The Federal Reserve Board

What you should know about

Home Equity Lines

of Credit

Board of Governors of the Federal Reserve System

www.federalreserve.gov
0312
 What You Should Know about Home Equity Lines of Credit |i

Table of contents
Home Equity Plan Checklist ............................................................ 2

What is a home equity line of credit? ........................................ 3

What should you look for when shopping for a plan? ................... 4
Costs of establishing and maintaining a home equity line ............ 5
How will you repay your home equity plan? .................................. 6
Lines of credit vs. traditional second mortgage loans .................... 8
What if the lender freezes or reduces your line of credit? ............. 10

Glossary ..................................................................................................... A1

Where to go for help ............................................................................ A4

More resources ...................................................................................... A7

ii|What You Should Know about Home Equity Lines of Credit
 What You Should Know about Home Equity Lines of Credit |1

If you are in the

market for credit, a
home equity plan
is one of several
options that might be
right for you. Before making a decision, how-
ever, you should weigh carefully the costs of a
home equity line against the benefits. Shop for
the credit terms that best meet your borrowing
needs without posing undue financial risks.
And remember, failure to repay the amounts
youve borrowed, plus interest, could mean the
loss of your home.
2|What You Should Know about Home Equity Lines of Credit

Home Equity Plan Checklist

Ask your lender to help fill out this checklist.

Basic Features Plan A Plan B

Fixed annual percentage rate % %

Variable annual percentage rate % %

Index used and current value % %

Amount of margin

Frequency of rate adjustments

Amount/length of discount (if any)

Interest-rate cap and floor

Length of plan
Draw period

Repayment period

Initial fees
Appraisal fee

Application fee

Up-front charges, including points

Closing costs

Repayment Terms
During the draw period
Interest and principal payments

Interest-only payments

Fully amortizing payments

When the draw period ends

Balloon payment?

Renewal available?

Refinancing of balance by lender?

 What You Should Know about Home Equity Lines of Credit |3

What is a home equity line of

credit?
A home equity line of credit is a form of revolving credit in
which your home serves as collateral. Because a home often is a
consumers most valuable asset, many homeowners use home
equity credit lines only for major items, such as education, home
improvements, or medical bills, and choose not to use them for
day-to-day expenses.

With a home equity line, you will be approved for a specific

amount of credit. Many lenders set the credit limit on a home
equity line by taking a percentage (say, 75%) of the homes
appraised value and subtracting from that the balance owed on
the existing mortgage. For example:

Appraised value of home $100,000

Percentage x 75%
Percentage of appraised value = $ 75,000
Less balance owed on mortgage $ 40,000
Potential line of credit $ 35,000

In determining your actual credit limit, the lender will also

consider your ability to repay the loan (principal and interest) by
looking at your income, debts, and other financial obligations as
well as your credit history.

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
4|What You Should Know about Home Equity Lines of Credit

plan does not allow renewals, you will not be able to borrow
additional money once the period has ended. Some plans may
call for payment in full of any outstanding balance at the end of
the period. Others may allow repayment over a fixed period (the
repayment period), for example, 10 years.

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 checks to draw on your
line. Under some plans, borrowers can use a credit card or other
means to draw on the line.

There may be other limitations on how you use the line. Some
plans may require you to borrow a minimum amount each time
you draw on the line (for example, $300) or keep a minimum
amount outstanding. Some plans may also require that you take
an initial advance when the line is set up.

What should you look for when shopping

for a plan?

If you decide to apply for a home equity line of credit, look for
the plan that best meets your particular needs. 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. Remember, though, that the
APR for a home equity line is based on the interest rate alone and
will not reflect closing costs and other fees and charges, so youll
need to compare these costs, as well as the APRs, among lenders.

Variable interest rates

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
 What You Should Know about Home Equity Lines of Credit |5

daily newspapers or a U.S. Treasury bill rate). In such cases, the

interest rate you pay for the line of credit will change, mirroring
changes 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 impor-
tant to find out which index is used, how often the value of the
index changes, and how high it has risen in the past. It is also
important to note the amount of the margin.

Lenders sometimes oer a temporarily discounted interest rate

for home equity linesan introductory rate that is unusually
low for a short period, such as 6 months.

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 the index drops.

Some lenders allow you to convert from a variable interest rate

to a fixed rate during the life of the plan, or let you convert all or
a portion of your line to a fixed-term installment loan.

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 get a mortgage. 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;
6|What You Should Know about Home Equity Lines of Credit

Up-front charges, such as one or more points (one point

equals 1 percent of the credit limit); and
Closing costs, including fees for attorneys, title search, mort-
gage 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 estab-

lish the plan. And 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 lenders 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 oset the costs of estab-
lishing 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 a minimum monthly pay-
ment that includes a portion of the principal (the amount you
borrow) plus accrued interest. But, unlike with typical install-
ment loan agreements, the portion of your payment 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
only during the life of the plan, which means that you pay noth-
ing toward the principal. If you borrow $10,000, you will owe
that amount when the payment plan ends.
 What You Should Know about Home Equity Lines of Credit |7

Regardless of the minimum required payment on your home

equity line, you may choose to pay more, and many lenders
oer 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 o as you would a typical boat loan.

