Home Equity Options

Home-equity loans and lines of credit have become the preferred choice of most borrowers. Banks are offering a wide array of enticing options to make it easier for homeowners to get at their equity to pay for such things as reducing nondeductible credit card debt, college tuition, a new car or home improvements. There are deals that allow you to set up mini fixed-rate loans under a line of credit or fixed-rate loans that can be adjusted when rates drop, and lines of credit that can protect you from an overdraft in your checking account or let you tap 100% of your home's value, instead of capping it at the usual 75% to 80%.

LOAN VERSUS LINE OF CREDIT. The first thing you need to decide is whether to apply for a fixed-rate loan that offers fixed payments over a set period of time or a line of credit that you can tap at will. Your choice will depend on your plans for the money and how disciplined you are at handling available cash and repaying debt.

A fixed-rate loan is akin to a second mortgage— you borrow a set amount and repay it in fixed monthly installments over ten to 30 years. It is usually the best option if you need a given amount all at once— for a home improvement, say, or to start a business. With the fixed-rate loan, you are also unable to tap the equity at will.

A line of credit, on the other hand, replaces certainty with flexibility. You might arrange for a $50,000 line, for example, then borrow $1,000, $4,000,

Home-equity oans and ines of credit have become the preferred choice of most borrowers.

A line of credit is the way to go for people who will be borrowing irregular amounts to pay college tuition or to buy a new car.

or $5,000 simply by writing a check. Payback is as flexible as withdrawal, often with interest-only payments allowed during, say, a ten-year borrowing period. You will pay interest only on what you borrow, so if you don't borrow you won't owe anything. A line of credit is the way to go for people who will be borrowing irregular amounts to pay college tuition or to buy a new car.

HOW IT WORKS. Banks set a maximum credit limit at anywhere from 75% to 100% of the loan-to-value (LTV) ratio of your home. Determining your limit is not quite as easy as you might think. If a lender uses an 80% LTV ratio, for example, you could borrow up to 80% of the appraised value of your home, but the 80% figure includes all home debt. Let's say that your home is appraised at $150,000 and you owe $75,000 on a first mortgage. You would be eligible for a credit limit of $45,000. ($150,000 times 80% equals $120,000, less your outstanding mortgage of $75,000, leaves you with available equity of $45,000.)

Home-equity debt usually carries a variable interest rate that's somewhere between one and three points above the prime rate. At the time we went to press, the prime rate was 6.75%. That would produce a home-equity debt rate between 7.75% and 9.75%— considerably lower than the 14% to 17% or more you could pay on credit card debt or unsecured loans. Many banks also offer a lower teaser rate of 4% to 7% for the first six months to attract new customers. (A few go as low as 0%, per bankrate.com.) When you add in the tax savings, you just can't beat those rates. Let's say that you have a 9.75% home-equity loan and that you're in the 27% tax bracket. Your after-tax loan rate will be 7.12% (9.75% - [9.75 x 0.27] = 7.12).

Deals that allow up to 100% of equity borrowing are more costly. Expect to pay up to five points over prime—still a good deal compared to credit card rates. These deals may also come with dollar caps—say, a top loan of $10,000—regardless of how much equity you have in your home.

Home-equity lines are usually structured to expire far sooner than 30-year mortgages, although a few come due only when you sell. Generally, the loan period is divided into two segments—a "draw" period and a "payback" period. During the draw period, typically five years or so, you can borrow at will simply by writing a check. As you pay back the loan, your credit limit is restored accordingly. The length of the draw period is set out in your contract, along with minimum withdrawal amounts and any restrictions on how often you can tap the credit line.

The contract also spells out what happens when your draw period ends. You may be able to renew the credit line, for example, or be required to pay the outstanding balance at once. Alternatively, you could be required to repay the outstanding balance over a fixed period—say, ten years.

WHAT TO LOOK FOR WHEN YOU SHOP. Bankers are competing hard for new home-equity debt, so there are plenty of excellent deals to be found. That's great news for the consumer, but it also means you need to shop around to find the best deal for you.

You should be able to find a bank that's offering zero closing costs. This means that the bank will pick up the cost of the appraisal and document handling, which includes a credit check, title search and similar charges. (Low introductory fees and waivers of closing costs may not be offered if you opt for a 100% deal.) Even though there may be no closing costs, look at the fine print to see if there are annual fees associated with the deal or if you're obligated to repay closing costs if you shut down the credit line within a year without selling your home.

You pay an extra one-half percentage point or so on your interest rate for the privilege of avoiding closing costs. If you plan to borrow a large amount, you may want to ask your lender to lower the interest rate if you pay the closing costs up front (usually $200 to $300).

For those not comfortable with variable rates, banks offer loans with convertible features. That means if the prime rate goes down, your rate does too. If the

Even though there may be no closing costs, look at the fine print to see if there are annual fees associated with the deal.

