Getting a Loan

If you've been thinking about buying a home, you may wonder how to select the right financing for your budget and needs. This Financial Guide will explain the basics of most of the mortgage loans that are available today.

If you've been thinking about buying a home, you may be wondering how to select the best way to finance your purchase. With so many choices available--from traditional fixed rate loans to adjustable rate loans and reverse mortgages--it's more important than ever to educate yourself in order to find the right mortgage for your needs.

Traditional Mortgage

Many people prefer a traditional or a fixed-rate mortgage with fixed monthly payments, a fixed interest rate, and full amortization (or transfer of equity) over a period of 20 to 30 years. Because the interest rate is fixed, monthly payments that remain constant over the life of the loan and there is a maximum (and known) amount on the total amount of principal and interest that you pay during the loan. Traditionally, these mortgages have been long-term. As the loan is repaid, ownership shifts gradually from lender to buyer. These features work in the buyer's favor because inflation makes your payments seem less and your property worth more. So, although the payments seem hard to meet at first, that monthly payment becomes easier over time.

Example: You borrow $50,000 at 8% for 30 years. Your monthly payments on this loan would be $366.89. Over 30 years, your total obligation for principal and interest would never exceed this fixed, predetermined amount.

Tip: Fixed rate mortgages are usually available at higher rates than many other types of loans. But if you can afford the monthly payments, inflation and tax deductions may make a fixed rate mortgage a good financing method, particularly if you are in a high tax bracket and need the interest deductions.

Non-Traditional Mortgages

On the other hand, many home financing plans today differ materially from traditional mortgages. They may help you buy a home you couldn't otherwise afford, but they may also involve greater risks for buyers. For example, the interest rate and monthly payments may change during the loan to reflect what the market will bear. Or the interest rate may fluctuate while the payments stay the same, and the amount of principal paid off may vary. The latter approach allows the lender to credit a greater portion of the payment to interest when rates are high.

Some plans also offer below-market interest rates, but they may not help you build up equity.

When shopping for financing sources today, keep the following in mind:

• The sales price minus your down payment, i.e., the amount you finance
• The length, or maturity, of the loan
• The size of the monthly payments
• The interest rate or rates
• Whether the payments or rates may change
• How often and how much the payments or rates may change
• Whether there is an opportunity for refinancing the loan when it matures, if necessary

These concepts will be discussed in greater detail as we explore the different types of non-traditional financing.

15-Year Mortgage

The 15-year mortgage is a variation of the fixed-rate mortgage that is becoming increasingly popular. This mortgage has an interest rate and monthly payments that are constant throughout the loan. But, unlike other plans, this loan is fully paid off in only 15 years. And, it is usually available at a slightly lower interest rate than a longer-term loan. But it also requires higher payments.

In the 15-year mortgage, you pay off the loan balance faster than a long-term loan. Because of this, a smaller proportion of each of your monthly payments goes to interest.

Tip: If you can afford the higher payments, this plan will save you interest and help you build equity and own your home faster. The downside however, is that you are paying less interest and you may also have fewer tax deductions.

Adjustable-Rate Mortgage (ARM)

If you see an ad for a low-rate mortgage, it might be for an adjustable rate mortgage (ARM). These loans may have low rates for a short time-maybe only for the first year. After that, the rates can be adjusted on a regular basis. This means that the interest rate and the amount of the monthly payment can go up or down.

With an adjustable-rate mortgage, your future monthly payment is uncertain. Some types of ARMs put a ceiling on your payment increase or rate increase from one period to the next. Virtually all must put a ceiling on interest-rate increases over the life of the loan.

Today, many loans have interest rates (and monthly payments) that can change from time to time. To compare one ARM with another or with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps, negative amortization, and convertibility. You need to consider the maximum amount your monthly payment could increase.

Most important, you need to compare what might happen to your mortgage costs with your future ability to pay.

Planning Aid: See The Financial Calculator: Which Loan Is Better, Fixed or Adjustable?

Interest Rate Variation. Adjustable rate mortgages have an interest rate that increases or decreases over the life of the loan based upon market conditions. Some lenders refer to adjustable rates as flexible or variable.

In most adjustable rate loans, your starting rate, or "initial interest rate," will be lower than the rate offered on a standard fixed rate mortgage. This is because your long-term risk is higher-your rate can increase with the market-so the lender offers an inducement to take this plan.

Changes in the interest rate are usually governed by a financial index. If the index rises, so may your interest rate. If it falls, your interest rate also falls.

Rate Caps. To build predictability into your adjustable rate loan, some lenders include provisions for rate caps that limit the amount of any interest rate change. These provisions limit the amount of your risk. A periodic rate cap limits the amount the rate can increase at any one time. Because they limit the lender's return, capped rates may not be available through every lender.

Example: Your mortgage provides that even if the financial index it's tied to increases 2% in one year, your rate can only go up 1%. An aggregate rate cap limits the amount the rate can increase over the entire life of the loan. This means that even if the index increases 2% every year, your rate cannot increase more than 5% over the entire loan.

Many flexible rate mortgages offer the possibility of rates that may go down as well as up. In some loans, if the rate can only increase 5 %, it may only decrease 5%. If no limit is placed on how high the rate can go, there may be a provision that also allows your rate to go down along with the index.

Payment Caps

If the interest rate on your adjustable rate loan increases and your loan has a payment cap, your monthly payments may not rise, or they may increase by less than changes in the index would require.

Example: Your mortgage provides for unlimited changes in your interest rate, but your loan has a $50 per year cap on payment increases. You started with an 8% rate on your $75,000 mortgage and a monthly payment of $550.33. Now assume that your index increases 2 percentage points in the first year of your loan. Because of this, your rate increases to 10 %, and your payments in the second year rise to $658.18. Because of the payment cap, however, you'll only pay $600.33 per month in the second year.

