Equity loans: More popular, but more confusing

Mortgage bankers eagerly want to make 2004 the year of the home equity loan. First they have to clear up some misconceptions.

Many homeowners don't understand what an equity loan is. Lenders worry that consumers believe equity loans have high closing costs and are a hassle to apply for. And bankers think that a lot of potential borrowers don't know the differences between home equity loans and equity lines of credit.

These issues are coming up because mortgage rates have risen about 1 percentage point in the last year. With that rise in rates came the end of the long refinancing boom: In 2003, two out of three mortgage applications were from homeowners who were refinancing their loans, according to the Mortgage Bankers Association; in the second week of June 2004, the refinance share was 34 percent.

Last year, almost half of refinancing borrowers did "cash-out refis" -- they refinanced for more than they owed and pocketed the difference. Now that rates are higher, homeowners don't want to refinance again. "The only way to cash out is to take out a home equity loan or line," says Anthony Hsieh, president of HomeLoanCenter.

Lenders are chasing after equity borrowers by offering airline miles and gift cards at stores such as Costco, as well as by touting the ease and low costs of applying for the loans.

Home equity baffles
What, exactly, is a home equity loan? In a Lending Tree-sponsored survey of 802 homeowners, 20 percent of the respondents agreed with the statement: "Home equity loans and second mortgages are two names for the same thing." They were right. The other 80 percent said, incorrectly, that home equity loans and second mortgages are different things.

When you get a home equity loan, you are borrowing against your ownership stake in the house. The equity is the value of the house minus your mortgage balance. A home equity loan uses your equity as collateral. If your house is worth $200,000, and you owe $140,000 on the mortgage, you have $60,000 in equity. A home equity loan would allow you to borrow some or all of that $60,000.

You receive an equity loan as a lump sum, and repay it over a set time, usually at a fixed rate and for the same payment each month. A home equity line of credit, or HELOC, is a type of equity loan that works like a credit card. It has a credit limit and a revolving balance, meaning that you can borrow up to a certain amount, pay some or all of it back, and borrow again up to the limit. Rates on most lines of credit vary as the prime rate moves up and down.

Who needs a line, who needs a loan
Because they come in a lump sum, home equity loans generally are recommended for one-time expenses -- to consolidate credit card debt, pay for a new roof, buy a business. Equity lines of credit often are recommended for recurring expenses such as college tuition, or multistage projects such as home renovations, or to hold in reserve for emergencies such as job layoffs.

A line of credit starts with a draw period and ends with a repayment period. During the draw period, the homeowner can borrow against the credit line by using a charge card or a checkbook. Minimum monthly payments cover only the interest during the draw period. When the repayment period starts, the monthly payments cover interest and principal so that the balance is repaid by the time the credit line expires. The length of the draw and repayment periods varies with the lender and size of the credit line.