Are you interested in remodeling your outdated kitchen? Perhaps you're drowning in a sea of high-interest credit card debt, or need to find the money to send your child to college. Or maybe you just want the comfort of a cash reserve account, so that you'll be prepared for any unexpected bills. If so, and you're a homeowner, a home equity loan or line of credit may be right for you. Before you sign on the dotted line, however, do some research to make sure you get what's right for your needs.
What is home equity financing?
Home equity financing uses the equity in your home to secure a loan. For this reason, lenders typically offer better interest rates for this type of financing than they do for other, unsecured types of personal loans. Typically, you'll be able to borrow an amount equal to 80 percent of the value of your equity.
Tip: Home equity financing is different than mortgage refinancing, which is the process of taking out a new home mortgage loan and using some or all of the proceeds to pay off an existing mortgage (or mortgages) on the property.
Caution: Keep in mind that because home equity financing is secured by your home, you risk losing your home if you default on the contract.
Home equity financing may be either a loan or a line of credit.
Home equity loans
A home equity loan (often referred to as a second mortgage) is a loan for a fixed amount of money that must be repaid over a fixed term. Generally, a home equity loan:
- Advances the full amount you borrow at the beginning of the loan's term
- Carries a fixed rate of interest
- Requires equal monthly payments that repay the loan (including the interest) in full over the specified term
Home equity lines of credit
When you receive a home equity line of credit (HELOC), you're approved for revolving credit up to a certain limit. Within the parameters of the loan agreement, you borrow (and pay for) only what you need, only when you need it. Generally, a HELOC:
- Allows you to write a check or use a credit card against the available balance during a fixed time period known as the borrowing period
- Carries a variable interest rate based on a publicly available economic index plus the lender's margin
- Requires monthly payments that may vary in amount, based on changes in your outstanding balance and/or the prevailing interest rate
There are many types of HELOCs. Some questions to ask if you're considering one include:
- How often is the interest rate adjusted?
- What is the adjustment cap (if any) indicating how much the rate may change with any one adjustment?
- What is the overall ceiling (or lifetime cap) on the interest rate?
- What is the length of the borrowing term, and can it be renewed?
- Will the monthly payments be interest only, or will they include principal repayment?
- Will there be a balloon payment due at the end of the loan's term?
- Is there any option to convert the loan to a fixed-rate, fixed-term loan?
Caution: Some HELOCs may cap the monthly payment amount that you are required to make, but not the interest adjustment. With these plans, it's important to note that payment caps can result in negative amortization during periods of rising interest rates. If your monthly payment would be less than the interest accrued that month, the unpaid interest would be added to your principal, and your outstanding balance would actually increase, even though you continued to make your required monthly payments.
What are the costs involved?
The costs associated with getting a home equity loan or line of credit are often similar to those of getting a mortgage. They include:
- Application fee
- Property appraisal fee
- Points (where a point equals 1 percent of the amount of the loan or lending limit)
- Closing costs (e.g., attorney, title search, and mortgage preparation/filing fees)
In addition, a HELOC may impose an annual maintenance fee and/or a transaction fee for every withdrawal.
Before you decide on any one plan, shop around. Interest rates and other costs may vary among lenders. When comparing costs, don't simply compare the annual percentage rate (APR) of one plan against another--particularly if one is a home equity loan and the other is a HELOC. The APR for a home equity loan (second mortgage) takes any points and financing charges into consideration; the APR for a HELOC does not. Compare total costs.
Tip: If your principal residence will secure the home equity financing plan, the Truth in Lending Act gives you three days from the date the account is opened to cancel the contract. If you cancel the contract, do so in writing. The lender then cancels any security interest in your home and returns all fees you paid.
Here are some other points to consider before you decide to seek a home equity loan or line of credit:
- When you sell your home, you'll have to pay off the equity loan or line of credit. If you sell shortly after borrowing the money, the cost of obtaining the financing may undercut your profit in the sale.
- The cost of obtaining an equity line of credit might be prohibitive if you only draw a small amount from it.
- Leasing your home could be prohibited by the terms of a home equity financing contract.
Which is best--a loan or a line of credit?
What's best for you will depend on your individual circumstances, but here's a general guideline. If you'll need a fixed amount of money all at once for a certain purpose (e.g., remodeling the kitchen or paying off other high-interest debts), you might want to take out a home equity loan.
Example(s): You're remodeling the kitchen, and the contractor has told you the cost will be $35,000. Since you'll pay out all the money over the two months it will take to do the job, you decide to take a home equity loan. At a fixed rate of 7.25 percent for 15 years, your monthly payments will be $320 (in whole dollars). Your total interest charge will be $22,510.
If you'll need an indeterminate amount over a few years (e.g., funds for college or a cash reserve account), you might want to obtain a HELOC.
Example(s): Your child is going to college, and your out-of-pocket cost after financial aid is estimated to be $15,000 a year. To pay for the 4 years, you decide to take a HELOC for $60,000. During the 5-year borrowing period, you need to pay interest only on the outstanding balance. The contract stipulates a variable interest rate to be adjusted annually. At any time, you may convert the line of credit to a home equity loan; the term of such a loan cannot exceed 15 years, and the rate will be the currently prevailing rate at the time of conversion.
Example(s): In your child's first year of college, you spend $15,000; at 4.75 percent per year, your annual interest charge (in whole dollars) is $713. In the second year of school, good grades earn your child more scholarship money, and your costs go down to $12,000 for the year. At the current interest rate of 5.15 percent, your interest charges on your 2-year draw of $27,000 against the HELOC total $1,391. In your child's third year, continued high marks merit your child even more financial aid, and your cost for that year drops to $10,000. At 5.5 percent, the annual interest charge on your 3-year total draw of $37,000 is $2,035. In your child's final year of college, your cost is again $10,000. At 5.85 percent, your annual interest charge on a total 4-year draw of $47,000 is $2,750.
Example(s): Upon your child's graduation, you convert the HELOC to a $47,000 home equity loan with a fixed rate of 7.25 percent and a 10-year term. Your monthly payments are $551; your total interest payment on the loan over the 10-year term will be $19,214. When this figure is added to your HELOC annual interest charges for the 4 years your child was in college, your overall interest payments total $26,103.
Example(s): When your child started college, if you had taken out a home equity loan for $47,000 at a fixed rate of 7.25 percent for 15 years, your monthly payments would have been $429 and your total interest charge would have been $30,228.
Tax consequences of home equity financing
You may be able to deduct the interest you pay on up to $100,000 ($50,000 if married filing separately) of the principal you borrow under certain home equity financing plans. The interest you pay is generally deductible regardless of how you use the loan or line of credit proceeds (unless you use the proceeds to purchase tax-exempt vehicles). In other words, the loan or line of credit doesn't have to be obtained to buy, build, or improve your residence.
This article was prepared by Broadridge.
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