Home Equity Line of Credit Pitfalls

There are many reasons in life that'll make you turn to credit. Loss of a job, medical expenses, even paying for your kid's college expenses -- and a Home Equity Line of Credit may be the right option for you. But before you cll your broker and sign away your home, you should weigh up the costs of a home equity line of credit against the benefits.

It almost goes without saying that you should shop around for the home equity line of credit that best meets your requirements without imposing undue strain and risk. Remember, your home goes up as collateral against a home equity line of credit, so if you fail to make your repayments, your home is on the line.

So what exactly is a home equity line of credit? As stated above, it's a line of revolving credit that uses your home as collateral. Because your home is probably your most valuable asset (and it IS your home, after all), you should think carefully about why you want to take out this loan. Usually, because of the risks involved, homeowners only use home equity loans for larger expenses, not for day-to-day expenses. If you are approved for a Home Equity Line of credit, your lender will take a percentage of your home's appraised market value and subtract any mortgage payments owed to give you your credit limit. So for a house worth $100,000 at a lender's rate of 80% with $40,000 payed off the mortgage principle (so that'd be $60,000 still owed) you'll be given a credit limit of $20,000 (or 80% of $100,000 less $60,000). Of course other factors come into play, such as your credit history and your ability to repay the loan.

What to look out for when applying for a Home Equity Line of Credit

Just like a mortgage or bank loan, many Home Equity Line of Credit lenders will set a time limit to repay the loan or set a time to borrow credit. At the end of this period you might be able to take out another line of credit -- this will depend on the lender, so it's worthwhile finding this out before you sign on the line. And depending on who you borrow from, you may have to repay in full the amount you've borrowed. Make sure you know what you're dealing with BEFORE you sign up.

So, once you're approved, your Home Equity Line of Credit acts just like one great big huge credit card (only with your home as collateral). If your lender allows your Line of Credit a 10 year term, then you can borrow up to your credit limit whenever you want during this time. Look out for lenders who facilitate access to this line of credit by tying it into a credit card -- this makes access a whole bunch easier (but the temptation to use it a whole lot higher).

You should also whatch out for any limits on withdrawal. For instance some loans may require you to draw a minimum each time you need credit. Or you may be required to keep so many dollars outstanding balance. Or take out an advance upon approval.

Keep an eye out for these things. They'll vary from lender to lender and they may not fit your requirements.

Time to go shopping

So you've decided that you still want a home equity line of credit? What next? Shop around for the best plan! Ask the lenders questions. Give them worst case scenarios. Find out what they'll do and what you have to do. Remember, your home is at stake if you fail to repay the debt. There may be appraisal fees, application fees and closing costs and then, of course, there will be the interest rate applied to the loan.

Home equity lines of credit will usually involve a variable interest rate rather than a fixed. This rate will be based upon a reputable, well publicised and publicly available source such as a prime rate index in a national newspaper. It's important to remember that interest rates can go UP and down. The interest rate stated for the loan will most likely be the interest rate on the day you apply with a margin to allow for this fluctuation. Don't be fooled by this margin -- it will be a 'most-likely' scenario -- make sure you know what the source of the interest rates are and what their historical fluctuation is. If historically, your index reaches high rates frequently this will reflect on your repayments and you may find it difficult to repay your loan. However, home equity lines of credit will be capped to a maximum rate (and most likely a minimum rate too)

You may find that your lender will also give you an introductory rate to your home equity line of credit.Make sure you know how long the introductory rate lasts and what the rate will increase to. You may save a few bucks here, but you don't want to be surprised in 6 months time when the introductory rate expires. Also look out for any 'membership fees' or maintenance fees (that'd be annual charges to you and I) and any transaction fees. Do the math here. You may find it more beneficial to have a home equity line of credit with a slightly higher interest rate and lower fees than a low rate loan with high fees. This will really depend on how you intend to use the loan.

The Crunch

With some home equity line of credit plans, your monthly payment may not be enough to cover the interest and principle. In fact some are interest only payments which will leave the principle untouched. So if you take out a home interest line of credit for $10,000 you may find yourself owing some or all of that once the plan ends! Given this situation, you'll be required to make one final payment to close the loan. As you can see, this payment could be quite a significant sum. This kind of large last payment is referred to as a balloon payment. Don't be caught out with this. Typically people will have to refinance to meet this payment.

You'll also most likely not be able to rent your home during the term of the Home Equity Line of Credit plan. And if you sell, you'll most likely have to repay the entirety of balance then and there.

The most important thing to consider with a home equity line of credit is not "How much do I need?" but "How much can I repay?". If you misjudge this most important question you may well find yourself in a spiral of ever accumulating debt -- or you may lose your home. It sounds very bleak and very complex, but rest assured that Home Equity Lines of Credit can serve you well.