay 10%. Historical information regarding the behavior of various indices is available on-line and at your local library. A little research will help you determine which index you'd be most comfortable with.

Your variable rate plan will identify a maximum interest rate (ceiling or cap). Your loan may not exceed the rate cap during the life of the loan under any conditions.

Consider a loan which allows amortization--repayment in installments of principal and interest sufficient to retire the debt by the end of the plan. Try to amortize your loan, otherwise, you may incur a balloon payment at the end of the plan.

Negative Amortization

Under certain circumstances, depending on your program, the monthly payments may not adjust adequately to fully account for interest rate increases. In this event, negative amortization may occur. Negative amortization is when in which your loan balance increases. If this condition is a possibility with your loan, discuss with your lender how you can avoid it.

Some lenders may permit you to convert a variable 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.

Agreements generally will permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable-rate plans may not allow you to get additional funds during any period the interest rate reaches the cap.

Borrow Wisely

Perhaps you discover you can borrow much more than you expected, or need. A HELOC may seem to turn your home into a new type of credit card. If you default on a credit card, you may only damage your credit. If you default on a HELOC, you could lose your home.

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.

Establishing a home equity line (plan) can be expensive. If you incur substantial fees to set up the plan, and draw only a small amount against it, the cost of borrowing can be unreasonable. If you plan to use your credit line frequently, the costs of obtaining the equity line will be spread over larger and larger amounts, effectively reducing the cost of the plan. Because the lender's risk is lower for secured loans compared to unsecured loans, the interest rate on your equity line should be low compared to other, unsecured loans. Thus, annual percentage rates for home equity lines are generally lower than rates for other types of credit. (Be careful--the APR is based on the assumption that you're borrowing the maximum amount.) The interest you save could offset the initial costs of obtaining the line. Shop around before signing loan documents. Some lenders may offer zero-point/fee equity lines.

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.

Glossary

Annual Fee
An amount charged annually for having the line of credit available. The fee is charged regardless of whether or not you draw against the credit line.

Annual percentage rate (APR)
The cost of credit on a yearly basis expressed as a percentage. The APR is distinguished from the "named" or "nominal" rate which is the note rate.

Application fee
An application fee may include the cost of an appraisal and credit report. The fee is charged when applying for the loan.

Balloon payment
A lump-sum payment that you may be required to make under a plan when the plan ends. You should have the option to make payments sufficient to avoid making the balloon payment.

Cap
A limit on how much the variable interest rate can increase during the life of the plan.

Closing costs
Fees paid at the time of closing. Depending on the state in which you reside, these fees may pay for attorney's services, recording documents, real estate taxes, title search and title insurance.

Credit limit
The maximum amount you are allowed to borrow under the home equity plan. The limit can depend upon your income, debts, equity in your home and the bank's program guidelines.

Equity
The difference between the fair market value (appraised value) of your home and the debts claimed against it.

Index
A statistical indicator of a price level expressed as a rate. Examples include Prime, T-Bill, MTA, 11 Dist. COF, LIBOR, etc. The index is the base rate used by the lender to calculate the interest rate you pay on your loan.

Interest rate
The factor applied to the debt to determine the charge for borrowing money. The interest rate is expressed as a percentage.

Margin
The spread added to the index to determine the interest rate you are charged for borrowing money. The margin is expressed as a percentage.

Minimum payment
The smallest amount you are allowed to pay toward your debt. The minimum payment may include principal and interest.

Points
A point is equal to one percent of the amount of your credit line. Points are a closing cost which, under certain circumstances, may be recognized as interest by the IRS.

Security interest
"Security interest" is the type of interest a lender has in the property of the borrower. The borrower's property is set aside so that the lender can sell it if the borrower defaults on the loan. A mortgage and deed of trust are security instruments.

Transaction fee
The fee charged each time you draw on your credit line.

Variable rate
An interest rate that changes periodically. Payments may increase or decrease depending on a particular financial index.

Home Equity Loan Checklist

  Loan ALoan B
 
Basic Features
   
Fixed annual percentage rate    
Variable annual percentage rate    
Index used and current value    
Amount of margin    
Current rate    
Frequency of rate adjustments    
Amount and length of any discount     
Interest rate caps    
 
Length of plan
   
Draw period    
Repayment period    
 
Initial fees
   
Appraisal fee    
Closing costs    
Application fee    
 
REPAYMENT TERMS
   
 
During the draw period
   
Interest and principal payments    
Interest only payments    
Fully amortizing payments    
 
When the draw period ends
   
Balloon payment    
Renewal available    
Refinancing of balance by lender