Thus in the above example, your monthly payment should increase to $658.18, but because of a cap, it increases to only $600.33. Because this change in interest rates increases your debt, the lender may now apply a larger portion of your payment to interest. If rates get very high, even the full amount of your monthly payment won't be enough to cover the interest owed; the additional amount of interest you owe will be added to the principal. This means you now owe and eventually will pay interest on interest.

Negative Amortization. If your ARM contains a payment cap be sure to find out about "negative amortization." Negative amortization means the mortgage balance is increasing and occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your mortgage.

Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes do not cover all of the interest due on your loan. This means that the interest shortage in your payment is automatically added to your debt, and interest may be charged on that amount. You might therefore owe the lender more later in the loan term than you did at the start. However, an increase in the value of your home may make up for the increase in what you owe.

Prepayment and Conversion

If you get an ARM and your financial circumstances change, you may decide that you don't want to risk any further changes in the interest rate and payment amount. When you are considering an ARM, ask for information about prepayment and conversion.

• Prepayment. Some agreements may require you to pay special fees or penalties if you pay off the ARM early. Many ARMs allow you to pay the loan in full or in part without penalty whenever the rate is adjusted. Prepayment details are sometimes negotiable. If so, you may want to negotiate for no penalty, or for as low a penalty as possible.

• Conversion. Your agreement with the lender can have a clause that lets you convert the ARM to a fixed-rate mortgage at designated times. When you convert, the new rate is generally set at the current market rate for fixed-rate mortgages. The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may require a special fee at the time of conversion.

Variations of Adjustable Rate Mortgages. Another variation of the adjustable rate mortgage is to fix the interest rate for a period of time, 3 to 5 years, for example, with the understanding that the interest rate will then be renegotiated. These variations are:

• Rollover mortgages are loans with periodically renegotiated rates. Such loans make monthly payments more predictable because the interest rate is fixed for a longer time.

• Pledged account buy-down mortgage is another variation with an adjustable rate. This plan was introduced by the Federal National Mortgage Association (Fannie Mae), which buys mortgages from lenders and provides a major source of money for future mortgage offerings. In this plan, a large initial payment is made to the lender at the time the loan is made. The payment can be made by the buyer, the builder, or anyone else willing to subsidize the loan. The payment is placed in an account with the lender where it earns interest. This plan helps lower your interest rate for the first year.

Tip: This plan may not include any payment or rate caps other than those in the first years. But, there also may not be negative amortization, so possible increases in your total debt may be limited. Because of the buy-down feature, some buyers may be able to qualify for this loan that otherwise would not be eligible for financing.

Shopping for a Mortgage

When shopping for any type of adjustable rate mortgage, always remember to ask about the following:

• The initial interest rate
• How often the rate may change
• How much the rate may change
• The initial monthly payments
• How often payments may change
• How much the payments may change
• The mortgage term
• How often the term may change
• How much the term may change
• The index that rate, payment, or term changes are tied to
• The limits, if any, on negative amortization

Balloon Mortgage

Balloon mortgages have a series of equal monthly payments and a large final payment. Although there usually is a fixed interest rate, the equal payments may be for interest only. The unpaid balance, frequently the principal or the original amount you borrowed, comes due in a short period, usually 3 to 5 years.

Example: You borrow $30,000 for 5 years. The interest rate is 13%, and the monthly payments are only $325. But in this example, the payments cover interest only, and the entire principal is due at maturity-in 5 years. That means you'll have to make 59 equal monthly payments of $325 each and a final balloon payment of $30,325. If you can't make that final payment, you'll have to refinance (if refinancing is available) or sell the property.

Some lenders guarantee refinancing when the balloon payment is due, although they do not guarantee a certain interest rate. The rate could be higher than your current rate. Other lenders do not offer automatic refinancing.

Tip: Without such a guarantee, you could be forced to start the whole business of shopping for housing money once again, as well as paying closing costs and front-end charges a second time.

A balloon note may also be offered by a private seller who is continuing to carry the mortgage he or she took out when purchasing the home. It can be used as a second mortgage where you also assume the seller's first mortgage.

Graduated Payment Mortgage

Graduated payment mortgages (GPM) are designed for home buyers who expect to be able to make larger monthly payments in the near future. During the early years of the loan, payments are relatively low. They are structured to rise at a set rate over a set period, say 5 or 10 years. Then they remain constant for the duration of the loan.

Even though the payments change, the interest rate is usually fixed. So during the early years, your payments are lower than the amount dictated by the interest rate. During the later years, the difference is made up by higher payments. At the end of the loan, you will have paid off your entire debt.

Tip: One variation of the GPM is the graduated-payment, adjustable-rate mortgage. This loan also has graduated payments early in the loan. But, like other adjustable rate loans, it ties your interest rate to changes in an agreed-upon index. If interest rates climb quickly, greater negative amortization occurs during the period when payments are low. If rates continue to climb after that initial period, the payments will, too. This variation adds increased risk for the buyer. But if interest rates decline during the life of the loan, your payments may as well.

Growing-Equity Mortgage (GEM)

The growing equity mortgage (GEM) is tailored for first time homebuyers or young families whose incomes are likely to rise. These mortgages combine a fixed interest rate with a changing monthly payment. The interest rate is usually a few percentage points below market. Although the mortgage term may run for 30 years, the loan will frequently be paid off in less than 15 years because payment increases are applied entirely to the principal.

Monthly payment changes are based on an agreed-upon schedule of increases or an index.

With this approach, your income must be able to keep pace with the increased payments. The plan does not offer long-term tax deductions. However, it can permit you to pay off your loan and acquire equity rapidly.

