Financial Literacy 2007 - Home equity
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home equity
FAQ: borrowing against home equity

Besides having a variable interest rate, a HELOC has interest-only payments, at least in the early years of the loan. Some HELOCs are structured to have interest-only payments over the entire loan term with a balloon payment at the end of the loan. Other HELOCs become self-amortizing loans after an initial period of interest-only payments.

Because it's a line of credit, you only borrow what you need, although there might be a minimum draw against the line when you close on the loan. At least for part of the loan term, the credit line is a revolving credit. Paying down the loan balance frees up credit capacity.

The changes in the federal funds rate from June 2004 to June 2006 caused the interest rates on HELOCs to rise above the fixed rate of a home equity loan. Bankrate's national average for a HELOC is 8.16 percent and for a home equity loan it is 7.94 percent as I write this (mid-May 2007). That doesn't mean that the loan is necessarily the better choice. What you plan to do with the money and managing the monthly payments are important considerations, as well as what you think will happen with interest rates over the life of the loan. It's important to know how the interest rate is set with the HELOC. These loans can have rate ceilings and floors that limit how the rate adjusts.

Those are the basics on HELOCs and home equity loans. For more information on home equity lending, including tools to help you decide which loan is right for you, see the home equity toolkit.

Using HELOC for emergency fund

q_v2.gifWhat do you think of having a home equity line of credit (HELOC) on your home? My parents have no money saved at all but they have about $300,000 in equity in their home. Would it be wise to open a line for $25,000 just to have for emergencies?

a_v2.gifI think a home equity line of credit can be a realistic alternative to an emergency fund, although there are some downsides to this approach. First, it's common for the line to require a minimum withdrawal when the loan closes. So on top of the closing costs for the HELOC, the homeowner faces the interest expense on this minimum draw. Since most lines of credit have a prepayment penalty, the homeowner has to find a place to invest the money to mitigate that interest expense.

If the minimum draw is $10,000, the interest rate is at 8¼ percent, and your parents can only earn 5¼ percent on savings, there's a 3 percent spread between what they pay and what they earn. That's $300 per year. Let's say that closing costs were $800. Ignoring any tax impact from the potential mortgage interest deduction on their taxes, they spent $1,100 in year one to have a line of credit in place for financial emergencies. If an emergency fund is typically sized at three to six months worth of living expenses, you have to ask what percentage of the emergency funds $1,100 represents.

Another issue is that being able to draw against the line is only allowed in the early years of the loan agreement. As the ability to draw against the line expires, your parents would then have to pay off the old line and take out a new line to keep having the money available.

There's enough variability in closing cost, interest expense, prepayment penalties and draw requirements that it's worth it to compare different HELOCs. I suggest doing this without filling out an actual loan application because they don't want a series of loan applications on their credit reports. Just ask the lender for its HELOC terms. Low closing costs, low interest expense, long draw periods and short prepayment periods all contribute toward making a HELOC a viable alternative to establishing an emergency fund.

Finally, this alternative is for people with the financial discipline to use the loan for financial emergencies only. It's not meant to be a substitute for a credit card. People who can't keep their credit card balances under control probably shouldn't use a HELOC as an alternative to an emergency fund.

Comparing HELOC to refinance

q_v2.gifI currently owe $137,000 on a first mortgage at 6 percent and am considering a HELOC for home improvements. Most banks are offering interest-only loans. I'm wondering if this is a good choice or should I refinance the current mortgage to get cash out at 25 years.
-- Jenn Jumble

a_v2.gif Although home equity lines of credit, or HELOCs, have interest-only payments in the early years of the loan, you can still make additional principal payments on the loan to pay down the outstanding balance. The loan is likely to have a prepayment penalty for paying off the line too rapidly, but small amounts aren't likely to trigger a prepayment penalty.

The good thing about the HELOC is that you don't have to borrow the whole amount at closing. You can draw on the line as you need it, although it usually requires a draw at closing.

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If you're spending all the money in a short time span on home improvements, then a home equity loan may be the better choice. It will have a fixed rate and the monthly payments are self-amortizing, meaning the loan will be paid off with the last loan payment. The Bankrate interactive feature, "Home equity loans vs. lines of credit," can help you choose between a line and a loan.

A cash-out refinancing will give you the money upfront, but you're not likely to improve on your current 6 percent mortgage. The refi will have much higher closing costs than the home equity line or loan. The amount of closing costs and how long you plan to be in this home both weigh heavily on your choice of financing these home improvements.

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Advice for homeowners looking for options to use their home’s equity wisely. Delivered monthly.

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Ask Dr. Don

Time to sound HELOC alarm bells?

Dear Dr. Don, I have a variable-rate home equity line of credit, or HELOC, at 2.9 percent. I'd like to convert it to a fixed-rate mortgage. I have 20 years remaining to pay off the home equity line. Would it be beneficial... Read more

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