When a bank, mortgage company or credit union approves your home equity line of credit (HELOC), it doesn't give you a check. Instead, you get a checkbook; sometimes you receive a debit card too. You can write checks as you normally would (or use the card), except that each use is really a loan against your HELOC's credit limit.
You can use the HELOC to pay for any expense or purchase, and the bank will start to charge you interest as soon as the card is used or the check is cashed. Although the bank will insist on a minimum monthly payment, you are free to repay the loan in full at any time - and after you do, you're free to borrow again through continued use of the checks and card. In this sense, the HELOC is similar to a revolving line of credit or credit card.
All told, HELOCs are convenient. But are they too convenient? Some consumers who have amassed large credit card debts, have turned to HELOCs for help. They use the loans to pay off their credit cards and other debts, and consider themselves smart for swapping high-interest, non-deductible debt with a lower-cost loan that is tax-deductible. But what these folks often forget is the HE in HELOC: Home Equity. Banks are willing to provide this low-interest loan because they use your house as collateral. If you fail to repay the loan, you could lose your home.
So before signing the paperwork, make sure you understand all the terms of the loan. Here are some questions you should be able to answer before applying for a HELOC:
1. What rate will you be charged? Most HELOC interest rates are tied to the Federal Reserve's Prime Rate. As that rate increases, so does the interest rate you are charged. Banks that offer below-rate loans make up for it by charging you closing costs and other fees.
2. Are you being offered a loan with a balloon payment? Many HELOCs are for a certain term, often 10 years. At that time, you usually must reapply. Say you get a $25,000 HELOC with a 10-year term, and that you use $18,000. Ordinarily, your monthly payment would consist of interest and principal, so that the loan is repaid in 10 years. But if the bank gives you a balloon HELOC, your monthly payment will consist solely of interest payments. That might sound attractive to you, because the monthly payment will be lower and fully tax-deductible. But in 10 years, you'll still owe the full principal amount of $18,000. You might figure that this is not a problem because you'll just reapply and get a new HELOC for another 10 years. But if the bank refuses to grant the renewal - say, if you're out of work or facing other problems - you'll have to repay the full $18,000 immediately. If you lack the cash or savings, you could be forced to sell your house in order to repay the loan. So think carefully before accepting a balloon loan.
3. How much is the lender willing to loan? The larger your HELOC, the lower the rate. That's because of economies of scale: It's just as much work for the bank to underwrite a $100,000 loan as it is a $10,000 loan. So the more you borrow, the more cost-effective it is - and the more trouble you can get yourself into. Many lenders also require that each check you write be no less than X but no greater than Z, so ask about that, too.
4. What are the bank's fees and closing costs? In many cases, you can pay more in fees than you end up paying in interest. So, which is the better deal: a 4% loan that features a $1,200 fee, or a 5% loan that has a $150 fee? The answer depends on the amount of money you plan to borrow: The more you borrow and the longer you take to repay it, the better the first deal becomes.
Read the fine print, for fees come in many guises - appraisal fees, attorney's fees, loan fees, recording fees, points, loan application, title search, you name it. Many lenders also charge annual fees and transaction fees. And in many cases, the fees are considered part of the borrowed amount - and thus are charged interest, which further boosts your overall costs.
Finally, some lenders charge a fee if you sell the house before your HELOC's term has ended. And if you sell your house, you must pay back the HELOC's entire outstanding balance at that time.
5. Must you activate the HELOC? Because you get a checkbook and not a check, the bank makes no money by granting you a HELOC. That's why some banks require you to write a check of at least a certain amount within a certain time, or they'll cancel the credit line.
HELOCs are convenient, and banks make money selling them. Make sure you understand what you're buying.
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