Table of Contents
- What should I do if a friend or family member asks me to cosign a loan?
- How can I get the best deal on a home equity loan or an equity line of credit?
- What are the costs of obtaining a home equity line of credit?
- Should I obtain a home equity line of credit or a traditional second mortgage loan?
- How should I determine which of several loan alternatives is best?
Many people agree to co-sign loans for friends or relatives, as a favor, as a vote of confidence, or because they just can’t say no. Unfortunately, their act of kindness often backfires because according to many finance companies most cosigners end up paying off the loans they’ve cosigned–along with late charges, legal fees and all. Not only is this an unwanted out-of-pocket expense, but it can also affect the cosigner’s credit record.
While a lender will generally seek repayment from the debtor first, it can go after the cosigner at any time. When you agree to cosign a loan for a friend or family member, you are also responsible for its repayment along with the borrower.
Guaranteeing a loan is a better option than to cosign one in that where a loan is guaranteed, the lender can usually go after the guarantor only after the principal debtor has actually defaulted.
However, if you’ve decided you’re willing to cosign a loan, at the very least you should seek the lender’s agreement to refrain collecting from you until the borrower actually defaults, and try to limit your liability to the unpaid principal at the time of default. You should also plan on staying apprised of the borrower’s financial situation to prevent him or her from defaulting on the loan. An example of this might be having the lender notify you whenever a payment is late.
Cosigning an Account. You may be asked to cosign an account to allow someone else to obtain a loan. With cosigning, your payment history and assets are used to qualify the cosigner for the loan.
Tip: Cosigning a loan, whether for a family member, friend, or employee, is not recommended. Many have found out the hard way that cosigning a loan only leads to trouble.
It bears repeating that cosigning a loan is no different than taking out the loan yourself. When you cosign, you are signing a contract that makes you legally and financially responsible for the entire debt. If the other cosigner does not pay, or makes late payments, it will probably show up on your credit record. If the person for whom you cosigned does not pay the loan, the collection company will be entitled to try to collect from you.
If the cosigned loan is reported on your credit report, another lender will view the cosigned account as if it were your own debt. Further, if the information is correct, it will remain on your credit report for up to seven years.
Tip: If someone asks you to cosign a loan, suggest other alternatives such as a secured credit card by which they can build a credit history. If you are asked to cosign for someone whose income is not high enough to qualify for a loan, you are actually doing them a favor by refusing because they will be less likely to be overwhelmed by too much debt. If you’re still considering cosigning a loan, then you might want to consult an attorney before taking any action to find out what your liability is, if in fact the other person does default.
Tip: If you have already cosigned for someone, and he or she is not making payments on time, consider making the payments yourself and asking the cosigner to pay you directly, in order to protect your credit rating.
If you decide to apply for a home equity loan, look for the plan that best meets your particular needs. Look carefully at the credit agreement and examine the terms and conditions of various plans, including the annual percentage rate (APR) and the costs you’ll 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 Rates. 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 loans-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.
Some lenders 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 permit the lender to freeze or reduce your credit line under certain circumstances, such as during any period the interest rate reaches the cap.
Many of the costs in setting up a home equity line of credit are similar to those you pay when you buy a home.
For example, these fees may be charged:
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.
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. 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 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 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 because the APRs are figured differently. The APR for a traditional mortgage takes into account the interest rate charged plus points and other finance charges. The APR for a home equity line is based on the periodic interest rate alone. It does not include points or other charges.
Use the legally-required disclosures of loan terms to compare the costs of home equity loans.
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 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 has changed before the plan is opened (other than a variable-rate feature), the lender must return all fees if you decide not enter into the plan because of the changed term.
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 $100 for a year might cost you $10 in interest. If there were also a service charge of $1, the finance charge would be $11.
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 $100 for one year and pay a finance charge of $10. If you can keep the entire $100 for the whole year and then pay back $110 at the end of the year, you are paying an APR of 10 percent. But, if you repay the $100 and finance charge (a total of $110) in twelve equal monthly installments, you don’t really get to use $100 for the whole year. In fact, you get to use less and less of that $100 each month. In this case, the $10 charge for credit amounts to an APR of 18 percent.
All creditors-banks, stores, car dealers, credit card companies, 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–before you sign a credit contract or use a credit card–so you can compare costs.