Using the roof over one’s head as collateral for sizable amounts of credit has become an extremely popular and efficient way to borrow. Equity is the difference between your home’s appraised — or fair market — value and your outstanding mortgage balance. If you have equity in your home, borrowing against it might be a very effective way to get some things you need at a good price.
What We'll Cover
- Why they’re popular
- Fixed-rate loan vs. line of credit
- What you can do with the money
- Here are some ways to use equity loans:
- The cost of a loan
- Beware of the ‘balloon’ payment
- Fees and other costs
- What lenders look for
- How is LTV calculated for a home equity loan?
- Risks of high-LTV loans
- The good and bad aspects
- Refinancing a home equity loan
- Watch out for scams
- How to cancel the deal
- 12 tips for wise use of equity
- The Truth-in-Lending Act
This guide will help you understand the ins and outs of home equity borrowing, the opportunities and the consequences.
Why they’re popular
The practice of borrowing against the value of a home has skyrocketed in popularity.
There are two key reasons for this surge: low interest rates and tax deductibility.
When tax changes in 1986 eliminated deductions for most consumer purchases, home equity loans became a way to buy goods and still get a deduction.
Let’s say you bought your home for $95,000 and made a 20 percent down payment of $19,000. You then took a first mortgage to pay the remaining $76,000. On the day you closed on your home, you automatically had 20 percent equity. You gain equity as you pay off the principal and your home grows in value.
Let’s say you’ve paid $12,000 toward the principal and your property — valued at $95,000 when you bought it — is now worth $115,000. Your beginning equity ($19,000), plus the principal you have paid ($12,000) and the increase in your property value ($20,000) gives you $51,000 in equity.
Banks and borrowers love it
Equity is a valuable asset because you can put it to use without having to sell your home. And because most people’s domicile is their biggest asset, lenders regard home equity loans as secure. For that reason, interest rates are lower than for other loans.
The average rates for a home equity line of credit or for a term equity loan are available from Bankrate.com’s current survey of 4,000 banks around the country.
Home equity products usually have a higher interest rate than first mortgages. (Bankrate.com’s mortgage rate survey will show you those differences.) But compare home equity loan costs to your credit card or department store charge cards. Check out Bankrate.com’s current credit card rate survey, then figure in a tax deduction on your home equity loan, in most cases for up to $100,000 of borrowed money, and you’ve got yourself a deal.
The scary part is that if you default on the loan, the lender could foreclose on your home. That’s why these loans are statistically most suited to stable, middle-aged borrowers. The average home equity customer is 35 to 49 years old with a household income of $83,998, according to the Consumer Bankers Association. Fifty- to 64-year-olds are the second biggest borrowers of home equity.
Most have held the same job and owned their home for about eight years. About 2 percent default on their loans.
“Home equity customers tend to be very good at paying back their loans,” says Bill Hampel, chief economist for the Credit Union National Association in Washington, D.C.
Fixed-rate loan vs. line of credit
There are two types of home equity loans: term, or closed-end loans, and lines of credit.
Both are sometimes referred to as second mortgages, because they’re secured by your property, just like your original (first) mortgage.
Home equity loans and lines of credit are usually for a shorter term than first mortgages. The most common type of mortgages runs 30 years, while equity loans typically have a life of five to 15 years.
A home equity loan, sometimes called a term loan, is a one-time lump sum that is paid off over a set amount of time, with a fixed interest rate and the same payments each month. Once you get the money, you cannot borrow further from the loan. To see current home equity loan rates.
A home equity line of credit (HELOC) works more like a credit card. You are allowed to borrow up to a certain amount for the life of the loan — a time limit set by the lender. During that time you can withdraw money as you need it. As you pay off the principal, your credit revolves and you can use it again. Let’s say you have a $10,000 line of credit. You borrow $5,000, but then pay back $3,000 toward the principal. You now have $8,000 in available credit. This gives you more flexibility than a fixed-rate home equity loan.
Credit lines have a variable interest rate that fluctuates over the life of the loan. Payments will vary depending on the interest rate and how much credit you have used. When the life span of a line of credit has expired everything must be paid off. A lender may or may not allow a renewal. To see current home equity line of credit rates.
