When we are short of cash, most of us turn to our credit cards or make use of personal loans for funds.
However, in most cases, swiping your card comes with an APR rate over 17-percent. Lenders understand that consumers are willing to pay a premium for access to immediate cash, and they make us pay for it in the form of an exceptionally high-interest rate.
Personal loans are not much better, and many of them come with high-interest rates as well. What if there is a better way to loan money from the bank without paying a fortune in interest charges? If you’re a homeowner, then you have access to a loan facility with a far cheaper interest rate than that you would pay with personal loans or credit card.
A home equity line of credit is a viable option for homeowners in need of money, provided that they have some equity in their home.
What is Home Equity?
If you took out a home loan some years ago, then the chances are that you’ve paid down a significant portion of your mortgage. If your property costs $250,000, and you’ve managed to pay off $75,000 from the balance, then you have $175,000 remaining on your mortgage, minus interest costs. This calculation gives you $75,000 in equity in your home.
In the above example, you have $75,000 of equity in your home. The bank will issue you with a home equity line of credit for up to $75,000, allowing you to spend this money at will on any purchases you deem necessary.
The bank attaches the line of credit to your existing mortgage facility, allowing you to maintain your current monthly payment while benefitting from access to cash.
What is a Home Equity Line of Credit? (HELOC)
Some people may confuse home equity lines of credit with home equity loans. There is a distinct difference between the two facilities, and it’s vital that you understand the nuances of each.
A home equity loan is like a second mortgage. The bank allows you to loan money against the equity of your home, similar to the example described above. However, in the case of a home equity loan, the bank issues you with a lump sum of $75,000.
Your home equity loan comes with a fixed interest rate and a fixed payment, allowing you to benefit from gaining access to cash while paying the same monthly installment on your mortgage.
Home equity lines of credit differ in the fact that the bank will approve you for a loan of $75,000, but you don’t have to draw the full amount straight away. Instead, a home equity line of credit provides you with the facility where you can drawdown as much cash as you need – up to $75,000. You don’t have to draw the full amount at once, and should you need only $10,000, this leaves you with $65,000 remaining in your credit line, to draw and use as you please.
The bank only charges you interest on the amount you draw from the facility, in this case, $10,000. The remaining $65,000 is available in your credit line, but you do not pay any interest charges on these funds.
A home equity line of credit allows you to draw what you need, minimizing your monthly repayments and interest fees. In most cases, the lender charges a slightly higher interest fee for the facility than you would pay with your mortgage.
The average APR on a home loan is between 4 and 4.25-percent. However, the APR on a home equity line of credit could be as high as 5.69-percent. While the cost of the facility may be higher than your original mortgage, it’s substantially less than what you would be paying with a credit card or personal loan.
Home Equity Line of Credit Vs. A Home Equity Loan
A home equity line of credit has more flexibility, giving you greater control over the loan balance, and your interest costs. Since you only pay interest charges on what you use, it can save you thousands of dollars on unused funds that are sitting doing nothing but making your checking account balance look larger.
Unfortunately, when it comes to home equity lines of credit, there is a chance that the lender can freeze your credit line at any time. If banks encounter a lending crisis or liquidity crisis, such as what they experienced in 2008, these credit lines are the first to go onto the chopping block.
Therefore, while home equity lines of credit are more flexible and cost less to manage; they also come with a certain degree of risk that homeowners need to be aware of if they wish to use these facilities.
Interest rates on home equity lines of credit are variable, instead of fixed like they are with home equity loans. Therefore, your interest rate can either improve or worsen depending on the economic climate in the country. We are currently going into a period of rate cutting, where the Federal Reserve will reduce the interest rate. This type of monetary policy is beneficial for people using home equity lines of credit, as the cost of lending money from the bank reduces.
However, should monetary policy move back towards a tightening environment, where the Federal Reserve increases interest rates, then you’ll have to pay more on the money you loaned with your home equity line of credit.
How to Get a Home Equity Line of Credit
Home equity lines of credit are readily available from multiple lenders in the United States. It’s most common for people to visit the original lender for access to this facility. There is some benefit in approaching your bank that originated your mortgage, as you have a payment history with them, and they may offer you a favorable interest rate on the credit line.
However, you can obtain a home equity credit line from numerous lenders, including a local loan originator, a national broker, or a credit union.
When processing your application, the lender will check your credit score to ensure that you have a reputable lending status of paying back the money you owe. You may have had favorable credit when acquiring your mortgage initially, but in the years since, your credit score may have fallen to subpar levels, making you ineligible for a loan.
