The Home Equity Line of Credit: Is it Right For You?

By MortgageCreditProblems.com Columnist
Mortgage Credit Problems Columnist

A home equity line of credit, or HELOC, can be a smart strategy to help pay for home repairs, college tuition, or medical bills. But a credit line can be a curse if you can't make the payments, so evaluate the option carefully before you apply.

Home Equity Delinquencies Rise

Unlike credit card debt, a home equity line of credit is secured by your home, which means you could lose your property if you default. Rising delinquency rates, which hit record levels on home equity lines of credit in the second quarter of this year, are a good reminder to approach with caution, whether you have bad credit or a sterling financial history.

Home Equity Loan vs. Credit Line: What's the Difference?

Both types of credit let you borrow against your home equity, but while a home equity loan delivers a lump sum at closing, a HELOC is a revolving credit account. Home equity loans are most appropriate when you need a large sum all at once, such as for debt consolidation or medical bills. HELOCs are best for ongoing expenses, like tuition, a series of home improvements, or to provide cash flow for a new business.

Know the Terms of Your Home Equity Financing

The home equity credit line is open for a certain amount of time, such as ten years. You can borrow at any point, although there may be some restrictions, such as a minimum amount per draw. Read the credit agreement's fine print to understand the terms. Once the drawing period is over, the repayment period begins and you can no longer tap the funds.

Consider Mortgage Interest Rates and Caps

Interest rates for home equity credit lines are typically adjustable and based on a publicly available index, such as the prime rate. Learn the amount of the margin, which the lender adds to the index to determine the rate you pay. Find out how often your rate can change and how high the index has risen historically. Learn your loan's interest rate caps, which limit how much your rate can be increased at one time and also how high it can go over the loan's lifetime. Know your loan's floor, which determines how low your rate can go.

Figure the Costs and Compare Mortgage Lenders

You'll pay closing costs and other fees when you open a HELOC, although they are considerably less than the costs of refinancing a mortgage. Some plans charge annual membership and transaction fees. If you're getting the credit line to save on interest, make sure those costs don't eat up any savings from the low rate.

How Will You Pay?

The portion you repay during the credit line's term may not be enough to cover the principal, which means you'll owe a balloon payment at the end--this is typical, with many loans amortized over thirty years but due in fifteen. Think about how you'll pay that off before signing a credit agreement. If you can't finance the balloon payment or cough up the money yourself, you could lose your home.

Shop carefully for the best deal if you decide a home equity credit line is right for you. Use the form on this page to get up to four free quotes from lenders.

Sources:

http://www.federalreserve.gov/pubs/HomeLine/default.htm#equity

http://www.marketwatch.com/story/consumer-loan-delinquencies-hit-record-high-2009-10-01

http://www.aba.com/EP/default.htm

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