The Savvy Homeowner’s Home Equity Plan

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A home equity line of credit is a way for you to use the value of your home even after it has served as collateral for your first mortgage. “Equity” is a term for the portion of market value in your house remaining free, ready to access. If your home equity is high, you can use it to generate cash. Unlike a mortgage, this credit line allows you to borrow continuously until you reach a certain amount per period.

A typical line of credit lets you borrow up to $20,000 during the “draw period” in whatever fashion you prefer, usually through an issued card or checkbook. After the draw period, which often lasts several years, you enter the repayment period and pay the loan off. In all, the loan may last as long as 25 years. Sometimes draw periods are much shorter and, if you repay from year to year, lenders will let you renew the credit line or potentially convert it into a traditional loan. Either way, you only pay interest on the money that you actually withdraw.

First Have a Purpose

Never apply for a line of credit you do not need. If you are late on your payments, a home equity line of credit can go into default just like a first mortgage. This means you could borrow $20,000 but end up losing your $200,000 house through a foreclosure. First, find a purpose for the line of credit, preferably one that enhances the value of your house or life.

For example, a home equity line may be useful in paying off debt on credit cards and auto loans for consolidation, especially when the home loan has a better interest rate. Typically, home equity loan interest is tax deductible, while the debt you replace is not. Other expenses that require recurring deposits are also potential reasons to open the line of credit – tuition, for example, or a lengthy construction project, or in some cases, small business considerations such as inventory.

What the Lender Looks At

When you apply for a home equity line of credit, the lender examines several key pieces of information. The first is, naturally, your credit history, which should be as strong or stronger as when you took out your first mortgage. Second, the lender looks at how much equity is in your home. Say your home is worth $200,000 on the market (the lender orders a home appraisal to find out). But you still owe $100,000 on your first mortgage, so your equity is the remaining $100,000.

Lenders will not allow you to borrow that full $100,000. Instead, they typically limit the line of credit to 70 to 80 percent of the appraised value. In this case, 70 percent of $200,000 is $140,000. Subtract the $100,000 still on your first mortgage, and you could take out a line of credit for $40,000. Finally, lenders will set payment terms, including the draw and repayment periods, if applicable. Payment structures may vary considerably.

Key Terms to Consider:

A Good Index: Most lines of credit have variable interest rates. This means the interest rate follows a particular index or rule based on general economic statistics. Find out which index is used, how often it is updated, and its history. If the index has a habit of rising quickly or unpredictably, you may want to back away and find a more favorable rate. Otherwise, your monthly payments might be far higher than expected.

Caps and Discounts: Variable rates have caps on how much the interest rate can increase. Lenders can also offer brief discount rates for the first several payment periods. Remember to examine these caps and discounts when looking for an ideal rate.

Extra Fees: Interest is not the only thing you have to worry about. Lenders make you pay for appraisals, applications, points to lower interest rates, and closing costs. Together, these costs could come to several thousand dollars. Keep a close eye on all fees when considering any credit line package. Store up cash to pay the fees before considering tapping into your home equity.

Payment Terms: Some lenders want you to make a minimum monthly payment, others allow you to pay interest only, and some have lengthy waits before repayment periods. Many lines of credit operate on a balloon payment structure in which the entire balance is owed immediately after the draw period ends. It is best to choose a payment structure that eats into the principal as much as possible so you can lower this final payment. Avoid balloon payments if possible, unless you know you can budget enough cash to cover them – in this case, balloon payments may help reduce total interest.

Future Plans: If you sell your house, you will have to use some of the proceeds to immediately pay off the line of credit. Compare how much value you will get out of the credit line compared to the upfront costs in starting it. If you might sell your house in several years, the deal could be a poor one for you.

Manage Your Debt Wisely

A home equity line of credit requires careful planning and foresight in order to use properly. Do not apply for a credit line just for extra cash – always have a strategy in place, and a backup strategy for paying back the credit line in case your income situation changes. Used correctly, an equity credit line can solve debt problems and offer funds for life-changing investments. If you choose to create one, focus on the terms and realize the full potential of your house value!

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