Equity loans: More popular, but more confusing

By Holden Lewis

Mortgage bankers eagerly want to make 2004 the year of the home equity loan. First they have to clear up some misconceptions.

Many homeowners don't understand what an equity loan is. Lenders worry that consumers believe equity loans have high closing costs and are a hassle to apply for. And bankers think that a lot of potential borrowers don't know the differences between home equity loans and equity lines of credit.

These issues are coming up because mortgage rates have risen about 1 percentage point in the last year. With that rise in rates came the end of the long refinancing boom: In 2003, two out of three mortgage applications were from homeowners who were refinancing their loans, according to the Mortgage Bankers Association; in the second week of June 2004, the refinance share was 34 percent.

Last year, almost half of refinancing borrowers did "cash-out refis" -- they refinanced for more than they owed and pocketed the difference. Now that rates are higher, homeowners don't want to refinance again. "The only way to cash out is to take out a home equity loan or line," says Anthony Hsieh, president of HomeLoanCenter.

Lenders are chasing after equity borrowers by offering airline miles and gift cards at stores such as Costco, as well as by touting the ease and low costs of applying for the loans.

Home equity baffles
What, exactly, is a home equity loan? In a Lending Tree-sponsored survey of 802 homeowners, 20 percent of the respondents agreed with the statement: "Home equity loans and second mortgages are two names for the same thing." They were right. The other 80 percent said, incorrectly, that home equity loans and second mortgages are different things.

When you get a home equity loan, you are borrowing against your ownership stake in the house. The equity is the value of the house minus your mortgage balance. A home equity loan uses your equity as collateral. If your house is worth $200,000, and you owe $140,000 on the mortgage, you have $60,000 in equity. A home equity loan would allow you to borrow some or all of that $60,000.

You receive an equity loan as a lump sum, and repay it over a set time, usually at a fixed rate and for the same payment each month. A home equity line of credit, or HELOC, is a type of equity loan that works like a credit card. It has a credit limit and a revolving balance, meaning that you can borrow up to a certain amount, pay some or all of it back, and borrow again up to the limit. Rates on most lines of credit vary as the prime rate moves up and down.

Who needs a line, who needs a loan
Because they come in a lump sum, home equity loans generally are recommended for one-time expenses -- to consolidate credit card debt, pay for a new roof, buy a business. Equity lines of credit often are recommended for recurring expenses such as college tuition, or multistage projects such as home renovations, or to hold in reserve for emergencies such as job layoffs.

A line of credit starts with a draw period and ends with a repayment period. During the draw period, the homeowner can borrow against the credit line by using a charge card or a checkbook. Minimum monthly payments cover only the interest during the draw period. When the repayment period starts, the monthly payments cover interest and principal so that the balance is repaid by the time the credit line expires. The length of the draw and repayment periods varies with the lender and size of the credit line.

Generally speaking, interest is tax-deductible on the first $100,000 of debt with both types of loans.

Rate difference
Rates on home equity loans tend to be higher. In Bankrate.com's June 9 national rate survey, the average rate on a home equity loan was 7.24 percent and the average rate on an equity line of credit was 4.77 percent. We're near the bottom of the rate cycle, so someone who closes today on a variable-rate equity line of credit will probably end up paying a higher rate than a neighbor who closes today on a fixed-rate home equity loan. "But you've got a long way to go, because it's still a big spread between home equity loans and home equity lines of credit," says Brian Regan, vice president and chief consumer officer for Lending Tree.

Lenders are looking for equity customers to replace their vanishing refinancing borrowers. In addition to dangling incentives such as airline miles, they are touting the low expense of applying for equity debt. A few years ago, homeowners had to pay closing costs -- usually between $150 and $800 -- for equity loans or lines of credit.

But now many equity lines of credit come with no fees, especially if the borrower makes an initial draw (akin to a credit card charge) when the account is opened. Sometimes you have to make an initial draw of thousands of dollars to get the fees waived. With equity loans, aggressive lenders either charge no fees or a few hundred dollars' worth.

"Most companies, such as us, give them away," says Hsieh of HomeLoanCenter. And with inducements such as air miles, "nothing gets a customer more excited than somehow dreaming of a free vacation to Hawaii," he adds.

As a further incentive, lenders are trying to make it as easy as possible to apply for equity debt and to close on it. Many lenders allow you to apply online or over the phone, and the approval decision takes 15 minutes or less. Most equity loans and lines of credit make do with an automated valuation instead of requiring a visit from an appraiser. Customers often have a choice of where to have the closing -- at home, at work, in a bank office, even at a coffee shop.

Banks are looking for ways to encourage customers to use their equity lines of credit instead of letting them sit idle for a rainy day. With its Home Asset Management Account, Wells Fargo increases a customer's credit limit as the home's value increases. With its fixed-rate option, Bank of America lets customers convert all or part of the balances on equity lines of credit into fixed-rate loans -- in essence, combining equity loans and equity lines of credit into one product.


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