Shared Appreciation Mortgage (SAM)

In the shared appreciation mortgage (SAM), you make monthly payments at a relatively low interest rate. You also agree to share with the lender a sizable percent (usually 30% to 50%) of the appreciation in your home's value when you sell or transfer the home, or after a specified number of years.

Because of the shared appreciation feature, monthly payments in this plan are lower than in many other plans. However, you may be liable for the dollar amount of the property's appreciation even if you do not wish to sell the property at the agreed-upon date.

Tip: Unless you have the cash available, this could force an early sale of the property. Also, if property values do not increase as anticipated, you may still be liable for an additional amount of interest.

There are many variations of this idea, called housing equity plans in the US. Some are offered by lending institutions and others by individuals.

Example: Suppose you've found a home for $100,000 in a neighborhood where property values are rising. The local savings and loan is charging 9% on home mortgages, assuming you paid $20,000 down and chose a 30-year term, your monthly payments would be $643.70, or about twice what you can afford. But a friend offers to help. Your friend will pay half of each monthly payment, or $321.85 for 5 years. At the end of that time, you both assume the house will be worth at least $125,000. You can sell it, and your friend can recover his or her share of the monthly payments to date plus half of the appreciation. Or, you can pay your friend that same sum of money and gain increased equity in the house.

Another variation may give your partner tax advantages during the first years of the mortgage, after which the partnership is dissolved. You can buy out your partner or find a new one. Your partner helps make the purchase possible by putting up a sizable down payment and/ or helping make the monthly payments. In return, your partner may be able to deduct a certain amount from his or her taxable income.

Shared appreciation and shared equity mortgages were partly inspired by rising interest rates and partly by the notion that housing values would continue to grow over the years to come. If property values fall, these plans may not be available.

Tip: Before proceeding with this type of plan, check with a tax advisor to determine deductibility of interest.

Assumable Mortgage

An assumable mortgage is a mortgage that can be passed on to a new owner at the previous owner's interest rate.

During periods of high rates, most lending institutions are reluctant to permit mortgage assumptions, preferring to write a new mortgage at the market rate. Some buyers and sellers are still using assumable mortgages, however. This has recently resulted in many lenders calling in the loans under "due on sale" clauses. Because these clauses have increasingly been upheld in court, many mortgages are no longer legally assumable. Be especially careful, therefore, if you are considering a mortgage represented as assumable.

Tip: Read the contract carefully and have an attorney or other expert check to determine if the lender has the right to raise your rate in this mortgage.

Seller "Take-Back" Mortgages

This mortgage, provided by the seller, is frequently a second trust and is combined with an assumed mortgage. The second trust (or second mortgage) provides financing in addition to the first assumed mortgage, using the same property as collateral. (In the event of default, the second mortgage is satisfied after the first).

Seller take-backs frequently involve payments for interest only, with the principal due at maturity. Some private sellers are also offering first trusts as take-backs. In this approach, the seller finances the major portion of the loan and takes back a mortgage on the property.

Tip: Another development now enables private sellers to provide this type of financing more frequently. Previously, sellers offering take-backs were required to carry the loan to full term before obtaining their equity. However, now, if an institutional lender arranges the loan, uses standardized forms, and meets certain other requirements, the owner take-back can be sold immediately to Fannie Mae. This approach enables the seller to obtain equity promptly and avoid having to collect monthly payments.

Wraparound Mortgage

Another variation on the second mortgage is the wraparound. Wraparounds may cause problems if the original lender or the holder of the original mortgage is not aware of the new mortgage. Upon discovering this arrangement, some lenders or holders may have the right to insist that the old mortgage be paid off immediately.

Land Contract

Borrowed from commercial real estate, this plan enables you to pay below-market interest rates. The land contract or installment sale agreement as it is also known permits the seller to hold onto his or her original below-market rate mortgage while "selling" the home on an installment basis. The installment payments are for a short term and may be for interest only. At the end of the contract the unpaid balance, frequently the full purchase price, must still be paid.

Caution: The seller continues to hold title to the property until all payments are made. Thus, you, the buyer, acquire no equity until the contract ends. If you fail to make a payment on time, you could lose a major investment.

Buy-Downs

A buy-down is a subsidy of the mortgage interest rate that helps you meet the payments during the first few years of the loan. There are several things to think about in buy-downs:

1. Consider what your payments will be after the first few years. If this is a fixed rate loan, the payments in the above example will jump to the rate at which the loan was originally made. If this is an adjustable rate loan, and the index to which your rate is tied has risen since you took out the loan, your payments could go up even higher.

2. Check to see whether the subsidy is part of your contract with the lender or with the builder. If it's provided separately by the builder, the lender can still hold you liable for the full interest rate, even if the builder backs out of the deal or goes out of business.

3. See if the sales price has been increased to cover a builder's interest subsidy. A comparable home may be selling around the corner for less. At the same time, competition may have encouraged the builder to offer you a genuine savings. It pays to check around.

There are also plans called consumer buy-downs. In these loans, the buyer makes a sizable down payment, and the interest rate granted is below market. In other words, in exchange for a large payment at the beginning of the loan, you may qualify for a lower rate on the amount borrowed. Frequently this type of mortgage has a shorter term than those written at current market rates.

Rent with Option to Buy

In a climate of changing interest rates, some buyers and sellers are attracted to a rent-with-option to-buy arrangement. In this plan, you rent property and pay a premium for the right to purchase the property within a limited time period at a specific price. In some arrangements, you may apply part of the rental payments to the purchase price.

This approach enables you to lock in the purchase price. You can also use this method to buy time in the hope that interest rates will decrease. From the seller's perspective this plan may provide the buyer time to obtain sufficient cash or acceptable financing to proceed with a purchase that may not be possible otherwise.

