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| | BobVila.com > Channels > Finance > All Articles > Understanding Home Equity Loans
Understanding Home Equity Loans
Maybe you’ve recently received a personalized mailing estimating the equity in your house and the cash now available to you. Home equity is a hot lending product and a great resource if you know the facts.
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Take the time to make a realistic assessment of your home’s value and your current financial need before deciding to borrow from stored equity in your home.
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For years, experts have attributed the rise in mortgage debt to the Tax Reform Act of 1986, which eliminated the tax deduction for consumer credit and expanded the home mortgage interest deduction. Home values skyrocketed and low interest rates let consumers lock in great terms and take advantage of their growing equity by withdrawing their appreciated wealth. The result is that during 2002 and 2003, homeowners liquidated about $540 billion in equity and increased household mortgage debt by $1.4 trillion.
How Equity is Used
Home equity is an interesting concept. It is a variable amount of wealth discovered by subtracting the outstanding mortgage balance from the fair market, or current appraised value of a home. For example, if a home is appraised at $200,000 and the mortgage is $130,000, the equity is $70,000—today.
Homeowners access that wealth with home equity loans (HELs) and home equity lines of credit (HELOCs), financial products that use the homes as collateral. Lenders typically allow homeowners to borrow from 80 percent up to 100 percent of the equity they have stored in the home.
According to Scott Sauer, a credit union president in Wisconsin, the rule of thumb when deciding which loan to select is that consumers who have a one-time need—such as a new car—typically seek a home equity loan. Those with ongoing needs—like college tuition payments, medical bills, or long-term home improvement projects—would seek a home equity line of credit.
Loans and Lines of Credit
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Beware of borrowing too much against your home’s value and emptying it of precious equity.
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A home equity loan is basically a straightforward arrangement. It is a closed-end, one-time loan. Basically a second mortgage, it is set up for a fixed amount over a fixed term. When payments are made, the loan amount is paid down.
A home equity line of credit is a completely different animal, according to Sauer. A HELOC is open-end, revolving credit and is usually tied to a variable interest rate. It’s easiest to picture it as a credit card with an approved credit limit determined by the homeowner’s equity.
Often lenders will require a minimum draw on a HELOC—say $500 each time. Some lenders supply a plastic card that resembles a credit card for making withdrawals; others provide a checkbook; and some require the homeowner to call the lender to have money transferred and a check sent. Interest rates for HELOCs are typically lower than for other loans and offer the flexibility of withdrawing money only as needed.
So Easy They’re Dangerous
Sauer cautions homeowners about jumping too quickly to withdraw equity. “With a $25,000 line of credit against their home,” he says, “people start to see it as ‘easy money.’ Soon it’s ‘We’re going to Jamaica.’ The next thing you know their house is up for sale. People tend to extend their line of credit, first borrowing $10,000, then $15,000, and then it’s $20,000. Before they know it, they’re spending money they normally would not have. If they would have had to apply for separate loans, it would have slowed them down a bit,” he says.
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Points to consider:
• The Truth in Lending Act gives homeowners three days from the day the account was opened to cancel their credit line. However, the homeowner must inform the lender in writing within those three days. According to the FDIC, the lender must then cancel its security interest in the home and return all fees paid.
• Payments on some loans may not cover interest due so the loan balance could increase rather than decrease.
• Under certain conditions, a creditor may terminate the plan and require payment of the outstanding balance in full in a single payment and impose fees upon termination; prohibit additional extensions of credit or reduce the credit limit; and, as specified in the initial agreement, implement certain changes in the plan.
• For variable-rate products, the APR, annual percentage rate, does not include costs other than interest.
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Rising interest rates and a leveling or even dropping off of housing values could impact the desirability of a HELOC. Since many home equity lines have adjustable-rate terms, rising interest rates increase monthly payments and make loans harder to repay.
Enticing Borrowers
Homeowners are faced with many incentives to use their home equity. A common marketing technique is to offer low “teaser” rates that are then adjusted quarterly.
Another draw is the purchase-and-renovate loans that enable borrowers to finance a home purchase plus remodeling costs based on the home's value after improvements. Some lenders even allow credit limits to increase automatically as a home appreciates in value. HELOCs can be set up with fixed rates for the first several years to reduce fears of rising interest rates.
Remember that lenders review mortgage portfolios to search out customers who would be preapproved for a home equity product. Some even determine who has delinquent credit cards and offer them the chance to consolidate credit card debt with a HELOC. So use your equity wisely and do your homework before borrowing.
Text by Maureen Blaney Flietner
Copyright BobVila.com © 2005
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