Home Equity
Tapping home equity is cheap, but qualifying for a loan is tough
If you're looking to make home improvements, pay for your kid's college or pay down credit card debt, a home equity line of credit is a cheap way to borrow money -- if you can qualify.
The average home equity line of credit, or HELOC, costs about 5.4% right now, according to our survey of major lenders.
That's about as low as we saw all last year and far less than you'll find with most other consumer loans.
In some areas of the country, lenders are offering HELOC rates of 5% or less to homeowners with excellent credit.
These variable-rate loans allow homeowners to borrow against the equity in their homes on an as-needed basis.
You pay interest only on what you borrow, and the interest is tax deductible for all but those homeowners subject to the alternative minimum tax.
HELOC rates are based on the prime rate -- the floating interest rate banks charge their best commercial customers -- plus a margin.
Prime has held at a six-decade low of 3.25% since 2008, and it doesn't look like it's going to increase anytime soon.
That's because the Federal Reserve has said it will keep short-term interest rates at record lows at least through mid-2013 in an effort to stimulate the economy.
This means lines of credit should remain a cheap borrowing option for some time.
But remember, these are variable-rate loans, so when interest rates increase, the cost of your loan will increase, as well.
Most banks cap the cost of such loans at 18% -- although we are a very long way from having to worry about something like that.
Although lines of credit are incredibly cheap, they are also difficult to get.
With home values declining throughout much of the country, many homeowners can't qualify because they don't have enough equity.
We've lost about half of the equity we had in our homes in 2006, according to the Federal Reserve, and about one in five homeowners with a mortgage owe more on their property than it is currently worth.
Even if you have some equity in your home, you might not have enough to qualify.
Lenders require borrowers maintain 15% to 20% of their equity after taking the HELOC into account.
To figure out what size HELOC you can get, subtract the balance you owe on your mortgage from what your home is currently worth. Your equity is the difference between what your home is worth and how much you owe.
If, for example, your home is worth $200,000, and you owe $140,000 on your first mortgage, you’d have 30% equity, or $60,000.
If the borrower required you to retain 20% of that equity, or $40,000, your HELOC would allow you to borrow a maximum of $20,000.
Many lenders won’t extend a HELOC for less than $10,000.
A line of credit could be the cheapest option to begin paying down debt -- particularly if you're swapping interest of 15% or more charged by credit cards for a 5% HELOC.
But this loan is secured by your home, so if you default on your payments, you could lose your residence.
People who lack the discipline to repay more than the minimum (which may be interest-only) should avoid HELOCs because increased monthly payments brought on by more borrowing, higher interest rates or a balloon payment later on could make the HELOC impossible to repay.
HELOCs also won’t help you save money on debt consolidation if paying off your credit card balances means you’ll start acquiring new debt on those cards.
The required monthly payments on a HELOC vary by lender.
Our line of credit calculator can help you do the math and determine how long it might take to pay off your credit line.
A traditional home equity loan is another borrowing option.
It differs from a home equity line of credit in that it requires you to borrow a lump sum all at once. It's also a fixed-rate loan that requires you make the same payment each month until the debt is retired, much like a mortgage.
Once you pay it back, you’ll have to apply for a new loan or line if you want to borrow again.
In today’s market, the interest rate is also more that a point higher. The average home equity loans cost about 6.6%, according to our survey.
A home equity loan could be a better option if you want to borrow a specific amount for a one-time project and you want the security of knowing what your interest rate will be for as long as you have the loan.
But for most homeowners seeking to borrow from their equity, a HELOC will remain a better deal as long as interest rates remain low.
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