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The New, More Responsible Home-Equity Line of Credit

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As housing prices continue to creep upward, high-end homeowners looking for something bigger and better may find it cheaper to renovate than to relocate. For them, a home-equity line of credit is an option.

With a home-equity line of credit, or Heloc, lenders make available a certain amount over a set period, with the home as collateral. Then, homeowners can dip in to borrow and pay off the balance multiple times over the time period. Helocs typically have an adjustable rate, which averaged 5.30% on Jan. 16, according to HSH.com, a mortgage-information website.

This differs from a home-equity loan, in which a homeowner borrows a lump sum, usually at a fixed rate, which averaged 6.20% on Jan. 16. Some lenders, such as Bank of America, however, have eliminated loans and only offer lines mostly because of lack of interest by borrowers, says David Steckel, Bank of America's home-loans product executive.

Before the recession that started in 2008, many equity borrowers used Helocs to consolidate other high-interest debt, such as credit-card bills. Now home improvement and one-time large expenses, such as college tuition, are more popular uses, with borrowers tending to be higher income with strong credit profiles, says Brendan Coughlin, who heads the consumer lending business for Dedham, Mass.-based Citizens Bank.

"We're seeing consumers using home equity again, but much more responsibly," he adds. Citizens Bank's home equity line origination volume has been rising by about 25% to 30% annually for the past two years.

Qualification rules, however, are tighter than they were in '08, Mr. Coughlin says. The industry standard for equity-line lending is up to 85% of a home's loan-to-value ratio, meaning the total amount of the equity line plus the outstanding balance of the primary mortgage can't exceed 85% of the home's appraised value, he adds. A few lenders, including some credit unions, are beginning to allow higher LTVs up to 90% or 95%.

Citizens requires a minimum 640 credit score, but most equity borrowers have a loan-to-value ratio of 60% to 65% and a score in the mid to high 700s, Mr. Coughlin says.

Home-equity lines typically have adjustable interest rates pegged to the short-term rate set by the Federal Reserve. Therefore, they rose when the Fed increased the rate by a quarter point to 3.50% in December. This differs from mortgage interest rates, which are priced off 10-year Treasury-note yields and don't rise as steeply when short-term rates are increased.

With the Fed widely expected to raise short-term rates a few more times in 2016, equity lines might seem less attractive to borrowers who could still get a 30-year, fixed-rate jumbo mortgage at an average of 3.86% on the week ending Jan. 29, according to HSH.com. However, consumer attraction to home-equity lending has less to do with interest-rate comparisons than with the smaller size, shorter term and flexibility of these products.

Another positive indicator for home-equity borrowing is a predicted upswing in home-remodeling activity. Annual spending growth for home improvements is expected to increase from 4.3% in the first quarter of 2016 to 7.6% in the third quarter, meaning total annual spending will surpass the previous peak in 2006, according to a Leading Indicator of Remodeling Activity report released Jan. 21 by the Joint Center for Housing Studies of Harvard University.

"Upper-income households are more likely to undertake home improvements in general," says Kermit Baker, project director of Harvard's Remodeling Futures Program. As long-term interest rates and home purchase prices increase, people also may prefer to remodel their current home instead of swapping out for a more expensive one with a higher interest rate, he adds.

Here are some other points when considering a home-equity line of credit:

Shop around for best rate. Some lenders offer rates that are lower than Fed short-term rates. And on some products, borrowers have the option of locking a rate if they fear that rates will rise, Mr. Steckel says.

Few or no fees. While some lenders charge no closing costs, others have origination fees or annual maintenance fees for equity lines.

Tax deductible. Don't forget that interest on up to $100,000 of a home-equity loan can be deducted on your tax return.