Home equity lines of credit: here today, gone tomorrow?

Home equity lines of credit are very popular with customers. These loans are a convenient tool for financing big-ticket items, such as home improvements, medical bills or higher education. However, due to the subprime mortgage crisis and significant home-value declines, nowadays the majority of banks are limiting customer access to HELOC accounts. In this situation you can try to restore your credit line or shop for another line of credit.

HELOC basics 

A home equity line of credit (HELOC) is an open-end loan in which real property serves as collateral. The home is often a consumer’s biggest asset, so many people use their lines of credit only for significant expenses.

Similar to a credit card, HELOC is a revolving line of credit which lets people borrow the amount of money they need. You can repay the balance and borrow again up to the specified pre-set credit limit. When you want to withdraw cash, you can either write a check or use a special plastic card. 

The maximum amount of money you can borrow under a HELOC plan depends on the size of the equity in your home. Many creditors set the borrowing limit by taking a percentage (for example 75%) of the appraised market value of the home and subtracting the amount of debt you owe on the existing mortgage.

For example, if the appraised market value of your home is $100,000, a percentage is 75%, and your mortgage debt is 40,000, then you can get a $35,000 home equity line of credit. 

While determining your borrowing limit, lenders may also consider additional information to evaluate your potential credit risk: income, current debts, other financial obligations, and your credit score.

HELOC terms typically vary from five to twenty five years. At the end of the repayment period you must pay off your whole balance in full. Otherwise, the lender is legally allowed to foreclose.

Generally, the term is divided into a draw period (5-10 years) and a repayment period (10-20 years). During the draw period it is allowed to borrow money as many times as you need, up to the credit limit. The borrower can pay off the entire balance in full, or just the interest accumulated on the balance. 

Once the draw period is over, the borrower can no longer borrow money from the home equity line of credit. If he or she has an outstanding balance, the payments will be amortized to eliminate the debt within the repayment period.

Lenders may impose some limitations on how you can use the line of credit. For example, some HELOC plans impose a minimum amount you can borrow each time you want to take money out of your home equity line of credit. 

HELOC rates

HELOC is typically an adjustable-rate mortgage. It means that your interest rate will be based on a certain financial indicator (such as the prime rate published in major newspapers or a U.S. Treasury bill rate). To calculate the APR that you will pay, most creditors add a margin (for example 2%) to the index rate.

Variable interest rates can change over time because the index rate also changes. That’s why it makes sense to find out your future index rate and margin, how often the index changes, and the statistics of its fluctuations over several last years. 

Some lenders can offer home equity lines of credit with fixed rates. However, although the APR remains unchangeable, your monthly bill can still fluctuate based on the amount of money that you borrowed during the previous month. 

Some lenders allow customers to convert an adjustable HELOC rate to a fixed rate. In this case you will need to pay a fee. 

HELOC is often called the cheapest method of borrowing. The reason is obvious: this type of loans poses less risk to the lender because it is secured with a property. Lender has the right to sell your property in case of your default and use this money to cover your financial obligations. That’s why HELOC comes with more favorable terms to the borrower than unsecured loans or credit cards. 

Under any HELOC plan, customers pay interest only on the amount of money that they have borrowed. If, for example, your available credit limit is $200,000 and you borrow $5,000, than you will need to pay interest on the $5,000. 

Besides APR, there are some other charges that you need to pay: a fee for estimating the value of your home, an application fee, upfront charges, closing costs, etc. Many of them are similar to the fees you pay when you purchase a home. 

One of the main reasons why HELOC loans are so popular is that their interest can be deductible under federal and many state tax laws. You receive a great opportunity to convert high interest non-deductible debt (such as credit cards and auto loans) to tax-deductible debt. It makes the borrowing costs lower. You can get more information about tax deductions at the Internal Revenue Service website.

HELOC freeze

Under agreements, financial institutions have the right to cut back or cut off your line of credit if the value of your home falls. As a result, in 2008 the main HELOC lenders including Bank of America, JP Morgan Chase, Washington Mutual, National City Mortgage and Wells Fargo started to inform borrowers that their home equity lines of credit had been frozen or reduced. 

What are they afraid of? If you default and your house is sold, first of all the money will be used to pay off your first mortgage. The rest of the money will be used to pay off your HELOC. It means that if the value of your home has become significantly lower there may not be enough funds to cover all debts. 

Thousands of home equity lines of credit have already been cut back or frozen by lenders. Even if you have a solid credit history and have always made payments on time, you may be also affected. This can be an unpleasant surprise if you were going to use your HELOC to make a home improvement or cover medical bills. 

If you want to restore your line of credit, you have several available options. First of all, you can contact your lender and prove that the value of your home is still the same. Contact an appraiser who knows the area you live in and ask him to estimate your property. This method requires time and money – you will need to pay several hundred dollars for the appraisal. And there is no guarantee that the lender will cancel his decision.

You can also try to refinance with another creditor. Despite uncertain economic times, there are still some HELOC lenders on the market. However, you may need to have a solid credit score, stable income and no other financial obligations in order to qualify for a new home equity line of credit. 

If you decide to apply for a new HELOC, search for the plan that best fits your needs and requirements. Look carefully at the credit agreement and examine the terms and conditions of various HELOC plans, including the interest rates and additional fees you will need to pay.

If you have a rainy day fund and no immediate need for a big ticket purchase, you may do nothing. Some day the credit crisis will be over. In an emergency, you can withdraw funds from your savings account. It is a more profitable option because you won’t need to pay off any debts or interest accrued on your balance.