Understanding Home Equity Lines of Credit
Applying for a home equity line of credit is similar to — but much simpler than — refinancing your home. Instead of refinancing, which can include expensive closing costs, you simply apply for a line of credit against the equity in your home.
A line of credit is like a loan, but instead of getting cash or a check from the lender, you get a checkbook to spend your equity on anything you want. If you write checks from that account (to yourself or anyone else), the line of credit is considered activated, and you must pay at least the minimum loan payment, an amount that repays the check(s) you've written in about 10 years.
The more checks you write, the higher your payment will be. Using the account also lowers your equity in your home until you pay the loan back.
The following sections help you determine the advantages and disadvantages associated with home equity lines of credit, and deciding whether a home equity line of credit is right for you.
Advantage: You Can Pay Off Debts with a Lower-Rate Loan
Although home equity lines of credit carry an interest rate that's usually about two percentage points higher than your primary mortgage interest rate, if you use the line to pay off high-interest credit card debt, you'll save a bundle.
Most lenders change their home equity line of credit interest rates daily or weekly. You might write a check when the interest rate is 6 percent and end up paying it off for several years at 8 or 10 percent. For this reason, plan to repay your line of credit as soon as possible after tapping it.
Advantage: Interest Is Probably Tax Deductible
The interest on your line of credit is usually tax deductible if you itemize — just like the interest on your mortgage payment is tax deductible. If you're paying less in taxes, you are, in a sense, lowering your interest rate even more.
Advantage: Applying Is a Cinch When You Buy or Refinance Your Home
If you're applying for a new mortgage or are refinancing, you can often apply for a home equity line of credit at the same time. This eliminates duplicating the loan-application paperwork and fees associated with applying for a loan (such as paying for your credit report).
Advantage: You Can Plan Ahead
If you know that your income is going to drop in the future, you can apply for a home equity line of credit long before this drop in income happens. Even though you won't be as good a credit risk after you reduce your income, you'll still have the home equity line of credit locked in and can use it if you need to.
Disadvantage: Annual Fees Can Be High
Some lenders charge annual fees of $20 to $150 for home equity lines of credit. Be sure to figure that amount into your calculations if you're planning to pay off a high-interest-rate debt with your home equity line of credit.
Some lenders offer periodic “sales” on annual fees for home equity lines of credit. If annual fees are too high for you, ask whether the fees will ever be discounted, perhaps during a slow month for applications or when you open a checking or savings account with the lender.
Disadvantage: Two Mortgage Payments
If you're using a home equity line of credit to pay off existing high-interest debt (like credit cards), your monthly payment for the home equity line of credit will most likely be lower than for the high-interest debt, due to the lower interest rate and the relatively long life of the loan (usually 10 years).
But if you're going to use the money to make improvements to your home or for any other new financial obligation, you'll have two monthly house payments instead of one, although the home equity line of credit payment is likely to be much lower than the payment for your primary mortgage. If you want to make only one payment, you'll have to refinance and take equity out of your home.
Disadvantage: You Must Have Enough Equity Available in Your Home
In order to get a home equity line of credit, you must have equity available in your home. After all, you're borrowing against the equity, and if you don't have much, you don't have anything to borrow against. Your home equity line of credit, then, will only be as large as your available equity, minus whatever down-payment amount the lender expects you to maintain with them (and that can be as much as 25 percent — check with your lender).
Disadvantage: You Lower the Equity in Your Home
If you're planning to use your home as part of your retirement plan, using a home equity line of credit will reduce your ability to do that. The more you tap into your equity, the less you'll receive in cash when you sell your house.
Disadvantage: You Must Own Your Own Home
You must own (or have a mortgage on) your own home in order to qualify for a home-equity line of credit. Even if you've been living in your grandmother's home and have made all the payments on it, if the house isn't in your name, you can't get a home-equity line of credit
Is a Home Equity Loan Right for You?
If you can answer yes to seven or more of the following questions, a home equity line of credit may be right for you!
You own your home (with or without a mortgage).
You have enough equity in your house to tap for a home equity line of credit. (Equity equals the current value of your home minus the payoff on the mortgage.)
The interest rate on the home equity line of credit is lower than the debt you'll pay off with the home equity line of credit.
Your total monthly payments will be lower than your current monthly payments after you tap your home equity line of credit.
You can afford both the home equity line of credit payment and your primary mortgage payment, along with your other debt.
The annual home equity line of credit fees are $50 per year or less.
You itemize deductions on your taxes (that is, you fill out 1040 Schedule A).
Your retirement account is well financed, so you don't need to pay off your house before you retire.