Lines of credit are accessed by specially issued checks or a credit card. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it and keep a minimum amount outstanding.
Financial institutions negotiate a home equity loan just like they do a mortgage: You have to pay off the loan or line of credit when you sell the house.
Which type should you choose?
The answer to this question is seldom black and white.
But there are some scenarios where the choice is obvious. For example, let’s say you need $7,000 to pay for your daughter’s wedding next month and $3,000 to fix your roof, which will take a week. You know exactly how much you need and both amounts are due in full fairly quickly. If you don’t have plans to borrow again, a straight home equity loan for $10,000 is more suited to your purpose.
But if you need money over a staggered period of time — for example, at the beginning of each semester for the next four years to pay for Jimmy’s schooling or for a remodeling project that will take three years to finish — a line of credit is the better choice. It gives you the flexibility to borrow only the amount you need, when you need it.
And if you borrow relatively small amounts and pay back the principal quickly, a line of credit can cost less than a home equity loan.
Consumers who have run up credit card debt will often borrow a lump sum and pay off their Visa, MasterCard and department store charges, then pay back the bank over time at a lower interest rate than the cards would have imposed. This sort of debt consolidation is the single most-popular reason people have for taking out home equity loans, and fixed-rate home equity loans are used slightly more often for this purpose lines of credit.
To help you determine which loan best suits your needs, ask yourself:
- When do I need the money?
- For how long do I need the money? Is it for a short-term purpose, or a long-term?
- How long do I need to pay it off?
- How big a monthly payment can I handle?
- Would a line of credit tempt me to use the money carelessly because it works similar to having a charge card or checking account?
Ask your lender:
- How long is the term of the closed-end loan?
- What is the life span of a line of credit?
- How large a line of credit do I qualify for?
- Is my line of credit renewable when the life of the loan expires?
- What are the interest rates?
- Do I have to use my credit line right away? (If you’re opening a credit line for future or emergency needs, you’ll want one that doesn’t require a minimum draw at closing.)
- Under what circumstances can you freeze, reduce or demand full payment of my loan?
- Can I lease my house during the time of the loan?
- Will you loan to me if my house is on the market (and at what rate)?
- If interest rates go down, how low will my loan go?
What you can do with the money
The majority of borrowers use a home equity loan for debt consolidation, like creating one payment to take care of all that credit card debt. The loans are also used for a wide variety of other purposes, such as home improvements, medical expenses, education, emergencies and big-ticket purchases.
Here are some ways to use equity loans:
Debt consolidation: Many people have racked up so much credit card debt they have turned to home equity to ease the burden. Doing this can significantly reduce your monthly interest charges, allowing you to save or invest that much more. If you’re paying a 17 percent annual percentage rate on a $10,000 Visa balance, for example, you can save a bundle over time by paying it off with a tax-deductible home equity loan at around 8, 9 or even 10 percent. Making monthly debt payments more manageable this way can come with a bonus — it can improve your credit rating. (Use this calculator to figure out the real cost of your debt.)
Tip and pitfall — Before you secure a loan, consider how you are going to prevent yourself from building up that credit card debt again. Cut up all but one or two cards, quit carrying them with you and start using cash more often.
Home improvements: Making upgrades and repairs to a house has aesthetic benefits by making your home safer or more comfortable to live in. It can also increase the fair market value of your house. That’s why many homeowners make home-equity financed improvements with an eye toward selling their property.
Tip and pitfall — Be sure the work is going to be worth what you’re putting into it. Kitchen and bathroom improvements raise value the most. But if you spend $10,000 to put in a patio, a prospective borrower may not consider it worth the higher price tag you put on your home.
If you’re making a small improvement before selling, make sure another option such as a credit card or a personal loan wouldn’t be a better way to pay for it.
Also, be aware that some lenders will not give you an equity loan if they know your home is on the market, and if they do, they might charge a fee. And remember that if you’ve used a home equity loan, when your house sells you have two loans to pay off.
Education: A loan used for college or technical school can pay for itself several times over if it lands the borrower a better job. More families are also turning to home equity to pay for their children’s education because the cost has skyrocketed, they haven’t saved enough for it and their incomes are too high to qualify for grants or government-backed loans.
