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 u se 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.
