How a Line of Credit Works

What is line of credit?

Line of Credit is an indulgent whereby a bank or a vendor extends a specified amount of unsecured credit to a specified borrower for a specified time period. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.

Home Equity Lines of Credit:

Home equity line of credit has proven to be the most popular line of credit for consumers. This is where you use your home equity as security. The bank assumes that you'll repay the line of credit to avoid losing your home in foreclosure.

Usually an individual’s credit limit will be determined, in part, by his/her loan to value ratio.

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 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.

Line of Credit vs Home Equity Loan:

With a home equity line, you will be approved for a specific amount of credit. Normally a home equity line of credit is more flexible than a home equity loan. You only borrow what you need, and you can typically go back for more money when you need to (as long as you stay below your maximum credit limit). You might use a checkbook to access your line of credit. A second mortgage typically involves a single loan that you repay over time. A line of credit will have a variable rate, while second mortgages can have a fixed or variable interest rate. Many lenders set the credit limit on a home equity line by taking a percentage (say, 75%) of the home’s appraised value and subtracting from that the balance owed on the existing mortgage.

Draw and Repayment Periods:

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. Your line of credit will have a draw period and a repayment period. During the draw period, you borrow money and use your line of credit. This may last for 10 years or so. During the repayment period, you repay principal and interest on the loan.

Closing Costs:

Like most loans, lines of credit have closing costs. Factor these in when you make your decisions on lenders and loan types.

Overdraft Line of Credit:

Another type of line of credit is the overdraft line of credit. These help you avoid overdraft fees in your checking account.

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 information 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 additional 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 fees paid to open the account.