What You Should Know About a Home Equity Line of Credit
One Way to Tap Equity
If you’re considering taking out a second mortgage or refinancing your home in order to take out some cash, here’s another option. Depending on what you are planning to do with the funds, a home equity line of credit may meet your needs.
This is a revolving type of credit, which uses your home as collateral. So unlike consumer credit, the interest you pay on a home equity line of credit may be tax deductible as mortgage interest. However, there are some limits. In general, only interest on home equity loans up to $100,000 can be deducted on your tax return if you itemize. (See right-hand box for a further explanation of the mortgage interest deductibility rules.)
With a home equity line of credit, rather than receiving a lump sum, you access the funds as you need them using special checks, or in some cases, a credit card.
Suppose you want to use the cash to do home improvements over the course of a year. With a traditional loan, you receive a lump sum and begin paying interest on it right away. A home equity line of credit allows you to pay for work as it is done, and leave the rest of the loan untapped – and therefore not subject to interest.
The Home Equity Line of Credit Details
Here’s how a home equity credit limit is determined. After a property inspection, the lender multiplies the appraised value of a home by a percentage (usually up to 85 percent) then subtracts what is owed on the mortgage. The balance is the maximum that can be borrowed.
As with most loans, the lender also verifies the borrower’s ability to pay based on income, work history, credit score and other financial obligations.
You can generally draw out funds for a fixed period of time, such as ten years. At the end of that draw period, some home equity credit lines allow you to renew if you wish. In either case, you continue to make monthly payments for a fixed period of time. Some credit lines, however, require you to repay the full amount when your draw period expires. With that in mind, be sure you understand the terms before signing.
Once you secure a home equity line of credit, you may be able to borrow the full amount at any time. But there are certain restrictions that might apply, for example, you might not be able to draw below a certain minimum, such as $300. You might also have to keep a minimum balance outstanding or to take an initial draw as soon as the loan closes.
The Cost of the Loan
Home equity lines of credit, like most loans, may have a variety of costs in addition to interest (see the lower right hand box for a list). Because the time commitment is shorter, the bank’s risk is lower, therefore home equity lines of credit may come with lower interest rates than longer loans. However, the interest rate is more likely to be variable than fixed. The variable rate is based on a publicly available index, such as the prime rate or the U.S. Treasury bill rate, plus margin. (Margin is the number of percentage points the lender adds to the index rate to determine the annual percentage rate.) Before agreeing to a home equity line of credit, be sure you know what index it is based on, how volatile the value of the index is, and how high it has risen in the past.
You may remember when consumer interest on car loans, credit cards, and other personal loans was tax deductible. Unfortunately, in the 1980s, the tax code was changed and the deduction for consumer interest was eliminated. But the good news is, mortgage interest may still be tax deductible, subject to limitations, for those who itemize on their tax returns. As home equity soared in the last several years, consumers started cashing out some of it by refinancing, taking out a second mortgage, or initiating a line of credit. If the funds are used to pay off high interest credit cards and personal loans…presto…the nondeductible consumer interest may become deductible. Still, any decision to take out a loan for which your home is collateral should not be made lightly. Shop around, find out the facts, and be sure you understand the terms of a loan before signing on the dotted line.