Using Your Home Equity Line of Credit

(April 6th, 2007)

Did You Know?

A 2005 study done by Harvard University shows that more than 80% of people over the age of 65 in USA own their own homes worth a total combined net worth of $3.95 Trillion. This $3.95 Trillion is almost 1/3rd of all Senior's wealth in America.

Home equity lines of credit allowed these seniors to own multile properties, as well as create additional monthly incomes. Seniors who own their own homes have a lot more net worth than seniors who rent.

Using the equity built up in your home, you can get lots of credit made available to you from many lenders, in whatever possible way you want to use it. Furthermore, the interest rate at which you achieve this home equity line of credit is usually a lot lower than credit card debt & other sources of financing. Also, the interest payments that you make are tax-deductible under certain circumstances. In this article, we will look at:

What's a Home Equity Line of Credit?

A home equity line of credit is a line of credit borrowed with your home as collateral. Therefore, if you fail to make payments on the borrowed credit amount, you will forfeit your home as it has been pledged as collateral. Because your home is probably the biggest asset you will ever own, most people use a home equity line of credit to pay for large education bills, home improvement costs and unexpected big medical bills. A home equity line of credit is not used for your day to day living expenses, that's just stupid.

Once you apply for a home equity line of credit, the lender will assess your credit limit (the most amount of credit that you can borrow at any given point). Your lender will set a percentage point in calculating the credit limit. For example, take the following hypothetical situation:

Full Value of House (Appraised) $250,000
Percentage (set by lender) 85%
Amount of Appraised Loan: $212,500
Less: Balance owing on Mortgage $(115,000)
Available Qualified Credit Limit $97,500 

Apart from this, the credit lender will also look at your current short term and long term debt. If your debt burden is high, this means you will be eligible for a lower credit limit. However if you do not have any debt, then you could be potentially eligible for all of this $97,500 credit limit.

You are allowed to withdraw money from your home equity line of credit at any time you want, provided you are approved for one. Some lenders will require you to keep a minimum balance in the line of credit every month. Withdrawals can be made using your credit card.

Annual Percentage Rate (APR) & Closing Rate of the Home Equity Line of Credit

Did You Know?
Your Annual Percentage Rate (APR) is based on your current credit score and Combined Loan to Value Ratio. The formula for Combined Loan to Value Ratio (CLTV) =Amount of Money Being Borrowed / Total Appraised Value of Potential Property. For example, if a borrower wants to borrow $120,000 while the full appraised value of his property is $200,000, then the Combined Loan to Value Ratio (CLTV) is $120,000 / $200,000 = 60%

Choose a credit lender that charges the lowest APR (Annual Percentage Rate). APR is the cost of borrowing credit expressed in percentage form, over the annual life. For example, some lenders will offer you an APR of 12% while others will offer you 15%. Obviously, the lower the APR, the lower the cost of borrowing credit. Furthermore, look at the closing costs of the home equity line of credit.

Closing costs include any attorney fees for drafting the line of credit agreement, fees for filing the line of credit, title search fees, insurance and any taxes payable.
Note: The APR does not incorporate any of these closing costs. These closing costs are separate and do not have any relationship with the APR.

Interest Rates on Home Equity Lines of Credit

In this section, we will differentiate between variable and fixed interest rates. A variable interest rate changes periodically and fluctuates with any ups and downs on a public Index. Examples of a Public Index include the US Treasury Bill, the prime rate published by the Federal Reserve, etc. When you apply for a home equity line of credit, the lender will specify the interest rate you will pay (based on the US Treasury Bill Index) plus a percentage of 2-3 points. This percentage of 2-3 points is known as the "Margin"

If you do take out a home equity line of credit, make sure you know how variably does the Prime Rate fluctuate, which Index it is based on, its highest point and any fluctuations in the Margin. Also note that some lines of credit have a cap or ceiling on how high the interest rates can rise. Some lenders will also let you transfer from a variable interest rate to a fixed interest rate (an interest rate that never changes over the life of the home equity line of credit).

Cost of setting up a home equity line of credit

Setting up a home equity line of credit is like that of buying a new house (and signing a new mortgage application). Some of the costs include:

  • Property appraisal fee (to appraise the current value of your home)
  • Credit application fee (which is NOT refundable if you get turned down for credit)
  • Attorney fees for drafting & filing the line of credit agreement, title search fees, insurance and any taxes payable.
  • Transaction fee charged on everytime you make a withdrawal from your line of credit
  • Some home equity lines of credit are also subject to annual maintenance & administration fees. Check your agreement and with your lender to find out more about this.

Repayment of Home Equity Loans

How you repay back your home equity line of credit depends on the type of lender you borrow from. Some lenders do not accept monthly payments (towards the principal amount), and will want 100% of their money back upon maturity of the loan. For example, if you take out a $100,000 home equity line of credit on January 1st, 2005 and it matures on Dec 31st, 2010, this means you will have to repay back the entire $100,000 on Dec 31st, 2010. Ofcoure, you will have to make interest payments on these loans, based on the Annual Percentage Rate (APR) and the Prime Rate.

Many smart consumers like to pay off their home equity lines of credit as fast as possible. For example, if you took out $50,000 to purchase an expensive car, you might want to set aside $1000 every month so as to be able to fully repay back your loan upon maturity. You don't want the maturity date to expire and you NOT having the $50,000 cash available to fully pay off your loan, that would be a total disaster! If you choose to pay your entire $50,000 original principal balance upon maturity, this is known as a "balloon payment." If you cannot make this balloon payment on your loan, the lender will simply confiscate your home from you.

What happens if you sell your home, while still owing money on the home equity line of credit? If you do so, you will have to fully repay back the loan immediately. Therefore, do NOT take out a home equity line of credit if you are planning to sell your home in the near future.

Disclosure of Home Equity Loan Terms

Under the Federal Truth in Lending Act, all home equity line of credit lenders are required to disclose to you the important terms of the loan. Some of these terms include:

  • Annual Percentage Rate
  • Closing costs including attorney fees for drafting & filing the line of credit agreement, title search fees, insurance and any taxes payable.
  • Terms of payment (whether it will be a one time balloon payment or variable monthly payments)
  • Idea about the Interest Rate charged, which Index it is based on and the Margin.

Cancelling a Home Equity Line of Credit Loan

If you put your principal residence as collateral against a home equity line of credit loan, the Federal Truth in Lending Act gives you 3 days from the date your account is opened to revoke your decision and cancel the home equity line of credit loan. You must inform the credit lender by writing an official letter. Within these 3 days, you will also be refunded any closing costs for which you might have paid, including appraisal costs and any application (attorney) fees.