Tip and pitfall — College often comes at a time when parents are close to retirement and using their equity could deplete income for later years. Those who qualify for government-backed loans might want to choose that option instead. Or, if the student can make do with a smaller infusion of cash, parents might consider a small, discounted personal loan in their name and their child’s. These loans can be structured so borrowers pay only the interest while their children are in school.
Medical expenses, emergencies, big-ticket purchases: An equity loan can be a godsend if you are hit with thousands of dollars in medical bills or you lose your job. Tax advantages and lower interest rates also make equity loans a smart way to finance a new car, motorcycle or some other high-price purchase.
The cost of a loan
Interest is the most expensive cost in a loan. Rates on home equity loans are either fixed or variable. Fixed rates stay the same over the life of the loan while variable rates move up and down. Bankrate.com’s latest survey of 4,000 banks shows the average rate on home equity loans.
Competition among lenders has many of them offering low introductory “teaser” rates, one or two points below prime, that are good for about six months. After that, the rate is adjusted according to a public index that reflects interest trends. The lender uses that index to decide how much the annual percentage rate will change during the life of the loan. Banks must use a public index rather than an internal one that could be arbitrary.
Most banks use The Wall Street Journal prime rate or the prevailing rates on Treasury notes as the basis for their home equity loan interest rate calculations. The all-important Journal number is derived from the base rate on corporate loans posted by at least 75 percent of the 30 largest U.S. banks.
The lender adds a margin, or fixed number of percentage points, to the index to determine the new rate each time it is adjusted. This can happen once a year or more. Each point is equal to 1 percent of the loan, so if you’re borrowing $10,000 one point would be $100.
By law, variable-rate loans must have a cap on how high the interest can climb over the life of the loan. Most variable-rate lines of credit also have a cap that limits how much, and how often, the interest rate can change during the course of a year. This cap typically prevents the rate from jumping more than two percentage points in a year.
Some plans also limit how low your interest can fall if rates drop.
The best news is that the interest on home equity loans is usually tax-deductible for up to $100,000 on your home’s principal mortgage balance.
Of course, the sooner you pay off the loan, the less it will cost you in interest.
- Shop around for a lender that offers “prime for life.” In any case, you shouldn’t pay more than two points above prime. Once you get a rate, go to Bankrate.com’s survey of home equity rates and compare.
- Check rates at your credit union or community bank.
- Ask the lender:
- How much can a variable interest rate go up at one time?
- What is the cap on a variable rate?
- What is the maximum monthly payment? The minimum?
- How often can you change the rate?
- What index do you use and how high has it risen in the past?
- Is the loan amortized, or is there a balloon payment? If not fully amortized, how much is the balloon and when is it due? (If there is a balloon, you don’t want to be surprised when the end of the loan rolls around and there is a lump sum payment due you hadn’t been aware of.)
- Chart out how high your payments would be at different rates by going to bankrate.com’s mortgage calculator or ask your banker to do it for you. Your lender is required to tell you how a variable rate is figured.
- Want a home equity loan? Understand that you cannot compare the annual percentage rate — the cost of the loan each year, expressed as a percentage — of a home equity loan against a home equity line of credit. They are calculated differently. The APR for a fixed-term equity loan takes into account the interest rate plus points and other finance charges. For a line of credit, the APR is based on the periodic interest rate and does not include points and other costs.
- Electronic payments sometimes get you a fractional break on interest rates. You usually need to have your loan from the same bank you have a checking or savings account to do this.
- Before you sign, consult a tax adviser about deductions on your loan because there are exceptions to deductibility.
Beware of the ‘balloon’ payment
On a traditional mortgage loan, borrowers pay only interest for several years. Then, as they still pay off interest, more of their monthly payment goes toward chipping away at the principal. At the end of the term, they owe nothing.
But loans that are not fully amortized — where the principal is NOT paid off over the life of the loan — are set up for a “balloon” payment. This is when the borrower has been paying only the interest, or some combination of interest and principal, and when the loan term expires the balance is due in full.
The balloon payment is more common to second mortgages. If you borrow $20,000, for example, and your monthly payments for 10 years have included only interest, you must fork over the $20,000 in principal at the end of the term.
