by Michael Licamele
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Do you have equity in the home that you own now? Do you need money for college education, home improvements, a long awaited vacation or a new car? Whether you have any equity or not, you may be able to take advantage of borrowing opportunities that did not exist one year ago.
Equity is defined as the value in your home, and is calculated by subtracting all outstanding mortgages from the market value of the home. Because loan balances and housing prices are changing constantly, the equity that home owners fluctuates as well. Lenders are less concerned with the exact dollar amount of equity in a home than the percentage of equity. For example, a home owner with a $500,000 mortgage on a $525,000 home has $25,000 in dollar equity but less than 5% in percentage terms. On the other hand, the owner of a $60,000 condominium with a first mortgage of only $40,000 has $20,000 in equity which is 33% on a percentage basis. Lenders would prefer to lend additional funds to the condominium owner because of the higher percentage of equity.
In is important to understand equity percentages because the maximum percentage of combined loan to value on a property is what has changed dramatically over the past two years. In the past, nearly all second mortgage lenders would not let the combined total of a borrower's first and second mortgage exceed 80% to 90% of the value of the property. A home owner with a $100,000 home and a $70,000 first mortgage could only borrow $10,000 (80% of $100,000 = $80,000 - $70,000 = $10,000). Today, that same home owner could not only borrow $30,000, the entire amount of the equity in the property, but could also borrow up to 125% of the value of the home. Unbelievable as it may sound, the borrower in the above example could actually obtain a loan for $55,000 in addition to the existing first mortgage.
Over the past several years, the number and type of home equity loans available to consumers has mushroomed as banks and finance companies have accumulated large amounts of cash that they need to lend back out to borrowers. The highly competitive nature of home equity lending has caused lenders to offer an increased number of programs to consumers. In addition to the usual rate competition, lenders continued to increase the maximum amount they would loan on a property. Programs have leaped from 80% to 90% to 100%, and have topped out at 125%. However, most people do not borrower more than 100% of the value of their home because rates are much better and because interest on any amount over 100% loan-to-value is not tax deductible.
Credit standards have been relaxed to a certain extent as well. Two years ago, a borrower had to have excellent credit for a home equity line or second mortgage term loan. Now borrowers who do not meet normal credit requirements will not get rejected, but will be offered a loan at a higher rate under B-C-D credit programs. With all of the available programs and choices, consumers have much to consider when choosing a home equity program.
Home Equity Lines of Credit
The typical home equity line is a form of revolving credit in which a borrower's home serves as collateral. A borrower is approved for a specific amount of credit-the credit limit-which will become the maximum amount that can be borrowed under the plan. Lenders usually require the line to be at least $10,000, but total credit lines can range up to $1,000,000. Once the home equity line is in place, a borrower can borrow up to the credit limit at any time. Many plans require a minimum draw against the line of between $250 and $500.
The borrower is usually required to repay at least the miniumum interest due each month for the first ten years. The interest rate on home equity lines is variable, usually based on the prime rate (which was 8.25% in July 2006), and is capped at a maximum that ranges from 15% to 20%. At the end of that period, most plans will take the existing remaining balance and turn it into a 10 or 15 year fully amortizing loan. Of course, if these programs continue to prevail in ten years, a consumer could always take out a home equity line from another lender and gain an additional ten years of interest-only loan payments.
Interest rates for home equity lines are based on a number of factors. The most important factor is the total loan-to-value that the equity line will create. The best pricing can be found for home equity lines using 80% or less of the value of a home, with pricing increases occurring when the total loan exceeds 80%, 90%, 100% and 125% of the value of the home. Many borrowers at 80% or less can obtain rates at below the prime rate with good credit, while those borrowers using the 125% loan program will pay 13% to 15%.
The loan size also determines the interest rate for many lenders. At one institution, a $10,000 home equity line carries a rate of prime plus 1% while a $100,000 line is at the prime rate. Some programs also carry introductory teaser rates for the first three or six months, often at prime less 1% or less. Each institution sets its own break points for rate differences, so be sure to investigate what is available in your area.
Another rate factor is based on whether or not the borrower will be taking out funds when the equity line is established, and whether or not the borrower is transferring or consolidating other debt balances. One New York lender, for example, offers a home equity rate at prime for the life of the loan if a borrower is is transferring at least $40,000 from another home equity line. Usually, the lender charges prime plus .75% for the same loan. Many lenders are now also offering free home equity lines at better rates if the borrower is refinancing or purchasing and "piggybacks" the home equity line on top of the first mortgage.
The last factor affecting rates is based on whether the borrower or the lender will pay closing costs. In today's market, there are some lenders that are offering to pay all closing costs on all of their loan programs. Some lenders give borrowers the option of a lower rate if they pay closing costs, which include appraisal, attorney, recording and other fees that usually range around $800. Other lenders tie closing costs to the loan amount that the borrower takes out at the closing of the loan. If the lender knows the borrower will take out $25,000, for example, then the bank will not mind paying the closing costs because they will make back the costs with interest payments within a few months.
Based on all of these rate factors, it becomes clear that the best pricing is reserved for the higher end borrower who takes out funds at closing. A home owner who obtains a $100,000 home equity line and takes out at least $25,000 at closing should be able to get an interest rate at prime for the life of the loan and not have to pay any closing costs. The borrower who applies for a $7,500 line, however, may have to pay closing costs and wind up with a rate over 9%.
Second Mortgage Term Loan Options
Should borrowers need only a specific amount for a designated purpose and would prefer a fixed rate loan, second mortgage terms loans exist. For A credit borrowers, rates on these programs are usually less than prime rate and are fixed. The down side of these loans is that they always require closing costs be paid by the borrower and the closing costs range closer to $1,000. Over time, however, a lower fixed rate second mortgage term loan could be less costly than a home equity line with no closing costs but higher rates.
A Caution for Borrowers
Simply because lenders are
lending furiously to anyone who will borrow, consumers should
be extremely wary of not getting in over their heads with home
equity debt. Consolidating other debts under a home equity line
is a great way to lower interest payments, gain tax deductibility,
and improve cash flow. Likewise, investments in home improvements
and education are highly advisable purposes for home equity borrowing.
Home equity loans of any type should never be used for day-to-day
expenses. On the positive side, it's a great time for borrowers
to get the best home equity financing in years.
Michael Licamele is the Editor of MortgageAlmanac.com and President of Residential Finance Network at rfnc.com.
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