Reverse Mortgage

If you already own your home and need to obtain cash, you might consider the reverse annuity mortgage (RAM) or equity conversion. In this plan, you obtain a loan in the form of monthly payments over an extended period of time, using your property as collateral. When the loan comes due, you repay both the principal and interest.

A RAM is not a mortgage in the conventional sense. You can't obtain a RAM until you have paid off your original mortgage. Suppose you own your home and you need a source of money. You could draw up a contract with a lender that enables you to borrow a given amount each month until you've reached a maximum of, for example, $10,000. At the end of the term, you must repay the loan. But remember, if you do not have the cash available to repay the loan plus interest, you will have to sell the property or take out a new loan.

Related Guide: Please see the Financial Guide: REVERSE MORTGAGES: How They Can Enhance Your Retirement.

Some Cautions

Before going ahead with a creative home loan, have a lawyer or other expert help you interpret the fine print. You should consider some of the situations you could face when paying off your loan or selling your property. And make sure you understand the terms in your agreement-such as acceleration clauses, due on sale clauses, and waivers.

Tip: In addition to any legal issues, financial considerations also come into play. Therefore, financial guidance is suggested helping before a final decision on the type of mortgage to take.

Acceleration Clause

An acceleration clause allows the lender to speed up the rate at which your loan comes due. Suppose you've missed a payment, and your contract gives the lender the right to "accelerate" the loan when a payment is missed. This means that the lender now has the power to force you to repay the entire loan immediately.

Sample acceleration clause: "In the event any installment of this note is not paid when due, time being of the essence, and such installment remains unpaid for thirty (30) days, the Holder of this Note may, at its option, without notice or demand, declare the entire principal sum then unpaid, together with secured interest and late charges thereon, immediately due and payable. The lender may without further notice or demand invoke the power of sale and any other remedies permitted by applicable law."

Tip: Know whether your contract waives your right to notice. If so, obtain a clear understanding in advance of what you're giving up. Try to get the clause removed. Have your attorney check state law to determine if the waiver is legal.

Due-On-Sale-Clause

A due on sale clause gives the lender the right to require immediate repayment of the balance you owe if the property changes hands. Here's an example of a due on sale clause: "gall or any part of the Property or an interest therein is sold or transferred by Borrower without Lender's prior written consent. . . Lender may, at Lender's option, declare all the sums secured by this Mortgage to be immediately due and payable."

Due on sale clauses have been included in many mortgage contracts for years. They are being enforced by lenders increasingly when buyers try to assume sellers' existing low rate mortgages. In these cases, the courts have frequently upheld the lender's right to raise the interest rate to the prevailing market level. So be especially careful when considering an "assumable mortgage." If your agreement has a due on sale provision, the assumption may not be legal, and you could be liable for thousands of additional dollars.

Mortgage Terms

To buy or sell a home today, it's important to know the vocabulary. Understanding terms like amortization or appreciation can save you time and money; it can also prevent you from obtaining a mortgage ill-suited to your needs.

When you first buy a home you're likely to make a down payment on the property. However, because you financed the purchase, you are now in debt and the lender owns most of the property's value. In traditional mortgages, the monthly payments on the loan are weighted. During the first years, they are largely interest; in time, more of each payment is credited to the loan itself, or the principal.

Gradually, as you pay off principal, you build up equity, or ownership. Your equity also increases if the value of the home increases. This process of gradually obtaining equity and reducing debt through payments of principal and interest is called amortization.

Repaying debt gradually through payments of principal and interest is called amortization. Today's economic climate has given rise to a reverse process called negative amortization. This means that you are losing, not gaining, value, or equity, because your monthly payments may be too low to cover the interest rate agreed upon in the mortgage contract. Instead of paying the full interest costs now, you'll pay them later, either in larger payments or in more payments. You will also be paying interest on that interest.

In other words, the lender postpones collection of the money you owe by increasing the size of your debt. In extreme cases, you may even lose the equity you purchased with your down payment, leaving you in worse financial shape a few years after you purchase your home than when you bought it.

Example: Suppose you signed an adjustable rate mortgage for $50,000 in 1996. The index established your initial rate at 9.15%. It nearly doubled to 17.39% by 1999. If your monthly payments had kept pace with the index, they would have risen from $408 to $722. But because of a payment cap, they stayed at $408. By 1999 your mortgage had swelled from $50,000 to $58,350, even though you had dutifully paid $408 every month for 48 months. In other words, you paid out $20,000 but you were $8,000 more in debt than you were three years earlier. During the next few years despite the fact that the index fell gradually, you were still paying off the increases made to your principal from earlier years.

Certain loans, such as graduated payment mortgages, are structured so that you regain the lost ground with payments that eventually rise high enough to fully pay off your debt. And you may also be able to pay off the extra costs if your home is gaining rapidly in value or if your income is rising fast enough to meet the increased obligation. But if it isn't, you may realize a loss if, for example, you sign a below-market adjustable rate mortgage in January and try to sell the home in August when interest rates are higher. You could end up owing more than you'd make on the sale.

By using the equity in your home, you may qualify for a home equity line of credit (HELOC), a sizable amount of credit that is available to you to use when you need it, and, at a relatively low interest rate. Furthermore, under the tax law, and depending on your specific situation, you may be allowed to deduct the interest because the debt is secured by your home. This Financial Guide provides the information you need to determine which home equity loan is right for you.

Before signing for a home equity loan, such as a line of credit, carefully weigh the costs of a home equity debt against the benefits. If you are thinking of borrowing, your first step is to figure out how much it will cost you and whether you can afford it. Then shop around for the best terms, i.e., those that best meet your borrowing needs without posing undue financial risk. And, remember, failure to repay the line of credit could mean the loss of your home.

What Is a Home Equity Line Of Credit (HELOC)?

