As home prices began their long slide, banks pulled the plug on home-equity lending. Homeowners who had already snagged home-equity lines of credit lost out, too, as many received notice that their lines of credit had been frozen. Home-equity loan originations are still 80% below their peak, according to a recent report from Moody's Analytics and Equifax. But as the housing market emerges from the doldrums, home-equity borrowing is beginning to perk up, too.
Pick your flavor. A home-equity loan, which usually comes with a fixed monthly payment and interest rate, is best for projects or purchases with a one-time, fixed cost, such as consolidating debt. Home-equity lines of credit, or HELOCs, make sense for ongoing expenses, such as long-term home-improvement projects or college-tuition payments. HELOCs usually have a variable rate that's tied to the prime rate, plus or minus some percentage. On a fixed-rate loan, a borrower with good credit (with a FICO score of about 720 to 740) may pay 6.5%; that same borrower would likely pay the prime rate (currently 3.25%) plus 1.5 to 2 percentage points on a HELOC, says Keith Gumbinger, vice-president of HSH.com, a mortgage-information site. You may be able to trim your rate by a half-percentage point if you have a lot of equity and impeccable credit.
As with first mortgages, underwriting standards for loans backed by home equity are strict. Total borrowing -- including both your mortgage and home-equity loan or line of credit -- typically can't exceed 80% of the home's current market value, a far cry from the 90% to 100% loan-to-value ratios common during the housing boom. Most lenders aren't offering six-month teaser interest rates on HELOCs, either. And quickie, drive-by home appraisals, which involve no inspection of a home’s interior, have fallen by the wayside.
Shop smart. Compare terms from several lenders, including banks with which you already have accounts or loans. Those lenders may be willing to give you a break on rates or fees, says Nessa Feddis, vice-president and senior counsel of the American Bankers Association.
Check with regional banks and credit unions, too. They avoided much of the fallout from the housing bubble and have been leading the way in granting new home-equity loans and HELOCs to borrowers with good credit. Plus, they tend to charge lower rates. Recently, the average credit-union variable rate on a $50,000 HELOC was 4.4%, according to Informa Research Services; the average bank rate was 4.6%. A 15-year fixed-rate home-equity loan averaged 6.1% with a credit union and 6.3% with a bank.
Before you apply, get a free credit report to make sure your record is free of errors, and purchase your credit score (go to www.myfico.com to buy it for $20). You'll likely need a minimum FICO score of about 680 to 700 to qualify. If your score is not that high -- or if you want to boost it to get a better rate -- you might want to hold off on the loan application until you can pay down more debt or to allow time for negative information on your report to disappear.
Closing costs, which may include an appraisal and credit check as well as notary and documentation fees, could run $500. With a HELOC, you may be able to avoid those fees if there's an early-termination clause; as long as you keep the line open for a certain period (typically three years), the lender absorbs the fees. Check whether a HELOC has a lifetime cap on the rate. Caps are typically about 9% to 10%, says Fred Arnold, director and treasurer for the National Association of Mortgage Brokers.
Small banks and credit unions may be more inclined than large banks to take personal circumstances into account, especially if your qualifications are borderline in one area because of a temporary setback. It may help to highlight opportunities to increase your income or pay off debt -- say, an upcoming promotion that will include a raise.
HELOC shock. With a home-equity line of credit, you can usually choose to pay only interest during the draw period, which typically lasts five or ten years. After that, payments of interest plus principal kick in for ten or 20 years.
According to the U.S. Office of the Comptroller of the Currency, nearly 60% of all current HELOC balances will switch to payments of interest plus principal between 2014 and 2017. Many borrowers took out these loans between 2004 and 2007, when lending standards were looser, and are sailing through a decade making interest-only payments at rock-bottom rates. If variable HELOC rates rise down the road, borrowers could face a double whammy of increased interest and higher payments when the draw period closes. For example, someone with a fully used $75,000 line of credit at 3.75% would owe $234 per month during the interest-only period. When the draw period ends, the payment at a 3.75% rate would jump to $444 for 20 years of interest-and-principal payments. If the rate increases to 5.75%, the payment spikes to $526.
If your HELOC payments are scheduled to switch to interest plus principal in the next few years, paying off as much principal as you can manage during the draw period can ease the sting. If you owe more on your mortgage and home-equity loan or line of credit than your home is worth, refinancing through the Home Affordable Refinance Program (HARP) may be an option.
If you qualify to refinance the first mortgage, lenders that hold home-equity loans or HELOCs will typically work with you, Arnold says. If you're not able to refinance your first mortgage, you may be able to negotiate to pay less than the full balance on your second loan.
Once interest rates begin to rise (the Federal Reserve expects short-term rates to remain near zero through mid 2015), you may want to transfer a variable-rate HELOC into a fixed-rate installment loan. Many HELOCs that were opened three to five years ago have a conversion option written into the terms, Arnold says. Otherwise, you'll have to requalify for the loan.
This article first appeared in Kiplinger's Personal Finance magazine. For more help with your personal finances and investments, please subscribe to the magazine. It might be the best investment you ever make.