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).
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 Economy.com 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.
By offering lower rates than credit cards and other available credit sources, HELOCs have been highly attractive to homeowners. They are often a sensible resource to pay for major expenses such as a home renovation, auto purchase, and tuition.
But these were primarily intended to be used as an installment loan rather than as a revolving line of credit. If the lender reports your HELOC to a credit agency as an installment loan, your credit score will not be hurt as long as payments are made on time. But if it's reported as a revolving line of credit, your credit score can drop if the bank shrinks or freezes your credit line.
According to an April survey by the Federal Reserve, lenders are doing just that. Some 70 percent of financial institutions reported that they have tightened credit standards for new applications for revolving home-equity lines of credit, and half have reduced existing lines of credit. Lenders state that their primary reason for tightening HELOCs is the decline of collateral below the appraised value of the home. A secondary reason given is changes in borrowers' financial circumstances.
In today's credit crunch, it is important to pay close attention to your credit. HELOCs must be used wisely in order to protect your greatest asset – your home. If you plan to make these loans a part of your financial future, take advantage of these strategies:
•Be proactive in managing your home-mortgage investment. If you have a HELOC, contact your lender to find out how they report your home-equity line to credit agencies and any adjustments they might have made to their underwriting standards.
•If your lender freezes your HELOC, appeal to the bank that originated it with an updated appraisal of your property or credit information. You can get the latter from annualcreditreport.com.
•Before drawing down on your home's equity, factor in a rising-interest-rate environment. Evaluate whether you could comfortably repay the loan if the interest rate rose by 2 to 3 percent.
•Only use a HELOC for major expenses such as tuition or home improvements. It is not a piggy bank for nonessential purposes such as a fancy vacation.
•When shopping for a HELOC, hunt for the best rate and no cost deal at bankrate.com. A loan from a quality financial institution is as important as low rate. A HELOC should never affect your credit score negatively if it is reported correctly and you pay in a timely fashion.