A home equity line of credit (also called a home equity plan) is a form of revolving credit in which your home serves as collateral. Because the home is likely to be a consumer's largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills--not for day-to-day expenses.

With a HELOC, you are approved for a specific amount of credit, which is referred to as your credit limit. A line of credit is the maximum amount you can borrow at any one time while you have the home equity plan.

Many lenders set the credit limit on a home equity line by taking a percentage (75% in this example) of the appraised value of the home and subtracting the balance owed on the existing mortgage. For example:

In determining your actual credit line, the lender will also consider your ability to repay by looking at your income, debts, and other financial obligations, as well as your credit history.

Home equity plans often set a fixed time during which you can borrow money, such as ten years. When this period is up, the plan may allow you to renew the credit line. But in a plan that does not allow renewals, you will not be able to borrow additional money once the time has expired. Some plans may call for payment in full of any outstanding balance. Others may permit you to repay over a fixed time.

Once approved for the home equity plan, you will usually be able to borrow up to your credit limit whenever you want. Typically, you will be able to draw on your line by using special checks.

Under some plans, borrowers can use a credit card or other means to borrow money and make purchases using the line. However, there may be limitations on how you use the line. Some plans may require you to borrow a minimum amount each time you draw on the line--for example, $300--and to keep a minimum amount outstanding. Some lenders also may require that you take an initial advance when you first set up the line.

What to Look For

If you decide to apply for a HELOC, look carefully at the credit agreement. Examine the terms and conditions of various plans, including the annual percentage rate (APR) and the costs you will pay to establish the plan.

Tip: The disclosed APR will not reflect the closing costs and other fees and charges, so compare these costs, as well as the APRs, among lenders.

Interest Rate Charges and Plan Features

Home equity plans typically involve variable interest rates rather than fixed rates. A variable rate must be based on a publicly available index (such as the prime rate published in some major daily newspapers or a U.S. Treasury bill rate). The interest rate will change, mirroring fluctuations in the index.

To figure the interest rate that you will pay, most lenders add a margin, such as 2 percentage points, to the index value.

Tip: Because the cost of borrowing is tied directly to the index rate, find out what index and margin each lender uses, how often the index changes, and how high it has risen in the past.

Sometimes lenders advertise a temporarily discounted rate for home equity lines-a rate that is unusually low and often lasts only for an introductory period, such as six months.

Variable rate plans secured by a dwelling must have a ceiling (or cap) on how high your interest rate can climb over the life of the plan. Some variable-rate plans limit how much your payment may increase, and also how low your interest rate may fall if interest rates drop.

Some lenders may permit you to convert a variable rate to a fixed interest rate during the life of the plan, or to convert all or a portion of your line to a fixed-term installment loan.

Agreements generally will permit the lender to freeze or reduce your credit line under certain circumstances. For example, some variable-rate plans may not allow you to get additional funds during any period the interest rate reaches the cap.

Costs of Obtaining a Home Equity Line

Many of the costs in setting up a home equity line of credit are similar to those you pay when you buy a home, such as:

• A fee for a property appraisal, which estimates the value of your home
• An application fee, which may not be refundable if you are turned down for credit
• Up-front charges, such as one or more points (one point equals one percent of the credit limit)
• Other closing costs, which include fees for attorneys, title search, mortgage preparation and filing, property and title insurance, as well as taxes
• Yearly membership or maintenance fees

You also may be charged a transaction fee every time you draw on the credit line.

You could find yourself paying hundreds of dollars to establish the plan. If you were to draw only a small amount against your credit line, those charges and closing costs would substantially increase the cost of the funds borrowed.

On the other hand, the lender's risk is lower than for other forms of credit because your home serves as collateral. Thus, annual percentage rates for home equity lines are generally lower than rates for other types of credit.

The interest you save could offset the initial costs of obtaining the line. In addition, some lenders may waive a portion or all of the closing costs.

How will You Repay Your Home Equity Plan

Before entering into a plan, consider how you will pay back any money you might borrow. Some plans set minimum payments that cover a portion of the principal of the amount you borrow plus accrued interest. But, unlike the typical installment loan, the portion that goes toward principal may not be enough to repay the debt by the end of the term. Other plans may allow payments of interest alone during the life of the plan, which means that you pay nothing toward the principal. If you borrow $10,000, you will owe that entire sum when the plan ends.

Regardless of the minimum payment required, you can pay more than the minimum and many lenders may give you a choice of payment options. Consumers often will choose to pay down the principal regularly as they do with other loans. For example, if you use your line to buy a boat, you may want to pay it off as you would a typical boat loan.

Whatever your payment arrangements during the life of the plan--whether you pay some, a little, or none of the principal amount of the loan--when the plan ends you may have to pay the entire balance owed all at once. You must be prepared to make this balloon payment by either refinancing it with the lender, obtaining a loan from another lender, or some other means. If you are unable to make the balloon payment, you could lose your home.

With a variable rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a plan that calls for interest-only payments. At a 10 percent interest rate, your initial payments would be $83 monthly. If the rate should rise over time to 15%, your payments will increase to $125 per month.

Even with payments that cover interest plus some portion of the principal, there could be a similar increase in your monthly payment, unless the agreement calls for keeping payments level throughout the plan.

When you sell your home, you probably will be required to pay off your home equity line in full. If you are likely to sell your house in the near future, consider whether it makes sense to pay the up-front costs of setting up an equity credit line. Also keep in mind that leasing your home may be prohibited under the terms of your home equity agreement.

Line Of Credit vs. Traditional Second Mortgage

If you are thinking about a home equity line of credit, you also might want to consider a more traditional second mortgage loan. This type of loan provides you with a fixed amount of money repayable over a fixed period. Usually, the payment schedule calls for equal payments that will pay off the entire loan within that time.