Whatever your payment arrangements during the life of the

planwhether you pay some, a little, or none of the principal
amount of the loanwhen 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%
interest rate, your monthly payments would be $83. If the rate
rises over time to 15%, 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 o

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.
8|What You Should Know about Home Equity Lines of Credit

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. This
type of loan provides you with a fixed amount of
money, repayable over a fixed period. In most cases,
the payment schedule calls for equal payments that
pay o 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
 What You Should Know about Home Equity Lines of Credit |9

the APRs, because the APRs on the two types of loans are fig-
ured dierently:

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.

Disclosures from lenders

The federal Truth in Lending Act requires lenders to disclose the

important terms and costs of their home equity plans, including
the APR, miscellaneous charges, the payment terms, and infor-
mation about any variable-rate feature. And in general, neither
the lender nor anyone else may charge a fee until after you have
received this information. You usually get these disclosures
when you receive an application form, and you will get addi-
tional disclosures before the plan is opened. If any term (other
than a variable-rate feature) changes before the plan is opened,
the lender must return all fees if you decide not to enter into the
plan because of the change.

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 feespaid to open the
account.
10|What You Should Know about Home Equity Lines of Credit

What if the lender freezes or reduces your

line of credit?
Plans generally permit lenders to freeze or reduce a credit line
if the value of the home declines significantly or, when the
lender reasonably believes that you will be unable to make
your payments due to a material change in your financial
circumstances. If this happens, you may want to:

Talk with your lender. Find out what caused the lender to
freeze or reduce your credit line and what, if anything, you
can do to restore it. You may be able to provide additional
information to restore your line of credit, such as documen-
tation showing that your house has retained its value or
that there has not been a material change in your financial
circumstances. You may want to get copies of your credit
reports (go to the Federal Trade Commissions website, at
www.ftc.gov/freereports, for information about free copies)
to make sure all the information in them is correct. If your
lender suggests getting a new appraisal, be sure you discuss
appraisal firms in advance so that you know they will accept
the new appraisal as valid.

Shop around for another line of credit. If your lender does

not want to restore your line of credit, shop around to see
what other lenders have to oer. You may be able to pay o
your original line of credit and take out another one. Keep in
mind, however, that you may need to pay some of the same
application fees you paid for your original line of credit.
 What You Should Know about Home Equity Lines of Credit |A1

Glossary
Glossary
Annual membership or maintenance fee
An annual charge for access to a financial product such as a line
of credit, credit card, or account. The fee is charged regardless of
whether or not the product is used.

Annual percentage rate (APR)

The cost of credit, expressed as a yearly rate. For closed-end
credit, such as car loans or mortgages, the APR includes the
interest rate, points, broker fees, and other credit charges that the
borrower is required to pay. An APR, or an equivalent rate, is not
used in leasing agreements.

Application fee
Fees charged when you apply for a loan or other credit. These
fees may include charges for property appraisal and a credit
report.

Balloon payment
A large extra payment that may be charged at the end of a mort-
gage loan or lease.

Cap (interest rate)

A limit on the amount that your interest rate can increase. Two
types of interest-rate caps exist. Periodic adjustment caps limit the
interest-rate increase from one adjustment period to the next.
Lifetime caps limit the interest-rate increase over the life of the
loan. By law, all adjustable-rate mortgages have an overall cap.

Closing or settlement costs

Fees paid when you close (or settle) on a loan. These fees may
include application fees; title examination, abstract of title, title
Glossary A2|What You Should Know about Home Equity Lines of Credit

insurance, and property survey fees; fees for preparing deeds,

mortgages, and settlement documents; attorneys fees; record-
ing fees; estimated costs of taxes and insurance; and notary,
appraisal, and credit report fees. Under the Real Estate Settle-
ment Procedures Act, the borrower receives a good faith estimate
of closing costs within three days of application. The good faith
estimate lists each expected cost as an amount or a range.

Credit limit
The maximum amount that may be borrowed on a credit card or
under a home equity line of credit plan.

Equity
The dierence between the fair market value of the home and
the outstanding balance on your mortgage plus any outstanding
home equity loans.

Index
The economic indicator used to calculate interest-rate adjust-
ments for adjustable-rate mortgages or other adjustable-rate
loans. The index rate can increase or decrease at any time. See
also Selected Index Rates for ARMs over an 11-year Period
(www.federalreserve.gov/pubs/arms/arms_english.htm) for
examples of common indexes that have changed in the past.

Interest rate
The percentage rate used to determine the cost of borrowing
money, stated usually as a percentage of the principal loan
amount and as an annual rate.

Margin
The number of percentage points the lender adds to the index
rate to calculate the ARM interest rate at each adjustment.
 What You Should Know about Home Equity Lines of Credit |A3

Glossary
Minimum payment
The lowest amount that you must pay (usually monthly) to keep
your account in good standing. Under some plans, the minimum
payment may cover interest only; under others, it may include
both principal and interest.

