Understanding the Line of Credit

A line of credit is an agreement between bank or vendor and a specific borrower when bank extends a specified amount of unsecured credit for a specified time period. A borrower can obtain a Personal Line of Credit (PLC) without any collateral or can use their home or other assets to secure a line of credit. Once you're approved for a PLC, creditor will usually mail you a cheque book that you can use to draw on the line of credit. A PLC is a flexible way to get extra funds for things like home renovations, vacations or even a big screen TV. You can withdraw any amount of funds up to the predetermined, approved credit limit - which is based on your personal financial situation. Once you've paid it back, you can use it again and again without re-applying.

A Personal Line of Credit could be for you if any of the following apply:

You need to borrow additional funds now or in the near future. This is very helpful for people who run their own business and may require extra cash due to changing business conditions or unexpected expenses.
You want to make purchases knowing the money is there when you need it. This is not what most financial advisors will tell you to do with your Line of credit though. Remember, any cheque you write using your line of credit is a debt and you will have to come up with money to pay it back sooner or later.
You want a payment flexibility that goes beyond a regular credit card advances. As a borrower you have extra control on your payment due date, amount you want to pay and how often you want to pay.
You need access to funds for purchases on an ongoing basis (for example, for home renovations or investments). This is one of the best feature of line of credit type of loans. Remember, you have a approved credit for a specified period and how and when you want to use that credit is totally your own decision.

Key Benefits
A unsecured line of credit can save you money with a competitive interest rate that is lower than most retail credit cards. It's variable but still lot lower than your credit cards. Also, amount of credit available is usually higher than what most credit cards can offer you. There is a transaction or cash advance fee with most credit card advances but it may be waived off with a line of credit.
Interest rates are lower than credit cards. For example, if a typical credit card has a prime rate of 22.99%, you can easily get a line of credit for about 14.99%. Now in this example, if you look closely, 14.99% is still is high interest rate, but it is still 8% lower than any retail credit card. Your interest rate could be even lower if your personal line of credit is secured by the equity in your home or other assets.
You make interest payments only on the funds you use, not your total credit limit. this is just simple mathematics. If you have a $50,000 line of credit available and you are only using $10,000, you will pay interest on $10,000 aND NOT $50,000.
You receive free personalized duplicate line of credit cheques. These cheques look just like your average checking account cheques and can be used in exactly the same manner. As a consumer, you pay no service charges for setting up a personal line of credit or writing cheques on your line of credit.

As you can see, a line of credit offers you the convenient of a one-time application with money available whenever you need it and you don't have to re-apply for credit every time. Further, you can borrow any amount up to your credit limit, at any time.

Home Equity Line of Credit(HELOC) - A home equity line of credit is a form of revolving credit in which your home serves as collateral. Because the home is likely to be a consumer's largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills and not for day-to-day expenses. Remember, you're putting your home on line anytime you apply for a home equity line of credit, so you may lose your home if you start using this credit line as regular credit cards.

With a home equity line, you will be approved for a specific amount of credit--your credit limit, the maximum amount you may borrow at any one time under the plan. Many lenders set the credit limit on a home equity line by taking a percentage (say, 75 percent) of the home's appraised value and subtracting from that the balance owed on the existing mortgage. Your income, debts and other financial obligations as well as your credit history is also going to play a very important role in your actual credit limit and whether you get approved or not. Many home equity plans set a fixed period during which you can borrow money, such as 10 years. At the end of this "draw period," you may be allowed to renew the credit line. If your plan does not allow renewals, you will not be able to borrow additional money once the period has ended. Remember, your credit history can change fairly quickly and anytime you re-apply to renew or get a new home equity line of credit, your credit report will be looked at. So any previous approval doesn't guarantee any future success. Once approved for a home equity line of credit, you will most likely be able to borrow up to your credit limit whenever you want. Typically, you will use special cheques to draw on your line. Under some plans, borrowers can use a credit card or other means to draw on the line.

What should you look for when shopping for a Creditor?

If you decide to apply for a home equity line of credit, look for the plan that best meets your particular needs. There is fierce competition in home equity loans and line of credit market. Make sure you read the credit agreement carefully, and examine the terms and conditions of various plans, including the annual percentage rate (APR) and the costs of establishing the plan. The APR for a home equity line is based on the interest rate alone and will not reflect the closing costs and other fees and charges, so you'll need to compare these costs, as well as the APRs, among lenders.