Tip: Consider a traditional second mortgage loan instead of a home equity line of credit if, for example, you need a set amount for a specific purpose, such as an addition to your home.

When deciding which type of loan best suits your needs, consider the costs under the two alternatives. Look at the APR and other charges.

Tip: Do not simply compare the APR for a traditional mortgage loan with the APR for a home equity line of credit because the APRs are figured differently. For a traditional mortgage the APR takes into account the interest rate charged plus points and other finance charges. The APR for a HELOC, on the other hand, is based on the periodic interest rate alone and does not include points or other charges.

How to Compare Costs

The 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. In general, neither the lender nor anyone else may charge a fee until after you have received this information. Use these disclosures to compare the costs of home equity loans.

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 has changed before the plan is opened (other than a variable-rate feature), the lender must return all fees if you decide not to enter into the plan because of the changed term.

Caution: When you open a home equity line of credit the transaction puts your home at risk. For your principal dwelling, the Truth in Lending Act gives you three 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 creditor in writing within the three-day period. The creditor must then cancel the security interest in your home and return all fees-including any application and appraisal fees-paid in opening the account.

The Finance Charge and the Annual Percentage Rate (APR)

Credit costs vary. By remembering two terms, you can compare credit prices from different sources. Under Truth in Lending, the creditor must tell you-in writing and before you sign any agreement-the finance charge and the annual percentage rate.

The finance charge is the total dollar amount you pay to use credit. It includes interest costs, and other costs, such as service charges and some credit-related insurance premiums. For example, borrowing $10,000 for a year might cost you $1,000 in interest. If there were also a service charge of $100, the finance charge would be $1,100.

The annual percentage rate (APR) is the percentage cost (or relative cost) of credit on a yearly basis. This is your key to comparing costs, regardless of the amount of credit or how long you have to repay it:

Example: You borrow $10,000 for one year at a 10% interest rate. If you keep the entire $10,000 for the whole year and then pay back 11,000 at the end of the year, the APR is 10%. On the other hand, if you repay the $10,000, and the interest (a total of $11,000) in 12 equal monthly installments, you don't really get to use $10,000 for the whole year. In fact, you get to use less and less of that $10,000 each month. In this case, the $1,000 charge for credit amounts to an APR of 18%.

All creditors including banks, stores, car dealers, credit card companies, and finance companies must state the cost of their credit in terms of the finance charge and the APR. Federal law does not set interest rates or other credit charges. But it does require their disclosure so that you can compare credit costs. The law says that these two pieces of information must be shown to you before you sign a credit contract or before you use a credit card.

Comparing Loan Terms

Even when you understand the terms a creditor is offering, it is easy to underestimate the difference in dollars that different terms can make. Consider the three credit arrangements below. Suppose you are going to borrow $6,000. How do these choices stack up? The answer depends partly on what you need.

The lowest cost loan is available from Lender A.

If you were looking for lower monthly payments, you could get them by paying the loan off over a longer period of time. However, you would have to pay more in total costs. A loan from Lender B-also at a 14% APR, but for four years-will add about $488 to your finance charge.

If that four-year loan were available only from Lender C, the APR of 15% would add another $145 or so to your finance charges as compared with Lender B.

Other terms, such as the size of the down payment, will also make a difference. Be sure to look at all the terms before you make your choice.

Special Considerations

A home equity line of credit is open-end credit, similar to bank and department store credit cards, gasoline company cards, and certain check overdraft accounts. Open-end credit can be used again and again, generally until you reach a certain prearranged borrowing limit. The Truth in Lending Act requires that open-end creditors tell you the terms of the credit plan so that you can shop and compare the costs involved.

When you are shopping for an open-end plan, the APR represents only the periodic rate that you will be charged, which is figured on a yearly basis. For instance, a creditor that charges 1-1/2 percent interest each month would quote you an APR of 18 percent. Annual membership fees, transaction charges, and points, for example, are listed separately and are not included in the APR. Be sure to keep all of these in mind when comparing all of the costs involved in the plans.

Creditors must tell you when finance charges begin on your account, so you know how much time you have to pay your bill before a finance charge is added. Creditors may give you a 25-day grace period, for example, to pay your balance in full before making you pay a finance charge.

Creditors also must tell you the method they use to figure the balance on which you pay a finance charge; the interest rate they charge is applied to this balance to come up with the finance charge. Creditors use a number of different methods to arrive at the balance. Study them carefully as they can significantly affect your finance charge.

• Adjusted balance method. Some creditors, for instance take the amount you owed at the beginning of the billing cycle, and subtract any payments you made during that cycle. Purchases are not counted. This practice is called the adjusted balance method.

• Previous balance method. With this method, creditors simply use the amount owed at the beginning of the billing cycle to come up with the finance charge.

• Average daily balance method. Under one of the most common methods, the average daily balance method, creditors add your balances for each day in the billing cycle and then divide that total by the number of days in the cycle. Payments made during the cycle are subtracted in arriving at the daily amounts, and, depending on the plan, new purchases may or may not be included. Under another method, the two-cycle average daily balance method, creditors use the average daily balances for two billing cycles to compute your finance charge. Again, payments will be taken into account in figuring the balances, but new purchases may or may not be included.

One final note: Be aware that the amount of the finance charge may vary considerably depending on the method used--even for the same pattern of purchases and payments.

If, like thousands of others, you are having trouble paying your debts, it is important to take action. Doing nothing can lead to much larger problems in the future-even bigger debts, such as the loss of assets such as your house, and a bad credit record. This Financial Guide suggests how you can help improve your relationships with creditors, reduce your debts, better manage your money and get a fresh start.

How can you tell when you have too much debt? What if bill collectors are not calling yet, but you are having difficulty paying monthly bills? If these problems seem familiar, you should take action.

