Home Equity

Establishing a Home Equity Line of Credit to Finance Home Improvements and Construction

A home equity loan allows you to get a loan by using the equity in your home as your collateral. A home equity loan (second mortgage) can be obtained in a lump sum or used as a revolving home equity line of credit (HELOC).

Home equity lines of credit are popular financing tools used as home improvement and construction loans. Borrowers love the fact that you only pay interest on the equity you use, and you can draw from your credit line more than once without having to apply for a new loan each time, so you can pay each contractor as needed.

Many HELOC plans set a fixed period (usually 10 years) during which you can borrow money and make interest only payments. At the end of this "draw period," you may be allowed to renew the credit line, but some plans don't allow renewals. Some plans make you pay the entire balance of the loan at the end of the draw period. Others may allow fully-indexed (principal and interest) repayment over a fixed period (the "repayment period").

Unlike a fixed mortgage rate loan with a fixed payment for the life of the mortgage, HELOCs are adjustable rate mortgages (ARMs) with variable interest rates based on a publicly available index (such as the prime rate published in some major newspapers like the Wall Street Journal or a U.S. Treasury bill rate).

The Federal Reserve suggests that if f you decide to apply for a HELOC, to look for the plan that best meets your particular needs. They further suggest that 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. Don't forget that the APR for a HELOC is based on the interest rate alone. They do not reflect the closing costs and other fees, so you'll need to compare these costs in addition to the APR when shopping for a second mortgage loan.

With short-term rates expected to rise again, refinancing your HELOC to a fixed-rate loan may be a good hedge against inflation, especially if your rates are due to adjust again soon. You may also consider mortgage refinancing if you still need money after your draw period has ended and your plan doesn't allow renewals or if you have a large balance to pay.