Is a home equity line of credit a fit for you?
Rising home values and low interest rates are a powerful combination for homeowners looking for more financial breathing room.
The trend, fueled by the two-year housing recovery, has helped spur many borrowers to take out a home equity line of credit against the value of their home.
Such a loan, also known as a "HELOC," can give borrowers more financial flexibility and typically at a lower interest rate than a credit card. But HELOCs can also pose risks, should interest rates rise sharply or home values plummet.
When the housing market crashed in late 2007 it wiped out the equity many borrowers had in their home, prompting lenders to slash their available credit. Others overextended themselves financially, assuming home prices would continue to rise and boost their ability to use borrow more money against their equity.
That’s not deterring many homeowners from using a portion of their homes’ value as a piggy bank. Available credit extended via HELOCs to U.S. homeowners jumped 27 percent to $120 billion in the 12 months ended June 30, according to Experian Decision Analytics data.
"It’s important to think about whether the payments are affordable and whether it’s worth putting the equity in your house at risk," said Debbie Goldstein, executive vice president at the Center for Responsible Lending.
Here are five tips to help determine whether a HELOC is right for you.
1. KNOW THE BASICS
Home equity lines of credit essentially function like a credit card or a traditional line of credit. Borrowers can tap a portion of their available credit, pay it off, and use it again for the term of the credit line or draw period, which is typically 10 years.
After that, any unpaid balance converts to a loan that must be repaid over a predetermined period, typically 10-20 years. In some cases, a lender will require payment in full at the end of the draw period.
One key benefit HELOCs have over standard bank loans that are not secured by real estate is borrowers can deduct their interest payments on balances up to $100,000 against their tax liability.
2. CONSIDER THE INTEREST RATE
Because the terms of HELOCs can vary, it’s essential to understand how interest rates will be applied on your loan.
Beyond determining the length of the draw period and starting interest rate, you’ll want to know whether the terms of the loan include payment in full at the end of the draw period, and how much time, if any, you’ll have to pay back the balance.
Lenders generally base the starting interest rate on HELOCs on the prime rate. Look for lenders that offer to cap that prime rate over the life of the loan, which will protect against a spike as rates fluctuate over the draw period.
Interest rates on HELOCs have been trending lower this year. The average now is around 4.87 percent, according to Bankrate.com. That’s based on a $30,000 line of credit with a combined loan-to-value ratio of 80 percent. The loan-to-value ratio is determined by weighing how much a borrower would owe on home loans against what the property is worth.
Many economists predict loan rates could go higher beginning next year, when the Federal Reserve is expected to start raising interest rates.
3. DON’T ASSUME YOU’LL QUALIFY