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Has the credit crunch hit your home equity line?

Lenders are shrinking these lines of credit, making it harder for Americans to finance major expenses.

By Kathleen Connell / June 16, 2008

For many high school seniors, spring graduation marks the start of the transition to college. It is also the time when parents finalize their college-financing plans. Unfortunately, those preparing to write large checks this fall to cover college expenses are faced with an increasingly limited college-loan market. In particular, many must deal with an unexpected tightening of a popular source of college financing: the Home Equity Lines of Credit (HELOC).

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Last year, 1 out of 4 parents planned to take out a home-equity loan to help pay for college, according to a survey by Next Step Magazine. College financial-aid offices are expecting this source of financing to grow as high as a third this fall.

Tapping home equity to pay for education can be a good move, notes Jim Holtzman, a financial planner in Pittsburgh. "[A] HELOC's tax-deductible low interest rate, generally at prime [5 percent] or below, makes sense as a source for college tuition if you don't have any other source of capital and would need to borrow from a higher rate, private college-loan program," he says. Rates on those loans average 8.5 percent.

A HELOC's value extends to many areas beyond college finances, making them a standard part of prudent financial planning, says Gary Schatsky, a financial planner in New York, "I have established HELOCs for all of my clients as a cheaper form of borrowing and as a cushion for emergency funds. A HELOC is preferable, as it is a tax-advantaged buying opportunity," he says.

Many homeowners may receive bad news this summer, either through a letter from their lender freezing or reducing their HELOC, or when they try to tap their home equity and are denied. Some lenders are substantially reducing their exposure to such credit due to rising defaults, falling home prices, and declining home equity. Moody's reported that HELOC delinquencies were up 47 percent in the last year.

These credit lines were aggressively marketed by banks and other financial institutions over the past several years when home prices were rising rapidly. HELOCs were often offered at a teaser rate with no credit underwriting, assuming that houses (the collateral) would continue to rise in value.

These loans are now in the bull's-eye of regulators' concerns regarding lax underwriting standards by banks and are emerging as the next piece of fallout from rapidly declining home prices. The HELOC market has $1.1 trillion outstanding this year, doubling since 2002, according to the US Office of the Comptroller of Currency.