HOME-EQUITY LOAN WORKSHEET

Knowing the answers to these questions, adapted from a Federal Trade Commission checklist, will help you compare home-equity loans from different lenders. Before you compare, have in mind how much you want to borrow.

LENDER

What size credit line is available? _____

What is the length of time for repayment? _____

Is there access to loans by check or credit card? _____

What closing costs does the borrower pay:

Are there fees per transaction? What are they? _____

What are the repayment terms:

Is the monthly payment variable? _____

Do payments cover both principal and interest? _____

Can a balloon be refinanced or extended? _____

Is there a penalty for early repayment? _____

What are the default provisions? _____

prime goes up, you have the option of converting the balance of the loan or line of credit to a fixed-rate loan at the going rate. There should be no additional charge for the conversion. If your home-equity loan carries a fixed rate already, there are some banks that offer to reset the rate once during the life of the loan at no extra charge.

Most lines of credit offer you easy access to your credit by giving you a checkbook that you can use to tap your money whenever you need it. Some lenders also offer lines of credit linked to credit cards, debit cards, even ATM machines. You may even find a bank that's willing to hook your line of credit to your checking account so that you never again need to worry about bouncing a check.

With so many options available, you need to shop around and find the deal that offers the options that most suit your needs and lifestyle. If, for example, you know that you'll be tempted to spend more money if the credit is readily available, then you may not want a line of credit hooked to your checking account. When funds are less accessible, you'll be less likely to draw on them for a spontaneous purchase. A separate checking account may be more in tune with your needs. And remember that whatever terms you choose, you're putting your home up as collateral; if you can't repay, you could lose your home. Compare each loan you consider, according to these points:

Payment terms. These should be spelled out clearly. For example, you might be told that your line of credit is good for ten years, with a minimum monthly payment of $100 or 1/360 of the loan balance plus finance charges, whichever is greater. At the end of this ten-year draw period, you would have another five years to pay any remaining balance. Minimum terms during the repayment period would be 1/60 of the outstanding balance plus finance charges.

Watch out for negative amortization, which means that interest payments are too low to let you pay back the loan during its term. The balloon payment at the

Watch out for negative amortization, which means that interest payments are too low to let you pay back the loan during its term.

If something on your credit report turns sour, your borrowing rights could be frozen or reduced.

end could catch you off guard. If you can't pay or refinance, you may have to sell or face foreclosure.

Payment example. You must be given an example of what the minimum monthly payments would be if you borrowed a certain amount—say, $10,000—and the interest rate reached its maximum level.

Lenders' fees. These could include loan-application fees (typically around $150), one or more "points" (each at 1% of your credit limit) and a maintenance fee (often $75 or so).

Third-party fees. These fees usually include amounts for home appraisals, credit reports and legal fees, and might total between $500 and $900.

Rate features. Most home-equity loans are pegged to the prime rate. Lenders currently add one to three points to the prime to come up with their index rate. Should you encounter an equity line pegged to some other index—the 90-day Treasury bill or the LIBOR (the London Interbank Offered Rate), for example— ask the lender to provide you with an historical example showing how changes in the index rate in the past would have affected minimum payments due on the home-equity line compared with what you would have experienced with a loan tied to the prime. (An index that responds quickly to rising rates will also reflect a drop in rates much more quickly than a sluggish one such as the index of 52-week Treasury bills.)

You must also be told about any annual or lifetime rate caps that apply. The index must be one that is out of the lender's control. Banks aren't allowed to use their own cost of funds as an index or change the index at their discretion.

As a rule, lenders can't accelerate payments or change the contract terms once the line has been opened. But a rainy-day fund could dry up just when you need it. Most home-equity lenders check borrowers' credit every year or so. If something on your credit report turns sour, your borrowing rights could be frozen or reduced. A sudden drawdown when you haven't used any credit for an extended period or a request to switch to easier payback terms could also trigger a check. Lenders have the right to reappraise your home periodically to make sure there's still enough equity cushion for their safety.

Once you've found a good home-equity loan, compare the deal with a traditional second mortgage (see the following discussion) before you commit. You can't simply compare the APRs on the two loans, however. The APR on second mortgages takes into account the interest rate charged, plus points and other finance charges, while the APR on a home-equity loan is based solely on the periodic interest rate and excludes any points, annual fees, or other charges.

After you commit yourself, you have three business days to back out of the loan if your principal residence serves as collateral.

Once you have found a good home-equity loan, compare the deal with a traditional second mortgage before you commit.

PAYING OFF THE LOAN WHEN YOU SELL. You may be required to advise the lender when you put your house on the market. In any case, at settlement you must repay the home-equity loan along with your original mortgage. You'll face minor additional fees because clearing title involves an extra step. Your settlement lawyer must prepare a release, which can cost from $10 to $50, and file it, usually at a cost of another $10 to $25.

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