Understanding Home Equity Lines of Credit
An equity line, or HELOC as it is commonly known, is a line of credit secured by a lien on your home. As with commercial lines of credit, you are allowed to draw on your line at any time just by writing a check. They are an excellent source of instant cash for homeowners and can have significant benefits to homeowners if used to finance worthwhile purchases.
We ought to get one thing straight, however. The name comes from the fact that lenders base their lending decision in large part on the amount of equity you have in your home. In fact, these are EQUITY-DESTROYING loans. You have LESS equity after you use one. You will recall that part one of this series was devoted to how to BUILD equity, not how to DESTROY it.
One bank ad had bankers calling themselves the “Equity Police.” They would show up at a home and, finding “unused” equity, they would help people get a loan so they could use it up. Frankly, I think that was an inappropriate advertising program. I think banks ought to help people INCREASE their equity, not DESTROY it!
We have been through a period of unprecedented growth in real estate values. Economists make the case that people taking some (or all) of the increased equity in their homes and spending it, sometimes foolishly, were what financed the current economic expansion. No economist measures good spending versus stupid spending; it’s just consumer spending. But I think that a lot of it was stupid.
PHILOSOPHY: My industry has made it very easy for people to convert part of their wealth that was tied up in home equity into “stuff” that the homeowners often say was stupid a few years later.
The interest rate on HELOCs is adjustable, typically tied to the prime rate and occasionally to T-Bills or CD rates. With the prime rate at 8.25 percent today, equity line loans are in the 8 percent to 10 percent range depending on the borrower’s creditworthiness and other factors. The payment you make each month is based only on the outstanding balance and is typically interest-only for the first ten years, at which time the loan balance is frozen and converts to an amortizing loan, still with a variable rate.
The major benefit is that you can draw on the equity line any number of times. For example, you can start out by paying off high interest rate credit cards, lowering the interest rate perhaps from 18 percent to 9 percent. When that balance is paid off, you may wish to finance a car with your equity line instead of taking out a car loan. Finally, while they are not a good substitute for true education loans, they can be used to meet short-term needs, as when the tuition bill comes around when you are a little short on cash.
The interest on an equity line is, within limits, tax deductible, a benefit that lowers the effective interest rate compared with consumer loans and credit cards.
An innovation from the late 1990s is the “piggyback” loan, where an equity line is used to finance the purchase of a home. The homebuyer takes out a first mortgage for 80 percent plus another loan, an equity line, for the next 10 percent, 15 percent, or even all 20 percent of the purchase price. That way the homebuyer avoids Private Mortgage Insurance, or PMI. If this interests you, find a competent loan officer who can make the calculations for your situation. In 2007, PMI payments are tax deductible.
Banks love equity line loans because the loans they used to make on an unsecured basis are now secured by equity in homes, thereby reducing their risk. I understand that the default rate on HELOCs is so low as to be immeasurable. The combination of a good yield and low risk is something bankers dream about.
Equity line loans are very competitively priced and frequently the lender will pay the appraisal and title costs so they are offered with no or only nominal upfront costs to the borrower. Be sure to check the local banks and credit unions in your area to see if someone is having a “special.” Some lenders charge annual fees, but they are modest, perhaps $25 per year.
NOTE: If you get a “no closing cost” loan, you can almost always count on an early-termination fee if you terminate the loan before, typically, three years.
WARNING: If your line provides for only interest payments, you have to be diligent about paying the balance down on a regular basis so as to regain your equity. Before financing a purchase, be sure to budget your monthly payment to retire your loan balance. If you’ve used it to pay off credit cards, pay the balance off in two or three years. If you use it to buy a car, be sure the loan is paid off by the time you wish to replace the vehicle, say in four years.
Remember, too, that walking around with that equity line checkbook can be a temptation to buy something just because you can. People who can’t say “NO!” to their impulses should not get an equity line. It will just get them in trouble. Be careful not to use the equity line for frivolous purposes.
A high credit score often equals savings on loans and credit cards.
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