Borrowers sometimes do this to make their monthly payments more manageable. But after coasting along with easy payments, a balloon payment can be an ugly ending. You don’t know how interest rate cycles are going to change several years down the road, and you can’t look into the future and know the exact worth of your home. And if you can’t pay your balloon off at once, you could lose your home.
Some borrowers refinance the loan, obtain another loan or sell their house to pay the balloon.
The bottom line: Steer clear of balloon payments. If you can’t, make sure, make very sure, you can sell your house or come up with the dough some other way.
Fees and other costs
Many of the costs that come with a line of credit or term home equity loan are similar to the ones you pay when you buy a home. They can include:
- Closing costs, which may include attorney fees, a title search to verify your ownership of the home, mortgage preparation and filing, and insurance fees. Estimate 2 percent to 5 percent of the loan for closing costs.
- A fee for a property appraisal, which estimates the fair market value of your home. This is sometimes part of your closing cost.
- An application fee that covers the cost of processing the loan. This is not always refundable if you are denied credit.
- Points, which are service fees figured on the total amount of the loan or credit line and usually paid at closing. One point equals 1 percent of the loan. For a $30,000 loan or line of credit, one point would equal $300.
- Annual maintenance fees that can go as high as $100.
- Transaction fees each time you make a withdrawal from your credit line
- Cancellation fee. If you pay off the loan early, you may be required to pay this fee.
- Inactivity fee. Borrowers who don’t use their line of credit during a given period of time might be charged.
By the way …
- Want a home equity loan? Banks sometimes waive closing costs and other fees. Be sure to ask.
- Don’t go with a lender just because they will waive closing costs. Take into account the entire cost of the loan. Shop around for the best annual percentage rate.
- If your home has been appraised within the last six months, it may not be necessary to have another one as part of your loan procedure. Be sure to ask.
What lenders look for
Lending institutions consider several criteria when someone applies for a home equity loan. These criteria give the lender an idea of the big picture concerning your financial health and personality.
The rules are not always hard and fast. For example, applicant Joe Doe is shelling out half his income for bills, but when it comes to paying on time, he’s got a stellar past. Mr. Doe could still be a “go” for a home equity lender because one factor balances out another.
To prepare yourself for scrutiny, here’s a rundown of what a lender looks at in prospective home equity borrowers.
Credit history: Reports obtained through the major credit reporting agencies tell a lender a lot about your borrowing habits and how well you manage your money. These reports tell how much you owe, when you pay, and whether you’ve had any bankruptcies or judgments. Bad credit — such as late payments, repossessions and delinquent accounts — remains in your credit history for seven years. Bankruptcy remains on your record for 10 years.
The story of your credit determines your credit grade; it’s just like being back in school. If you get an A, the lender will quote you its best rate and terms. An A-minus might cost a little more in rate and fees. A grade of B is pricier still, and C costs even more. You don’t want to make a D.
If your credit grade is C or D, you may still qualify for a loan if you have factors that would balance out another credit blemish. But expect a “sub-prime” or “non-conforming” loan at a higher interest rate than the one your squeaky clean A-grade neighbor obtained.
You should examine your credit report and learn your credit score before you apply for a loan.
Source of income: Lenders know that an interruption of income due to loss of job or illness can cause a borrower to default on a loan. Hence, they look at several things in relation to earnings:
- Salary or wages from a job: Lenders want to know how much you make and how long you’ve been at your job, as well as how long you have been working in your particular field.
- Self-employment income: Your net earnings — gross income minus business expenses — and how many years the business has been providing this income.
- Unearned income: The annual amount and sources are important. Secure pensions, high-rated bonds and other stable sources are preferred.
Debt-to-income ratio: How much of your monthly income goes toward paying off your mortgage, credit card bills, car payment and other obligations — including the payments you would have to make on the loan for which you are applying — determines your debt-to-income ratio.
Of course, the lower the debt the better. Most people are expected to have a debt-to-income ratio of somewhere between 25 percent and 50 percent. When you hit 45 percent or more, you’re living on the edge and a lender is going to look twice. But if there are other factors in your favor, such as high income, it’s a judgment call on the part of the borrower.
Loan-to-value (LTV) ratio: In short, this is the ratio between what you owe on your house and what it’s worth.
