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What you should know about equity lines 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 specific 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 plan may be right for you. Or perhaps another form of credit
would be better. Before making a 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. And
remember, failure to repay the amounts you've borrowed, plus interest, could mean the loss of your home.  

What is a home equity line of credit?
A home equity line of credit 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 maximum
amount you may borrow at any one time under the plan. Many lenders set the credit limit on a home equity line by
taking a percentage (say, 75 percent) of the home's appraised value and subtracting from that the balance owed on
the existing mortgage.

In determining your actual credit limit, the lender will also consider your ability to repay, by looking at your
income, debts, and other financial obligations as well as your credit history.
Many home equity plans set a fixed period during which you can borrow money, such as 10 years. At the end of this
"draw period," you may be allowed to renew the credit line. If your plan does not allow renewals, you will not be
able to borrow additional money once the period has ended. Some plans may call for payment in full of any
outstanding balance at the end of the period. Others may allow repayment over a fixed period (the "repayment
period"), for example, 10 years.
Once approved for a home equity line of credit, you will most likely be able to borrow up to your credit limit
whenever you want. Typically, you will use special checks to draw on your line. Under some plans, borrowers can use
a credit card or other means to draw on the line.
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 plans may also require that
you take an initial advance when the line is set up.

What should you look for when shopping for a plan?
If you decide to apply for a home equity line of credit, look for the plan that best meets your particular needs.
Read the credit agreement carefully, and examine the terms and conditions of various plans, including the annual
percentage rate (APR) and the costs of establishing the plan. The APR for a home equity line is based on the
interest rate alone and will not reflect the closing costs and other fees and charges, so you'll need to compare
these costs, as well as the APRs, among lenders.
Interest rate charges and related plan features
Home equity lines of credit typically involve variable rather than fixed interest rates. The variable rate must be
based on a publicly available index (such as the prime rate published in some major daily newspapers or a U.S.
Treasury bill rate); the interest rate for borrowing under the home equity line changes, mirroring fluctuations in
the value of the index. Most lenders cite the interest rate you will pay as the value of the index at a particular
time plus a "margin," such as 2 percentage points. Because the cost of borrowing is tied directly to the value of
the index, it is important to find out which index is used, how often the value of the index changes, and how high
it has risen in the past as well as the amount of the margin.
Lenders sometimes offer a temporarily discounted interest rate for home equity lines--a rate that is unusually low
and may last for only an introductory period, such as 6 months.
Variable-rate plans secured by a dwelling must, by law, have a ceiling (or cap) on how much your interest rate may
increase over the life of the plan. Some variable-rate plans limit how much your payment may increase and how low
your interest rate may fall if interest rates drop.
Some lenders allow you to convert from a variable interest 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.
Plans generally permit the lender to freeze or reduce your credit line under certain circumstances. For example,
some variable-rate plans may not allow you to draw additional funds during a period in which the interest rate
reaches the cap.
Costs of establishing and maintaining a home equity line
Many of the costs of setting up a home equity line of credit are similar to those you pay when you buy a home. For
example,
 
  - A fee for a property appraisal to estimate the value of your home   
  - An application fee, which may not be refunded if you are turned down for credit   
  - Up-front charges, such as one or more points (one point equals 1 percent of the credit limit)   
  - Closing costs, including fees for attorneys, title search, and mortgage preparation and filing; property
and title insurance; and taxes. 

In addition, you may be subject to certain fees during the plan period, such as annual membership or maintenance
fees and a transaction fee every time you draw on the credit line.
You could find yourself paying hundreds of dollars to establish the plan. If you were to draw only a small amount
against your credit line, those initial charges would substantially increase the cost of the funds borrowed. On the
other hand, because the lender's risk is lower than for other forms of credit, as your home serves as collateral,
annual percentage rates for home equity lines are generally lower than rates for other types of credit. The
interest you save could offset the costs of establishing and maintaining the line. Moreover, some lenders waive
some or all of the closing costs.

How will you repay your home equity plan?
Before entering into a plan, consider how you will pay back the money you borrow. Some plans set minimum payments
that cover a portion of the principal (the amount you borrow) plus accrued interest. But (unlike with the typical
installment loan) the portion that goes toward principal may not be enough to repay the principal by the end of the
term. Other plans may allow payment 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 amount when the plan ends.
Regardless of the minimum required payment, you may choose to pay more, and many lenders offer a choice of payment
options. Many consumers 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 pay the entire balance owed, all at once. 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.
If your plan has a variable interest rate, your monthly payments may change. Assume, for example, that you borrow
$10,000 under a plan that calls for interest-only payments. At a 10 percent interest rate, your monthly payments
would be $83. If the rate rises over time to 15 percent, your monthly payments will increase to $125. Similarly, if
you are making payments that cover interest plus some portion of the principal, your monthly payments may increase,
unless your agreement calls for keeping payments the same throughout the plan period.
If you sell your home, you will probably be required to pay off your home equity line in full immediately. If you
are likely to sell your home in the near future, consider whether it makes sense to pay the up-front costs of
setting up a line of credit. Also keep in mind that renting your home may be prohibited under the terms of your
agreement.

Lines of credit vs. traditional second mortgage loans
If you are thinking about a home equity line of credit, you might also want to consider a traditional second
mortgage loan. A second mortgage provides you with a fixed amount of money repayable over a fixed period. In most
cases the payment schedule calls for equal payments that will pay off the entire loan within the loan period. You
might consider a second mortgage instead of a home equity line if, for example, you need a set amount for a
specific purpose, such as an addition to your home.
In deciding which type of loan best suits your needs, consider the costs under the two alternatives. Look at both
the APR and other charges. Do not, however, simply compare the APRs, because the APRs on the two types of loans are
figured differently:
 
  The APR for a traditional second mortgage loan takes into account the interest rate charged plus points and
other finance charges.   
  The APR for a home equity line of credit is based on the periodic interest rate alone. It does not include
points or other charges. 

Disclosures from lenders
The federal Truth in Lending Act requires lenders to disclose the important terms and costs of their home equity
plans, including the APR, miscellaneous charges, the payment terms, and information about any variable-rate
feature. And in general, neither the lender nor anyone else may charge a fee until after you have received this
information. You usually get these disclosures when you receive an application form, and you will get additional
disclosures before the plan is opened. If any term (other than a variable-rate feature) changes before the plan is
opened, the lender must return all fees if you decide not to enter into the plan because of the change.
When you open a home equity line, the transaction puts your home at risk. If the home involved is your principal
dwelling, the Truth in Lending Act gives you 3 days from the day the account was opened to cancel the credit line.
This right allows you to change your mind for any reason. You simply inform the lender in writing within the 3-day
period. The lender must then cancel its security interest in your home and return all fees--including any
application and appraisal fees--paid to open the account.
 
The material on this site is adapted from the brochure "When Your Home Is on the Line." Single or multiple copies
of the brochure are available without charge. Order the brochure by telephone, mail, or fax. Order on line.
Source: http://www.federalreserve.gov/pubs/HomeLine/