• Have you run several credit cards up to the limit?
• Do you frequently make only the minimum monthly payments on your credit cards?
• Do you apply for almost any credit card you are offered-without checking out the terms?
• Have you used the cash advance feature from one card to pay the minimum payment on another?
• Do you use cash advances (or use a credit card) for living expenses such as food, rent, or utilities?
• Are you unaware of what your total debt is?
• Are you unaware of how long it would take you to pay off all your current debts (excluding mortgages and cars) at the rate you are paying?

If you find any of these statements apply to you, you may need to learn more about managing debt before you try to reestablish credit.

Getting Started

Here are some specific steps you can take if you are in financial trouble:

1. Review each debt Make sure that the debt creditors claim you owe is really what you owe and that the amount is correct. If you dispute a debt, first contact the creditor directly to resolve your questions. If you still have questions about the debt, contact your state or local consumer protection office or, in cases of serious creditor abuse, your state Attorney General.

2. Contact your creditors. Let your creditors know that you are having difficulty making your payments. Tell them why you are having trouble--perhaps it is because you recently lost your job or have unexpected medical bills. Try to work out an acceptable payment schedule with your creditors. Most are willing to work with you and will appreciate your honesty and forthrightness.

Tip: Most automobile financing agreements permit your creditor to repossess your car any time you are in default, with no advance notice. If your car is repossessed you may have to pay the full balance due on the loan, as well as towing and storage costs, to get it back. Do not wait until you are in default. Try to solve the problem with your creditor when you realize you will not be able to meet your payments. It may be better to sell the car yourself and pay off your debt than to incur the added costs of repossession.

3. Budget your expenses. Create a spending plan that allows you to reduce your debts. Itemize your necessary expenses (such as housing and health care) and optional expenses (such as entertainment and vacation travel). Stick to the plan.

Related Guide: For some guidance in this regard, please see the Financial Guide: BUDGETING: How To Prepare A Workable Plan.

Tip: Try self-budgeting before taking more extreme measures.

4. Try to reduce your expenses. Cut out any unnecessary spending such as eating out and purchasing expensive entertainment. Consider taking public transportation or using a car sharing service rather than owning a car. Clip coupons, purchase generic products at the supermarket and avoid impulse purchases. Above all, stop incurring new debt. Leave your credit cards at home. Pay for all purchases in cash or use a debit card instead of a credit card.

5.Pay down debts using savings. Withdrawing savings from low-interest accounts to settle high-rate loans or credit card debt usually makes sense.

Tip: Selling off a second car not only provides cash but also reduces insurance and other maintenance expenses.

6. Find out if you are eligible for social services. Government assistance includes unemployment compensation, Temporary Assistance for Needy Families (TANF) formerly Aid to Families with Dependent Children (AFDC), food stamps, now known as Supplemental Nutrition Assistance Program (SNAP), low-income energy assistance, Medicaid, and Social Security (including disability). Other resources may be available from churches and community groups.

7. Try to consolidate your debts. There are a number of ways to pay off high-interest loans, such as credit cards, by getting a refinancing or consolidation loan, such as a second mortgage.

Caution: Be wary of any loan consolidations or other refinancing that actually increase interest owed, or require payments of points or large fees.

Caution: Second mortgages greatly increase the risk that you may lose your home.

8. Prepare a financial plan. A financial plan can alleviate financial worries about the future and ensure that you will meet your financial goals-whether they relate to retirement, asset acquisition, education, or just vacations.

Related Guide: For guidance on how to begin the financial planning process, please see the Financial Guide: YOUR FINANCIAL PLAN: Getting Started On A Secure Future.

Credit Counseling Agencies

If you are unable to make satisfactory arrangements with your creditors, there are organizations to help you accomplish this. For instance, National Foundation for Consumer Credit (NFCC) member agencies provide education and counseling to families and individuals. For consumers who want individual help, counselors with professional backgrounds in money management and counseling are available to provide support.

To promote high standards, the NFCC has developed a certification program for these counselors known as Certified Consumer Credit Counselors (CCCS). A counselor will work with you to develop a budget to maintain your basic living expenses and outline options for addressing your total financial situation.

If creditors are pressing you, a CCCS counselor can also negotiate with these creditors to repay your debts through a financial management plan. Under this plan, creditors often agree to reduce payments or drop interest and finance charges and waive late fees and over-the-limit fees. After starting the plan, you will deposit money with CCCS each month to cover these new negotiated payment amounts. Then CCCS will distribute this money to your creditors to repay your debts.

With more than 1,100 locations nationwide, CCCS agencies are available to nearly all consumers. Supported mainly by contributions from community organizations, financial institutions, and merchants, CCCS provides services free or at a low cost to individuals seeking help. To contact a CCCS office for confidential help call 1 (800) 388-2227, 24 hours a day, for an office near you or visit their website: NFCC

Personal Bankruptcy

Bankruptcy is a legal proceeding that is intended to give people who cannot pay their bills a fresh start.

Tip: A decision to file for bankruptcy is a serious step, which should be taken only if it is the best way to deal with financial problems.

There are two types of bankruptcy available to most individuals:

• Chapter 13 bankruptcy allows debtors to keep property which they might otherwise lose, such as a mortgaged house or car. Reorganizations may allow debtors to pay off or cure a default over a period of three to five years, rather than surrender property.

• Chapter 7 or "straight bankruptcy" involves liquidation of all assets that are not exempt in your state. The exempt property may include items such as work-related tools and basic household furnishings, among others. Some of your property may be sold by a court-appointed official or turned over to your creditors. You can file for Chapter 7 only once every eight years.