In general, the better your credit, the higher an LTV ratio lenders will allow you to carry
To calculate an LTV ratio, let’s say you agree to buy a home with a fair market value of $100,000. You put down $20,000 — or 20 percent — of the price as down payment. You borrow the rest — $80,000 — to complete the purchase. That means your mortgage LTV ratio is 80 percent, because your loan amount is 80 percent of the value of the home.
How is LTV calculated for a home equity loan?
Let’s say your house now has a fair market value of $150,000, and your first mortgage has a principal balance of $50,000. Your equity is $100,000. If you want to borrow $40,000 against that equity, combine that with what you owe ($50,000), and it leaves you with a total debt of $90,000.
In this case, your combined debts of $90,000 are compared with your home’s value of $150,000, for a total LTV ratio of 60 percent.
Traditionally, LTV caps are 80 percent, but there are lenders who will give out loans of 125 percent loan-to-value — which means they are letting you borrow more than your house is worth.
What you plan to do with the loan: Although prospective borrowers are not required to disclose why they want an equity loan, lenders will usually ask — and it is one of the factors they consider because it can help determine your ability to repay.
For example, if you plan to use the money to consolidate revolving credit debt, bankers see that as a positive.
“Different lenders have different factors,” says Steve O’Connor, senior director of residential finance for the Mortgage Bankers Association of America. “If they see you are using it to improve your risk profile they know that they are more likely to get repaid.”
Documentation: Be prepared to show your lender proofs of income, such as W-2s, tax returns and other earnings statements. Borrowers who can’t provide all the necessary documents to back up the numbers the lender is looking for may be denied credit or charged a higher interest rate.
Tip: Be sure you give accurate answers about your income, assets, debts and other information. Penalties can be tough for borrowers who give false information to obtain credit.
Risks of high-LTV loans
High loan-to-value products raise a borrower’s debt level above the value of their home — to as much as 125 percent.
For example, if you have a house worth $100,000, a first mortgage of $90,000, and a home equity loan of $35,000, you’re in debt $25,000 more than your house is worth.
“Home equity” is actually a misnomer for such loans. “Once you surpass your equity worth, you’re talking about unsecured debt,” says Steve O’Connor of the Mortgage Bankers Association.
Imagine selling your home and having to pay off the mortgage, plus come up with $25,000 at closing to pay off the home equity loan. Also consider that the interest on the amount that exceeds your home’s value is not tax-deductible.
The risk of such loans is not the only thing that is high. The interest rates are typically lower than most credit cards but much higher than the average for a regular home equity loan.
Despite its many drawbacks, the product can benefit folks who want to consolidate high-interest debt and plan to stay in one place a long time. One ironic thing in the consumer’s favor: since the amount that exceeds the home’s value is unsecured, a lender cannot take assets to recoup that money.
The good and bad aspects
Good aspects of home equity loans
- In most cases, borrowers can deduct the interest on loans up to $100,000 on their taxes.
- For banks, it is the least risky type of loan because it is secured by the borrower’s home.
- It carries a much lower interest rate than credit cards and unsecured personal loans.
- It can be used for a wide range of things — from paying for debts, home improvements, tuition, medical costs, cars, boats or a vacation.
- It can provide ready access to money in emergencies.
- Home equity loans stimulate the economy because consumers recirculate the money back into the market.
- If used wisely, the loan can brighten your overall financial status and improve your credit rating.
- Obtaining a home equity loan takes about two weeks at the most, half as long as qualifying for the first one.
The bad aspects of home equity loans
- If you default, you could lose your home, your biggest asset.
- Want a home equity loan? Such loans can be a risky spending tool for younger homeowners who are not established in their careers and have less experience owning a home and managing money; and for older lenders who would be tapping their nest egg close to retirement.
- Unlike fixed-rate home equity payments, monthly payments on variable-rate equity loans can go up substantially during high inflation — but your income may stay the same.
- High loan-to-value home equity loans may not be totally tax-deductible.
- The value of your home can fall over time, thereby lowering your equity.
- Buried deep in federal regulations are provisions that allow lenders to reduce or freeze a borrower’s credit line, or call for full payment of the loan, under certain circumstances.
- Using an equity loan to pay off debt may make monthly payments cheaper but could cost you more in the long haul.
- You may not be able to lease your home during the term of your loan.
