The difference between a credit card and a home equity line of credit lies in the use of the home as collateral. There are various reasons why people borrow money against their most valuable asset: expensive medical treatments, kids’ education, home improvements etc. Getting such a loan to cover day-to-day expenses would be a pretty bad decision, with serious consequences.
The home line of credit gives the borrower the possibility to withdraw a certain amount of credit within a limit established by the lender. This limit is calculated by subtracting a certain percentage of the home’s appraised value from the current mortgage balance.
Traditional Second Mortgage vs. Home Lines of Credit
With a traditional second mortgage, you’re walking on a trodden path. The loan has a fixed schedule of repayment, and you pay the same amount every month for the entire term of the loan. The homeowner may decide for a second mortgage or a line a credit depending on personal needs as well as on the specifics of every option.
Cost analysis is the first step in the decision making process. The customer needs to be well informed about the fees charged for the alternatives. Make sure you look into the APR and the rest of the charges, because the APR is determined in different ways.
- The lender may calculate the APR based on the interest rate and other financial charges within the second mortgage package.
- The APR may include no extra charge or points, except for the periodic interest rate.
Be a smart shopper and take the time to look into such matters. You could be rewarded with big savings.
Paying Back Your Home Equity Line of Credit Debt
Certain line of credit packages require minimum payments that extend over a certain part of the principal (i.e. the total amount borrowed), plus any accrued interest. This amount that goes toward the principal may be insufficient for covering the full debt by the end of the term; this is the major difference from a traditional second mortgage.
With other home lines of credit, the consumer pays only the interest throughout the loan term, which explains the name of interest-only loans. If you select such a plan, at the end of the loan you will not have paid anything of the borrowed amount, all your payments will have been for the interest rate. If you borrowed $10,000, this is the amount you still owe.
Lots of lenders offer a number of payment options for consumers to select. Some borrowers prefer to pay an amount higher than the minimum monthly payment. In such cases, people treat the line of credit like any other loan, making regular payments to eliminate debt. If they do so, they save money on the long run.
Consumers should be wary of very little or interest-only payments because this could be a shortcut to budget ruin. Once the plan has come to an end, the lender could request that the borrower pay the entire balance all at once. In order to avoid this “balloon payment”, you can pay the full amount, refinance the amount with the lender, get a loan from a new lender or find other means to deal with the problem. In most cases, solutions lead to further debt and money loss.
Failure to cover the balloon payment could cost you your home. Do not enter the loan agreement without first figuring out how to deal with the balloon payment at the end.
Why Get A Home Equity Line of Credit?
There are features that make a home equity line of credit attractive to borrowers, but the pros should always be weighed against the cons. Here are some of the reasons that motivate consumers when choosing such a credit package.
- Home equity lines of credit may serve for debt consolidation particularly for credit cards with high interest rates.
- Is the interest-rate tax deductible? Talk to a tax advisor to find out whether there are any potential tax benefits for using a home equity line of credit for home improvements.
- The home equity line of credit provides the cash for car or boat purchase.
- The borrower can cover the costs of their child’s college education.
- The borrower can eliminate a fixed second mortgage or another line of credit.
- The borrower can invest the money in a second home or some other property.
How Much Can You Borrow?
The two aspects that influence the amount one can borrow for a home equity line of credit are the borrower’s creditworthiness and the amount of outstanding debt. You can get as much as 85% of the appraised value of the house after deducting other amounts you still owe (like payment on a first mortgage). Here are some issues that the lender must clarify for you:
- What is the length of the home equity line of credit?
- Is there a minimum withdrawal requirement?
- Is there a minimum or a maximum amount that you can withdraw?
- How can the credit line be accessed, by credit cards, checks or both?
Finding the Right Home Equity Line of Credit
Knowing the benefits and the shortcomings of a home equity line of credit allows the borrower to make an informed decision. When you consider such a financial option, you may want to look for the following aspects:
- There is no application fee or, upon closing, there is a fee refund. Find out whether you get this fee back at the closing of the plan.
- There shouldn’t be any closing or home loan appraisal costs.
- There should be no fees for check-writing or HELOC account management.
- NO “usage” fees should be charged.
- The line of credit should have a variable APR equal or close to the prime rate, with quarterly adjustment. The only cost of the home equity line of credit should be the interest that is charged on the borrowed balance.
- There should be a periodic cap on the interest rate changes, meaning that the rate cannot exceed a set limit. Choose a HELOC that has quarterly not monthly adjustments. The increase in the monthly rate should be 0.5% or less.
- There should be a lifetime cap on all rate increases.
- If the interest rate rises, the borrower should be able to convert the home equity line of credit into a fixed rate mortgage.
- If conversion to a fixed rate loan is needed, the borrower should be allowed to make interest-only payments.
- The borrower’s repayment of the principal should be unrestricted.