In the 1990s, consumer attitudes toward home equity loans were largely negative and focused on avoidance. Loans of this type, called second mortgages, carried with them the stigma of financial desperation. In 1999, however, a series of Citicorp advertising campaigns were successful in changing attitudes. As of 2010, home equity loans are a common way for homeowners to get credit. These loans can be standard, lump-sum loans, or they can be a form of revolving credit called an equity line of credit.
Identification
Equity lines of credit use the value, or equity, in your home as collateral for a loan that works much like a credit card. A major difference between the two is that an equity line of credit has an expiration date. During the "draw period," or time that funds are available for withdrawal, you have full access to use equity funds in any way you choose. If the terms of the equity line of credit specify payment in full at the end of the draw period, you are subject to a balloon payment to clear an outstanding balance. Otherwise, you enter a repayment period during which you pay off the balance as you would for a standard loan.
Eligibility
Lenders set eligibility requirements according to your current income and debt load, credit rating and the loan-to-value ratio of your home. Loan-to-value is normally 75 to 85 percent of the appraised value of the home, less the amount you owe on outstanding mortgages. For example, if a current appraisal values your home at $300,000 and the balance of your mortgage is $100,000, you have $200,000 of equity value. At a 75 percent loan-to-value ratio, your credit limit would be $175,000.
Features
Most equity lines of credit feature variable interest rates and closing costs similar to those you encountered when taking out the original mortgage. Variable interest rates cause payments to fluctuate over time, according to the value of the index your lender uses. Most often, the index lenders use is the prime rate or value of a Treasury bill. The interest rate is the value of the index plus a margin of a few percentage points. Closing costs can include an application fee, title search, appraisal fee and points, which are a percentage of the amount you borrow.
Considerations
Lender terms and conditions vary widely with equity lines of credit, so it pays to shop and compare before making any decisions. The Federal Truth in Lending Act requires lenders to disclose information such as the annual percentage rate, payment terms and costs to open the line of credit at the time you receive a loan application. Important points to compare include interest rate, closing costs, continuing costs and repayment terms. In addition, if you open an equity line of credit you do have a three-day window of opportunity to close the account and receive a refund of all opening charges.
Warning
There are no restrictions prohibiting a lender from freezing or reducing your line of credit. Common reasons this can happen include a significant decline in the value of your home or a "reasonable belief" that you will be unable to make payments. In addition, if a reason for choosing an equity line of credit is due to the interest deduction allowed on your tax return, make sure you are eligible to itemize deductions. If you cannot, this feature does not apply. If you do itemize and are eligible to deduct interest, you can only deduct interest on the first $100,000. Interest on amounts over $100,000 is not deductible.
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