Refinancing a home equity loan
A lower interest rate and monthly payment on your home equity loan can free up cash for other uses, or make your debt more manageable. Interest rates move in cycles, so the best time to refinance is when rates drop.
“Refinancing tends to happen in surges — in fits and starts,” says Bill Hampel, chief economist for the Credit Union National Association in Washington, D.C. “Typically, rates should fall a point or more before you do it.”
Refinancing entails closing costs and other fees, so it’s important to know whether lower monthly payments will offset that cost. (Use this calculator to figure out the payments on a loan.)
“The smaller the drop in interest, the longer it’s going to take you to recover the cost of refinancing,” says Hampel.
Another factor to consider is how long it will take you to break even. For example, if refinancing costs run you $2,500 and your payments are $100 lower each month, it will take you 25 months to break even.
If you plan to sell your home in a year, refinancing is not the smart thing to do.
“If you plan to be there a long time, then it makes sense,” says Steve O’Connor, vice president of governmental affairs for the Mortgage Bankers Association of America.
Besides a lower interest rate, two other reasons to refinance are:
- The opportunity to convert all or a portion of your equity loan from an adjustable rate to a fixed-rate installment loan
- To obtain a shorter-term loan to build new equity more quickly.
When they refinance at a lower rate, some homeowners take the cash from the equity they’ve acquired to pay for a big expense such as a remodeling project or their kids’ college tuition.
Refinancing is also a way to avoid a balloon payment. If you combine your first mortgage and home equity loan or credit line, you can get one fixed-term payment and avoid paying a giant lump sum.
Be aware, though, that refinancing can be a bad deal for those who are taking out equity to pay off credit card debt. If you transfer $15,000 in credit cards to a new 30-year first mortgage, your monthly payments will be lower but it’s costing you more to pay off the revolving credit debt because of the lengthy term of the loan.
If you can swing it, you’re better off taking 10 years to pay off the charge cards because it will save you 20 years’ worth of additional interest.
You can refer to Bankrate.com’s calculator page to do the math.
Another downside of refinancing your equity loan is the possibility of dealing with a new lender, perhaps one in another state, who handles the loan differently. There may be new fees for copies of documents and other services. And rather than being able to visit your local banker, you could end up having to deal with questions and problems by phone, fax or e-mail.
Watch out for scams
If you’re a homeowner, you probably receive lender solicitations over the phone, by mail or via door-to-door sales. There are also countless print and TV ads encouraging you to tap into the equity in your home.
These offers can be tempting if you’re hard up for cash or longing to fulfill a dream of taking an around-the-world cruise on the QEII.
Some lenders target elderly homeowners or those with low income or credit problems, then take advantage of them with deceptive practices, including disguising the fact that they are using their home as collateral for a loan.
Here are some of the most common ways dishonest lenders scam homeowners:
Equity stripping: A lender says you can get a home equity loan even though you know your monthly income isn’t enough to keep up with the payments. The lender encourages you to pad your income on the application so the loan will be approved. They don’t care that you can’t afford the loan because they’ve got their eyes on your equity. If you default on the payments, they foreclose, taking your home and stripping you of the equity that’s taken years to build.
Loan flipping: This is where a lender encourages you to repeatedly refinance your loan and borrow more money. Let’s say you’ve got a nice, comfortable low-interest loan you’ve been paying for years building equity. Using the temptation of extra cash, the lender talks you into refinancing the loan.
After you’ve made a few payments, the lender comes calling again — offering an even bigger loan. You accept, and the lender refinances the original loan and sends you more money. But in refinancing, the lender has charged high points and fees and your interest rate has gone up. You have some extra money, but you also have a lot more debt stretched out over a longer period of time. The cash you received may be less than the costs incurred by refinancing. With each “flip” of the loan, you’ve increased your debt. If you get in over your head, you could lose your home.
Credit insurance packing: You’ve just agreed to a line of credit home equity loan on terms that seem affordable. At closing, the lender gives you papers to sign that include charges for credit insurance or other “benefits” that you didn’t ask for and don’t want. The lender hopes you don’t notice and doesn’t explain how much this will add to the cost of your loan, or they tell you the insurance comes with the loan, making you think there’s no extra cost.
