Home equity lines of credit have become increasingly popular. Rather than tap the equity in your home to use for other purposes by going through home loan refinancing, a home equity line of credit is a second and separate loan from your mortgage.
There are many advantages to home equity lines of credit. One is that you're not necessarily taking the entire amount of money that you qualify for in one lump sum. Instead, you have the ability to tap your line of credit for whatever amount of money you need, and whenever you need it. Some people even take out home equity lines of credit, but never use them. The idea is to have the money available in case of emergency.
Another advantage is that the costs are generally lower. Many lenders offer very attractive interest rates for home equity lines of credit. What's more, lines of credit often have lower closing costs than home loan refinancing.
A home equity line of credit is similar to a credit card. It's a form of revolving credit. Also, the rates on the line of credit can change, just as with a charge card (see below).
The difference is that you're using your home as collateral, where most credit cards do not require collateral. By having your home as collateral, you can qualify for much more credit than you could with a simple credit card.
When you're approved for a home equity line of credit, you'll be approved for a specific maximum amount. This amount is your credit limit. Many lenders set your credit limit by using a percentage of your home's appraised value, and then subtracting the amount you still owe on the principal balance. For example, if you have a home that's appraised at $300,000, the mortgage lender may only use $250,000 of that as the considered value of your home. And, if you still owe $150,000 on your home, you would have $100,000 as the potential amount for your equity line of credit.
Of course, the lender may or may not extend that full $100,000 to you for a home equity line of credit. There are other factors that come into play, such as other debts that you may have, your ability to pay based on your income, your credit history, and your credit score.
Lenders will typically set a fixed time during which you can borrow against your line of credit. This is because your circumstances may change. The lender may renew your line of credit at the end of what is called the "draw period." Or you may need to apply all over again.
If you have an outstanding balance on your line of credit at the end of the draw period, you may be required to pay that balance in full. Other lenders may give you a certain period of time, usually several years, in which you can pay off the balance.
Some lenders will put limitations on how little you can draw from your home equity line of credit at any one time. You may also be required to keep some sort of minimum outstanding balance. This is because the lender needs to make at least some money from the interest on your line of credit.
Before applying for a line of credit, do your homework. There are a variety of plans available, each with their own advantages or disadvantages.
Typically, home equity lines of credit have variable interest rates rather than fixed interest rates. Generally the variable rate is based upon an index rate such as the "prime rate," which is the rate that banks charge each other, or the U.S. Treasury bill rate. The rate that you'll be offered will be the rate of one of these indexes plus a margin of a certain number of percentage points.
Because your rate will be pegged to one of these indexes, it's important to know how often these indexes go up or down. Ask your lender how high the index has been in the past, as well as how low it has been.
By law, variable rate loans on a home must have a cap on the amount your rate may increase over the term of the loan. Some plans will not allow you to draw funds from your line of credit if interest rates reach the cap that was established when you opened your line of credit.
Many lenders offer extremely low introductory rates on home equity lines of credit. For example, a lender may advertise an introductory rate that's two percentage points below prime for six months. While it's certainly worth your time to explore these offers, be sure you know where your interest rate is going after the introductory period expires.
Before applying for a home equity line of credit, make sure that you can make the payments. As mentioned above, a home equity line of credit is similar in many ways to a credit card. If you have a balance that you owe, but you only make the minimum monthly payments, much of that monthly payment could be interest, and only a little of it could be principal. Thus, you could make payments forever, and hardly make a dent in the amount you owe.
So, plan on making more than the minimum monthly payments.
Also, be aware that, because your interest rate is variable, your minimum monthly payments can change.
When you decide to sell your home, you will likely have to pay the balance of your line of credit in full. Considering the costs involved with setting up a line of credit, doing so may not be advantageous for those who plan to sell their homes soon.
An alternative to a home equity loan may be to take a second mortgage against your home.
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