Lenders typically want to see a credit score above 600 before they will consider you for a home equity line of credit. Visit one of the major credit bureaus online, and look up your credit score for free, before you waste your time applying for a credit line.
Another factor determining your success with opening a home equity line of credit is your debt-to-income ratio. Lenders do not like to take the risk of loaning money to people that have too much debt outstanding. Their primary fear is that you will use the credit irresponsibly, and drive yourself further into unsustainable debt levels, which you will not be able to repay.
Lenders calculate your debt-to-income ratio by looking at your tax returns and payslips and comparing them to outstanding debts. Your income is not necessarily the defining factor in establishing your DTI ratio. For example, if you earn $50,000 a year, and only have $5,000 in debt, then you are in a better position than someone who owns $500,000 a year, but has $600,000 in debt.
Lenders typically want to see a debt to income ratio of less than 30-percent to approve you for a home equity line of credit.
Another factor that plays a role in obtaining a home equity line of credit is the loan-to-value ratio on your home. Lenders do try to ensure that you don’t borrow more than 80-percent of the value of your home through your credit line. To make this calculation, the lender takes into account the original purchase price of the mortgage as well as the size of the home equity line of credit you’re requesting.
Tips for Finding the Best Lender
Using the right lender for your home equity line of credit can save you thousands of dollars over the loan term. It’s essential to shop around for the best deal, as different lenders can offer significantly higher fee structures that vary widely from others. For instance, it’s possible to find some lenders that will issue a home equity line of credit, even with a poor credit score. However, you can expect to pay an outrageous interest fee on the money, that’s comparable to a credit card or personal loan.
The best lenders will offer programs and fees that suit your needs and goals. The Consumer Financial Protection Bureau recommends that you avoid using lenders that offer predatory lending tactics, enticing you to take a credit facility at exorbitantly high rates, because you have no other options.
It’s vital to understand that if the lender freezes or cancels your credit line, you could be held responsible for the entire amount of the facility loaned, with payment due immediately. If you can’t repay the facility, then the lender could foreclose on your home.
Therefore, it’s vital to consider insurance when taking out your home equity line of credit to protect you in this situation. Always read through the paperwork before you sign, and make sure that you understand all the terms and conditions involved with the credit line. If you’re having trouble with comprehending the terms and conditions, then it’s best to visit an accountant to get an accurate assessment of the contract before you commit.
Search through forums online to find other people that are currently using home equity credit lines and who they recommend as a lender. This kind of experience is invaluable to you, and it could help you from making the mistake of signing up with the lender that uses predatory tactics.
When to Avoid Home Equity Credit Lines
There are situations in life when we are so grateful to get our hands on money, that we throw caution to the wind. If you are in a desperate situation, then it’s advisable to avoid using home equity credit lines, as it increases your financial burden, and puts you one step closer to bankruptcy. Instead of applying for a credit line when you are desperate, it’s advisable to look for means to increase your income, instead of acquiring more debt.
Watch Out for Predatory Lending Tactics
If you’re applying for a home equity credit line, then here are a few red flags that you should watch out for when negotiating with the lender.
Some lenders may change the loan terms before closing, modifying the interest rates to a higher level, in the hope that you will not notice the changes before signing. It’s vital that you read through every single clause of the contract before putting pen to paper, and signing your name on the dotted line.
The lender may also insist on you taking out insurance as part of the loan; this is because they receive kickbacks on insurance policies sold along with the credit-line. Unfortunately, these insurance premiums may cost you a lot more than if you were to take out an independent insurance policy from a broker.
Some lenders may also issue credit lines that exceed your loan-to-value ratio, or they may offer you a credit line even if you have a low credit score. These lenders care more about their commissions than they do about your financial health. In most cases, they are hoping that you default on the loan, as they get kickbacks from lenders and insurance companies if you default.
Final Thought – Is a Home Equity Line of Credit Right for You?
In some cases, applying for a home equity line of credit may not be the best financial solution for you. There may be other alternatives that provide less risk and offer favorable repayment terms.
Cash-out refinancing is an example, and this vehicle involves replacing the outstanding amount of the mortgage with a new loan. The loan covers the outstanding debt while giving you an additional lump-sum worked into the new loan.
Reverse mortgages are an excellent idea for seniors that only own home. In this case, the lender issues a monthly check against the equity on your home. In both of these examples, the lender secures their risk in the deal against your property.