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Home Equity Line of Credit: 10 Things You Need to Know

Posted by  on Sep 28, 2010
 

1. Your Home is at Risk

As the name implies, a home equity line of credit (HELOC) is secured by your home. If you can't make your payments, you could lose your property.

2. Best HELOC Rates May Not Last

Everyone knows that 2010 has seen some of the lowest rates--including the best mortgage rates--in recent history. But a home equity line of credit is likely to have a variable rate, which should rise if other rates do. And, in August 2010, the New York Times reported that most financial industry insiders are expecting increases to begin soon.

3. Index is Critical

When you're choosing a home equity line of credit, find the index to which its rate is tied. The Federal Reserve suggests that you compare indices by establishing each one's current rate. Then compare HELOCs by adding in the loans' margins. Margins are set by lenders, and the index plus margin equals the loan's interest rate (subject to rate caps and floors).

4. Is Your Rate Capped?

Some lenders cap the rate that you could pay for your home equity line of credit--and they may put a floor below which your rate can't fall. If you think that rates are likely to increase significantly during the term of your loan, you should pick either a fixed-rate HELOC or one with a low cap.

5. How Much Money Can You Borrow?

Normally, a lender determines your credit limit by taking nyour home's appraised value and adjusting it by a multiplier determined by your credit score, income, and other debts and obligations. So, if your home is worth $200,000, and your multiplier 75%, you get $150,000. From this, the lender deducts the balance of your mortgage. So, if that balance is $100,000, then your home equity line of credit is $50,000.

6. Can Your Lender Freeze or Close Your HELOC?

Your home equity line of credit is a contract, and your lender can't normally alter it without your consent. However, there are exceptions. Many contracts allow your HELOC to be frozen or reduced if the value of your home drops significantly (MarketWatch says that a 50 percent drop in equity could be a trigger), or if the bank has good reason to think that you may be unable to keep up payments. And, of course, any delinquency on your part could be grounds.

Having said that, the Plain Dealer recently reported that a struggling bank "may freeze... customers' equity lines of credit to satisfy federal regulators..." It's not yet clear whether--and on what grounds--it can do that.

7. Interest Only or Minimum Payments?

Some HELOCs allow you to pay only interest on your outstanding balance, while others require you to make at least a minimum payment on the principal debt each month. Bear in mind that the latter may not be enough to zero your balance at the end of the term. You need to weigh the pros and cons of these alternatives, and choose the one that suits your needs better.

8. Repaying Your HELOC

What happens when your home equity line of credit expires? Well, some contracts require that you pay the full amount outstanding at once in what's called a "balloon payment". If you don't have the cash to do so, and you can't refinance with this or another lender, then you could lose your home. Other agreements allow you to pay down the debt over an extended period (it could be 10 years), but you won't be able to borrow against the line of credit during this time. Be sure you understand what the payback arrangements are for your HELOC before you sign anything, and prepare accordingly.

9. Restrictions to Look Out For

Some HELOC agreements may:

  • Make you repay your balance in full if you sell your home
  • Prevent you from renting out your property
  • Require you to keep a minimum balance outstanding
  • Insist that you borrow at least a minimum amount each time you use the line of credit

10. Two Golden Rules

The two golden rules for home equity lines of credit are the same as they are with other financial products:

  1. Be sure you fully understand terms and conditions before you sign anything
  2. Shop around for the best deal. You can start this process here.

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