If you do notice and object, the lender may use scare tactics, telling you that if you don’t want the insurance the loan will have to be rewritten, resulting in a delay and even reconsideration of your application. If you agree to buy the insurance, you end up paying extra for a product you do not want or need.
Deceptive loan servicing: The lender fails to provide you with accurate or complete account statements and payoff figures, making it almost impossible to determine how much you have paid and still owe. Or, after you get your loan, the lender starts sending you letters saying your payments are going to be higher than expected. They may tack on taxes and insurance you had already arranged to pay yourself; late fees even though your payments are on time; or legal fees you don’t understand.
Amid the confusion, you are paying more than you owe.
The home improvement loan: A contractor knocks on your door and offers to put on a new roof or remodel your two bathrooms. The contractor tells you they can arrange financing through a lender. You agree and the contractor starts work. Later, the contractor gives you papers and tells you the job will be halted unless you sign them. Unbeknownst to you, you have agreed to a home equity loan, with high points, fees and interest. To make it worse, you’re not happy with the work being done and the contractor, now that he has your signature, is not showing up for work every day.
Signing over your deed: You are having trouble paying your mortgage and the lender has threatened to foreclose. A “lender” contacts you with an offer to help you find new financing. In the meantime, the lender wants you to deed your property to him, saying it’s temporary to prevent foreclosure.
Once the lender has the deed to your property, they treat it as their own — borrowing against the equity or selling it. You’ve become the tenant, with the lender demanding “rent.” If the rent is late, the lender may try to evict you.
Protecting yourself against sharks
- Agree to a home equity loan if you can’t afford the monthly payments.
- Fold under pressure to sign documents.
- Sign documents you haven’t read or that have blank spaces to be filled in after you have signed.
- Agree to a loan that has extra products you don’t want to buy, such as credit insurance, or that includes terms that weren’t there when you applied.
- Allow the promise of extra cash or lower monthly payments to cloud your judgment about whether the cost is worth it.
- Deed your property to anyone. Instead, talk with an attorney or someone else you trust.
- Demand an explanation of any cost, term or condition you don’t understand. Federal law is very clear about what information must be provided in writing when you apply for a loan and before you sign any agreement.
- Shop around if you want credit insurance. Buying it from a lender may not be a good deal.
- Keep meticulous records of what you have paid, billing statements and canceled checks.
- Challenge charges you think are inaccurate.
- Check contractors’ references before having work done on your home, and get more than one estimate.
- Keep a copy of everything thing you sign.
- Be sure you are dealing with a reputable lender. You may want to check with your local Better Business Bureau, state licensing authority, chamber of commerce or a consumer protection agency.
How to cancel the deal
Maybe you found better credit terms or you got cold feet. A provision of the Truth in Lending Act gives you the right to cancel certain real estate loans within three business days without penalty.
You can rescind the transaction for any reason. In the case of home equity loans you can rescind only if you are using your principal residence — not a vacation or second home — as collateral.
During those three days the creditor should not take any action on the loan, such as giving you money. If you are dealing with a home improvement loan, the contractor should not deliver any materials or start work.
If you do exercise your right of rescission, you must do so in writing. Make sure your notice is delivered before midnight of the third business day.
For rescission purposes, business days include Saturdays but not Sundays or legal public holidays.
12 tips for wise use of equity
Before taking a home equity loan, look over these guidelines.
1. Make your mortgage payments a priority. It’s your home that’s on the line.
2. Don’t go with a high loan-to-value product. Lenders who let you borrow more than your house is worth may not be doing you a favor.
3. If you like plastic too much, forgo using a credit card to access a line of credit and get checks instead. Paper is a little harder to let go of.
4. Don’t tempt yourself by carrying your home equity credit card or checks with you all the time.
5. Keep some equity freed up for emergencies.
6. Maintain good credit. Banks monitor your payment habits and if they see a change for the worse, they could reduce or freeze your credit.
7. Read the fine print in your loan agreement.
8. If a lender is unfamiliar to you, check with government agencies to see if there have been any complaints.
9. Before you do anything, ask yourself whether you can afford more debt and, if so, how much.
10. If you’re out of a job, you could soon be out of a house too if you can’t make the loan payments. Investigate other resources — disability, unemployment, savings, borrowing against a 401(k), stocks, insurance policy or retirement plan — before you decide to take that risk.
