The Clint Murchison Award for the Loan of the Decade goes to ... (the envelope, please) ... the home-equity line of credit! Murchison, the late Texas zillionaire, sampled so widely from the world of credit that he wound up in bankruptcy court. That's a useful thought when contemplating this new way of borrowing that could tap you dry.
At first glance, home-equity lines look unbeatable: low interest rates, low monthly payments, flexible repayment terms, tax deductions for some of the interest expense.
But in one of those ironies so typical of banking, credit lines are perfect only for people who don't really need them and pure poison for people who do.
In a nutshell, this loan is a second mortgage against your house. But you don't borrow all the money at once. Instead, the bank gives you a large line of credit -- the amount depending on your income, the size of your first mortgage and the value of your house.
To take out a loan against your credit line, you merely write a check or put down a special credit card. Repayment schedules are incredibly loose, often lasting 20 years or more. Many borrowers will simply carry their loans until the house is sold, and repay the principal then (leaving them with less cash for a down payment on their next house). Of course, if you can't pay, you could lose your home.
Much of the advertising for home-equity lines of credit has also been incredibly loose. Here's what a borrower needs to know:
How much does the credit line really cost? Lenders advertise low interest rates, in the 10 percent area, sometimes with a "teaser" 6.6 percent for the first six months.
But that's only the start. Depending on your state, you may pay mortgage-closing costs. There may be loan-origination fees of 1 to 3 percent and annual fees of $15 to $100. So what looks on paper like a 10 percent loan might actually be costing you 15 percent or more, says Professor Richard Morse of Kansas State University. (The best loans carry low or no up-front fees.)
How much money do you need right now? Most borrowers open the largest possible line of credit on the assumption that it can't hurt. But it can hurt, in two ways.
First, your closing costs depend on the size of the credit line. The larger the line the more you pay -- which can raise your effective interest rate. If you opened a $75,000, 10.25 percent credit line at New York's Chemical Bank, and then borrowed $10,000 for five years, your effective rate of interest (counting all charges) would be 19.5 percent, Morse says.
Second, on your credit history, the total amount of your credit line is treated as an outstanding loan, even if you haven't borrowed against it. That might prevent you from getting a lower-cost loan somewhere else.
Can you handle a big variable-rate loan? A majority of credit lines float with the prime rate. If interest rates rise, so will your payments.
How fast will you repay? Lenders love borrowers who repay s-l-o-w-l-y, because it means you'll pay them more. In the first five to 10 years, lenders may require no principal payments at all -- just years and years of interest payments, after which your loan will not have been reduced by one penny. When the principal falls due, you'll probably have to refinance.
Even if you make principal payments every month, they may be so small that your loan declines only slightly -- again costing you more in interest. To avoid these costs, you must make monthly payments that are much larger than the lender requires.
I love good home-equity loans if you'll repay quickly; have cash reserves to eliminate the loan if payments get too high; substitute home-equity borrowing for more expensive credit-card loans; and have an income secure enough to cover rising payment.
But I hate them if you can afford only the minimum payments; are adding to your already-heavy debt; have uncertain earnings and are spending more than 35 percent of your income repaying mortgage and consumer loans.
It's simply not smart to stretch out consumer-loan repayments over 20 years or more because of the massive interest cost. Nor is it smart to drain home equity -- probably your largest pool of capital. Anyway, that's what Clint Murchison might tell you, if he were still aroun