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New Consumer Strategy to Prevent Freezing of Credit Lines

[Nov 4, 2008.]


Home equity lines of credit are looking very attractive to many consumers who still have access to them. With the prime rate recently being lowered to 4%, there aren't many options less expensive.

Consumers who treat the available credit on a home equity line of credit as an emergency fund or those who have plans to use that money to finance a large purchase in the near future should be concerned about a recent trend by banks -- the reduction of unused credit lines or the freezing of home equity lines of credit.

Banks are looking to minimize their losses at a time when property values continue to fall. Many equity lines of credit were obtained a time where the property may have been worth more than it is today, resulting in a riskier loan for the bank.

New Strategy

According to a recent NYtimes.com article:

But a new countermeasure is emerging: take out the money before the bank puts it out of reach. In this strategy, borrowers draw the maximum amount even if they don’t need it, then place the cash in a liquid, and safe, investment vehicle.

“I categorize this as liquidity protection,” said Oded Ben-Ami, a senior loan officer with the Sterling National Mortgage Company, based in Great Neck, N.Y.

Mr. Ben-Ami said he had suggested to mortgage clients that they consider drawing down the maximum amount possible from their home equity credit lines.

The Cost

Drawing the full amount of a home equity line of credit does come with a cost. If you borrow $100,000 on a line of credit with a rate of Prime + 0% (currently 4%), it would cost you $4,000 per year to keep that money assuming the rate remained the same.

Note: It is best to consult with a tax advisor with regards to the tax deductibility of the interest paid on a home equity line of credit. In some cases, the true cost of borrowing the money may be lower than the interest rate being charged.

If that money is placed in an interest-bearing account until needed, some or all of that cost may be offset by the interest earnings.

Risks Involved

If the value of the home drops and the money from the equity line of credit has been spent, the homeowner may find themselves in a position where they owe more on their home than it is worth.

Also, while rates on home equity lines of credit are currently low, they will at some point begin to climb, making the underlying payment more expensive.

Borrowing against your home equity line of credit can also have a negative impact on your credit score by increasing your credit utilization ratio. The more you borrow against what you have available, the lower your score will go.

Finally, if a lump sum is drawn and put somewhere accessible, a borrower may be tempted to access that money for reasons that were not intended or beneficial.

Each individual borrower needs to determine the importance of having access to the unused portion of their equity line of credit and what that is worth to them. If they trust themselves to be responsible with the money and feel the cost is justified, this may be a strategy they want to explore to ensure they do not lose access to the available equity in their home.


About Author:

Chris Rocks is the Regional Director of the National Credit Federation (NCF), a consumer advocacy group that assists small business owners and consumers overcome debt and credit challenges.

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