11. If you are going to use the money to make a large purchase, make sure it’s something that’s going to outlast the life of the loan. Don’t put your house on the line for a vacation or new clothes.
12. Don’t use home equity loans for day-to-day expenses. Those should be paid entirely out of your current income.
Equal credit opportunity
The Equal Credit Opportunity Act (ECOA) says that lenders can’t discriminate.
This federal legislation ensures that all consumers are given an equal opportunity to obtain credit. The law says that a creditor may not discriminate against you because of your sex, age, marital status, race, color, national origin, receipt of public assistance or because you may have exercised your rights under consumer protection laws.
Lenders cannot, by law, say or write anything, in advertising or other documents, that would discourage a responsible person from applying for credit.
What creditors CANNOT do:
- Ask for the sex, race, color, religion or national origin of an applicant. They can, however, ask about your permanent residency or immigration status.
- Ask about your plans for raising or having children. The creditor can, however, ask about the number of dependents and dependent-related financial obligations.
- Ask whether you receive alimony, child support or separate maintenance payments UNLESS you will rely on that income to pay back credit. But the lender must first explain that the income from these sources need not be revealed unless the applicant wishes to rely on it to establish credit-worthiness.
- Discount or refuse to consider income because it comes from part-time work, pension, annuity or retirement benefits.
- Discount income because of your sex or marital status. For example a creditor cannot count a man’s salary at 100 percent and a woman’s at 75 percent.
- A lender may not assume that a woman will stop working to raise children.
What creditors CAN do:
- Want a home equity loan? Ask about your marital status if you are applying for a joint account or one secured by property, or if you live in a community property state.
- Request information about a spouse if any of the following apply: you live in a community property state; the spouse is a co-applicant; the spouse will share use of the account; you rely on your spouse’s income; you rely on child support or alimony from a former spouse.
- Ask whether you pay alimony, child support or separate maintenance payments.
- Ask the names under which you have previously received credit.
- Ask an applicant to list any account upon which the applicant is liable and ask him provide the name and address of that account.
The Truth-in-Lending Act
You need to be able to compare the cost of borrowing to paying cash, and compare the costs of borrowing from different lenders. To ensure consumers can do that, the federal government mandates that lenders disclose certain costs and terms.
You usually get these TILA disclosures when you receive an application for a loan, and you will get additional disclosures before the plan is open.
What lenders are required to tell you:
The Truth-in-Lending Act requires lenders to disclose the terms and costs of all loan plans, including the annual percentage rate, points and fees; the total of the principal amount being financed; payment due date and terms, including any balloon payment where applicable and late payment fees; features of variable-rate loans, including the highest rate the lender would charge, how it is calculated and the resulting monthly payment; total finance charges; whether the loan is assumable; application fee; annual or one-time service fees; pre-payment penalties; and, where applicable, confirm for you the address of the property securing the loan.
In general, neither the lender nor anyone else may charge a fee until you have received this information.
Lenders who advertise must meet Truth in Lending Act disclosure requirements with respect to the loan rate and terms. These include:
- Specific credit terms in the ad must be made available to applicants.
- If an advertisement includes a rate, it must state the rate as an annual percentage rate (APR) using that term. This rate takes into account additional costs incurred, such as fees and points, in the first year of the loan.
- If the annual percentage rate may be increased after the loan is closed the advertisement must state that fact.
- The only other rate allowed in the ad is a simple annual rate or periodic rate that is applied to an unpaid balance. It may be stated in conjunction with, but not more conspicuously than, the annual percentage rate.
Where TILA applies
In general, this regulation applies to each individual or business that offers or extends credit when the credit is offered or extended to consumers; the credit is subject to a finance charge or is payable by a written agreement in more than four installments; the credit is primarily for personal, family or household purposes, if the loan balance equals or exceeds $25,000 or is secured by an interest in real property or a dwelling.
TILA also provides consumers with substantive rights in connection with certain types of credit transactions. Those include the right to cancel certain real estate lending transactions within three days (right of rescission), regulation of certain credit card practices and a means for fair and timely resolution
The Truth in Lending Act is something that can help you every time you apply for credit, no matter what sort.