Points (also called discount points)

One point is equal to 1 percent of the principal amount of a
mortgage loan. For example, if a mortgage is $200,000, one
point equals $2,000. Lenders frequently charge points in both
fixed-rate and adjustable-rate mortgages to cover loan origina-
tion costs or to provide additional compensation to the lender
or broker. These points usually are paid at closing and may be
paid by the borrower or the home seller, or may be split between
them. In some cases, the money needed to pay points can be
borrowed (incorporated in the loan amount), but doing so will
increase the loan amount and the total costs. Discount points
(also called discount fees) are points that you voluntarily choose
to pay in return for a lower interest rate.

Security interest
If stated in your credit agreement, a creditors, lessors, or assign-
ees legal right to your property (such as your home, stocks, or
bonds) that secures payment of your obligation under the credit
agreement.

Transaction fee
Fee charged each time a withdrawal or other specified transac-
tion is made on a line of credit, such as a balance transfer fee or a
cash advance fee.

Variable rate
An interest rate that changes periodically in relation to an index,
such as the prime rate. Payments may increase or decrease
accordingly.
 A4|What You Should Know about Home Equity Lines of Credit

Where to go for help

For additional information or to file a complaint about a bank,
savings and loan, credit union, or other financial institution, con-
Help

tact one of the following federal agencies, depending on the type

of institution.

Regulatory Agency Regulated Entity(ies) Telephone/Website

Federal Reserve Consumer Federally insured state- (888) 851-1920
Help chartered bank members of www.federalreservecon-
P.O. Box 1200 the Federal Reserve System sumerhelp.gov
Minneapolis, MN 55480

Consumer Financial Pro- Insured depository institu- (855) 411-2372

tection Bureau (CFPB) tions and credit unions www.consumerfinance.gov
P.O. Box 4503 (and their aliates) with
Iowa City, IA 52244 assets greater than $10
billion, and nondepository
institutions such as mort-
gage originators, mortgage
brokers and servicers,
larger participants of other
financial services products,
private education loan
providers, and payday
lenders
Oce of the Comptroller National banks and (800) 613-6743
of the Currency (OCC) federally chartered savings www.occ.treas.gov
Customer Assistance Unit banks/associations www.helpwithmybank.gov
1301 McKinney Street
Suite 3450
Houston, TX 77010

Federal Deposit Insurance Federally insured state- (877) ASK-FDIC or

Corporation (FDIC) chartered banks that are (877) 275-3342
Consumer Response not members of the Federal www.fdic.gov
Center Reserve System www.fdic.gov/consumers
1100 Walnut Street, Box #11
Kansas City, MO 64106
 What You Should Know about Home Equity Lines of Credit |A5

Regulatory Agency Regulated Entity(ies) Telephone/Website

Federal Housing Finance Fannie Mae, Freddie Mac, (202) 649-3811
Agency (FHFA) and the Federal Home www.fhfa.gov
Consumer Communica- Loan Banks www.fhfa.gov/Default.
tions aspx?Page=369
Constitution Center

Help
400 7th Street, S.W.
Washington, DC 20024

National Credit Union Federally chartered credit (800) 755-1030

Administration (NCUA) unions www.ncua.gov
Consumer Assistance www.mycreditunion.gov
1775 Duke Street
Alexandria, VA 22314-3428

Federal Trade Commission Finance companies, retail (877) FTC-HELP or

(FTC) stores, auto dealers, mort- (877) 382-4357
Consumer Response gage companies and other www.ftc.gov
Center lenders, and credit bureaus www.ftc.gov/bcp
600 Pennsylvania Avenue,
N.W.
Washington, DC 20580

Securities and Exchange Brokerage firms, mutual (202) 551-6551

Commission (SEC) fund companies, and www.sec.gov
Complaint Center investment advisers www.sec.gov/complaint/
100 F Street, N.E. question.shtml
Washington, DC 20549-
0213

Farm Credit Administra- Agricultural lenders (703) 883-4056

tion www.fca.gov
Oce of Congressional
and Public Aairs
1501 Farm Credit Drive
McLean, VA 22102-5090

Small Business Administra- Small business lenders (800) U-ASK-SBA or

tion (SBA) (800) 827-5722
Consumer Aairs www.sba.gov
409 3rd Street, S.W.
Washington, DC 20416
 A6|What You Should Know about Home Equity Lines of Credit

Regulatory Agency Regulated Entity(ies) Telephone/Website

Commodity Futures Trad- Commodity brokers, com- (866) 366-2382

ing Commission (CFTC) modity trading advisers, www.cftc.gov/Consumer-
1155 21st Street, N.W. commodity pools, and Protection
Washington, DC 20581 introducing brokers
Help

U.S. Department of Justice Fair lending and fair hous- (202) 514-3301
(DOJ) ing issues www.justice.gov/criminal
Criminal Division
950 Pennsylvania Avenue,
N.W.
Washington, DC 20530

Department of Housing Fair lending and fair hous- (800) 669-9777

and Urban Development ing issues www.hud.gov/complaints
(HUD)
Oce of Fair Housing/
Equal Opportunity
451 7th Street, S.W.
 What You Should Know about Home Equity Lines of Credit |A7

More resources
For more resources on mortgages and other financial topics, visit
www.federalreserve.gov/consumerinfo.

Resources