Understanding Interest rates, associated charges and everything else

Home equity lines of credit typically involve variable rather than fixed interest rates. The variable rate must be based on a publicly available index (such as the prime rate published in some major daily newspapers or a U.S. Treasury bill rate); the interest rate for borrowing under the home equity line changes, mirroring fluctuations in the value of the index. Most lenders cite the interest rate you will pay as the value of the index at a particular time plus a "margin," such as 2 percentage points. Because the cost of borrowing is tied directly to the value of the index, it is important to find out which index is used, how often the value of the index changes, and how high it has risen in the past as well as the amount of the margin. Lenders sometimes offer a temporarily discounted interest rate for home equity lines--a rate that is unusually low and may last for only an introductory period, such as 6 months. This is probably the most important thing that you must remember while considering home equity line of credit. If you're in an environment when interest rates are rising, it is not a smart idea to draw big on your HELOC. This is similar to ARM mortgage loans. Adjusted Mortgage Loans(ARM) usually have low interest rate to start with but they can quickly get out of hand if interest rates are adjusting upwards. However, any variable-rate plans secured by a dwelling must, by law, have a ceiling (or cap) on how much your interest rate may increase over the life of the plan. Some variable-rate plans limit how much your payment may increase and how low your interest rate may fall if interest rates drop. Having cap on your interest rate still doesn't help much since window if adjustment is still fairly large. For example if you have a HELOC at 7%, interest rate ceiling on this line is probably 10% which is still lot more than 7% and would cost you lot more if you carry substantial balance on this line of credit. To make things a little consumer friendly, some lenders allow you to convert from a variable interest rate to a fixed rate during the life of the plan, or to convert all or a portion of your line to a fixed-term installment loan. Plans generally permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable-rate plans may not allow you to draw additional funds during a period in which the interest rate reaches the cap.

Costs of establishing and maintaining a home equity line
Many of the costs of setting up a home equity line of credit are similar to those you pay when you buy a home. For example,

A fee for a property appraisal to estimate the value of your home
An application fee, which may not be refunded if you are turned down for credit
Up-front charges, such as one or more points (one point equals 1 percent of the credit limit)
Closing costs, including fees for attorneys, title search, and mortgage preparation and filing; property and title insurance; and taxes. In addition, you may be subject to certain fees during the plan period, such as annual membership or maintenance fees and a transaction fee every time you draw on the credit line.

You could find yourself paying hundreds of dollars to establish the plan. If you were to draw only a small amount against your credit line, those initial charges would substantially increase the cost of the funds borrowed. On the other hand, because the lender's risk is lower than for other forms of credit, as your home serves as collateral, annual percentage rates for home equity lines are generally lower than rates for other types of credit. The interest you save could offset the costs of establishing and maintaining the line. Moreover, some lenders waive some or all of the closing costs.

How will you repay your home equity plan?

Before entering into a plan, consider how you will pay back the money you borrow. Some plans set minimum payments that cover a portion of the principal (the amount you borrow) plus accrued interest. But (unlike with the typical installment loan) the portion that goes toward principal may not be enough to repay the principal by the end of the term. Other plans may allow payment of interest alone during the life of the plan, which means that you pay nothing toward the principal. If you borrow $10,000, you will owe that amount when the plan ends. Regardless of the minimum required payment, you may choose to pay more, and many lenders offer a choice of payment options. Many consumers choose to pay down the principal regularly as they do with other loans. For example, if you use your line to buy a boat, you may want to pay it off as you would a typical boat loan.

Whatever your payment arrangements during the life of the plan--whether you pay some, a little, or none of the principal amount of the loan--when the plan ends you may have to pay the entire balance owed, all at once. You must be prepared to make this "balloon payment" by refinancing it with the lender, by obtaining a loan from another lender, or by some other means. If you are unable to make the balloon payment, you could lose your home.

If your plan has a variable interest rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a plan that calls for interest-only payments. At a 10 percent interest rate, your monthly payments would be $83. If the rate rises over time to 15 percent, your monthly payments will increase to $125. Similarly, if you are making payments that cover interest plus some portion of the principal, your monthly payments may increase, unless your agreement calls for keeping payments the same throughout the plan period.

If you sell your home, you will probably be required to pay off your home equity line in full immediately. If you are likely to sell your home in the near future, consider whether it makes sense to pay the up-front costs of setting up a line of credit. Also keep in mind that renting your home may be prohibited under the terms of your agreement.

Lines of credit vs. traditional second mortgage loans

If you are thinking about a home equity line of credit, you might also want to consider a traditional second mortgage loan. A second mortgage provides you with a fixed amount of money repayable over a fixed period. In most cases the payment schedule calls for equal payments that will pay off the entire loan within the loan period. You might consider a second mortgage instead of a home equity line if, for example, you need a set amount for a specific purpose, such as an addition to your home. In deciding which type of loan best suits your needs, consider the costs under the two alternatives. Look at both the APR and other charges. Do not, however, simply compare the APRs, because the APRs on the two types of loans are figured differently:

The APR for a traditional second mortgage loan takes into account the interest rate charged plus points and other finance charges.
The APR for a home equity line of credit is based on the periodic interest rate alone. It does not include points or other charges.

To summarize the information, when you open a home equity line, the transaction puts your home at risk. If the home involved is your principal dwelling, the Truth in Lending Act gives you 3 days from the day the account was opened to cancel the credit line. This right allows you to change your mind for any reason. You simply inform the lender in writing within the 3-day period. The lender must then cancel its security interest in your home and return all fees--including any application and appraisal fees--paid to open the account. Also, if you don't see any major home improvement project coming there is no reason to keep a home equity line of credit opened. Remember, it's human nature to spend money that is available so easily but easy to overlook the downside of defaulting on a home equity line of credit. If you don't need it just don't keep it around and that could save you from lot more trouble in future

Source - Brochure "When Your Home Is on the Line." Single or multiple copies of the brochure are available without charge from The Federal Reserve Board.