Both types of bankruptcy may get rid of unsecured debts (those where creditors have no rights to specific property), and stop foreclosures, repossessions, garnishments, utility shutoffs, and debt collection activities. Both types also provide exemptions that permit most individual debtors to keep most of their assets, though these "exemption" amounts vary greatly from state to state.

Bankruptcy cannot clean up a bad credit record and will be part of this record for up to ten years. Thus, filing bankruptcy will make it more difficult to get a mortgage to buy a house. It usually does not wipe out child support, alimony, fines, taxes, and some student loan obligations. Also, under Chapter 13, unless you have an acceptable plan to catch up on your debt, bankruptcy usually does not permit you to keep property when the creditor has an unpaid mortgage or lien on it. Bankruptcy cases must be filed in federal court.

Tip: Be cautious when choosing a bankruptcy lawyer. Some of the less reputable lawyers make easy money by handling hundreds of bankruptcy cases without adequately considering individual needs and alternative solutions. Get recommendations from people you know and trust, and from employee assistance programs.

Related Guide: For information on making sure you pick the right lawyer, please see the Financial Guide:

Some public-funded legal services programs handle bankruptcy cases without charging attorney fees. Or these programs may provide referrals to private bankruptcy lawyers. Keep in mind that the fees of these attorneys may vary widely.

Scams And Pitfalls

Consumers with credit problems have paid millions of dollars to firms that claim they can remove negative information, clean up credit reports, and allow consumers to get credit no matter how bad the credit history.

These credit repair clinics charge consumers anywhere from $50 to $2,000, and often use questionable methods. Most clinics make misleading promises to consumers, and charge high fees for doing what you could do yourself--or simply take your money and do nothing at all.

Tip: Do not confuse the for-profit credit repair clinics discussed here with the non-profit Consumer Credit Counseling Services (CCCS) we discussed before.

Here are some common promises made by credit clinics and the reasons consumers should beware of such claims:

"Based on little-known loopholes in Federal credit laws, we can show you how to clean up your credit report!"

These "loopholes" are merely the provisions of the Fair Credit Reporting Act (FCRA), under which you have the right to challenge information in your credit report you believe incorrect. We discussed these provisions earlier in the section on "What To Do If You Have A Bad Credit Report." Credit repair clinics often flood credit bureaus with requests to check whether or not all negative data is correct. Credit clinics hope creditors will not be able to verify the information in a reasonable time period, causing the negative information to have to be dropped under the FCRA. Some credit clinics even tell consumers to challenge neutral information (e.g., name and address), hoping to distort file data so that the old, negative file will no longer be identifiable when a creditor asks for a consumer's file. Creditors and credit bureaus have become familiar with such tactics, and they have sought to use the provision of the FCRA that allows them to dismiss "frivolous" disputes of file information and to refuse to respond to repeated disputes of the same data.

"We can show you how to remove negative information from your file-including judgments."

Some clinics tell consumers to pay off any bills outstanding with the creditor in exchange for removal of negative information. Or, they may tell a consumer who has an account in collections to pay part of the balance with a check. The check is to carry a disclaimer saying that, by cashing the check, the creditor agrees to remove the account from collections and remove any negative information about the account from its files. Creditors are under no obligation to agree to such measures, and the fees paid to clinics for such advice is wasted.

"We can get you a major credit card-even if you've been through bankruptcy!"

What you are not told is that you will have to "secure" the card first. Most credit cards are unsecured; that is, you are not pledging any of your assets as collateral for any credit you may use. A card is secured when a consumer puts a deposit in the bank and gets a bankcard with a credit limit based on a percentage of that deposit. While a secured card can be an excellent tool for rebuilding credit, why should you pay the credit clinic just to provide an application and deposit slip?

Often for-profit or non-credential counseling organizations make promises that they cannot or do not keep. Be especially careful when asked for a large sum of money in advance.

Tip: Several states have enacted laws to protect consumers against the deceptive practices of many credit clinics. These state laws generally require credit clinics to inform consumers of their rights under the FCRA; be bonded (hold a type of insurance to protect consumers who may sue) if they accept payment in advance of services; accurately represent what they can and cannot do; and offer a cancellation period before any contract for services the consumer may sign takes effect. Check with your state attorney general's office to determine if there are any regulations for credit clinics in your state.

Tip: To check an organization's reputation, contact your state Attorney General, consumer protection agency, or Better Business Bureau.

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A Final Word: Don't lose hope, even if you despair of ever recovering financially. You can regain financial health if you act responsibly. The options presented here can put you on the road to financial recovery. Professional financial guidance can get you off to the right start.

Government and Non-Profit Agencies

The following agencies are responsible for enforcing federal laws that govern credit card transactions. Questions concerning a particular card issuer should be directed to the enforcement agency responsible for that issuer.

• State Member Banks of the Reserve System:

• National Banks:

• Federal Credit Unions:

• Non-Member Federally Insured Banks:

• Federally Insured Savings and Loans, and Federally Chartered State Banks:

• Other Credit Card Issuers (includes retail gasoline companies):

• The U.S. Postal Inspection Service:

This office covers mail fraud, sexually offensive materials, solicitations that look like government materials but are not. If you suspect such violations, contact your local Postmaster or Postal Inspector or:

Criminal Investigations Service Center
Attn: Mail Fraud
222 S. Riverside Plaza Ste 1250
Chicago Il 60606-6100
Tel. 877-876-2455

• The Federal Trade Commission:

• Direct Marketing Mail Opt-Out:

Consumers who do not wish to receive promotional mail at home

Direct Marketing Association
1120 Avenue of the Americas
NY, NY New York, NY 10036-6700
Tel. 212.768.7277
website: www.DMAChoice.org

• Low or No-Cost Credit Cards:

Bankrate.com lists banks charging no fees and low interest rates for credit cards. Visit the website: www.bankrate.com