Ask Liz Weston

Dear Liz: Are banks still lowering the amount of available credit? I’m concerned because we were hoping to use our home equity line of credit to pay for our children’s college educations, if need be.

Our current balance is less than 5% of the total available limit, but my credit reports show our credit line lender recently reviewed our credit history. I am concerned that our bank will lower our available credit as my son is about to start college. Are my concerns valid?

Answer: Perhaps. Lenders have been reducing home equity lines of credit as home values drop. If your mortgage balance and your line of credit total more than 60% of the current value of your home, you may be at risk of having your limit reduced right when you planned to use it.

If that’s the case and your son is heading off to school in the next year, it might be prudent to withdraw the money now and keep it in a savings account.

If college won’t start for several years, though, you might want to explore other options, since it’s generally not a good idea to borrow money so far in advance of when you’ll need it.

Fortunately, you have plenty of options when it comes to paying for college. Just make sure you fill out a Free Application for Federal Student Aid. Even if you don’t qualify for need-based aid, filling out the FAFSA will allow you to apply for federal student loans. Your son can get Stafford loans at a 6.8% fixed rate and you could get PLUS loans with a fixed rate ranging from 7.9% to 8.5%. Although the amount of student loans your son can get is generally limited to $31,000 for an undergraduate degree, PLUS loans allow you to borrow whatever you need to cover any costs not paid for by the student’s financial aid package.

Dear Liz: I’m in a potentially bad situation with my home equity line of credit. I’m trying to refinance my primary mortgage and would save nearly $150 a month. But the HELOC lender is dragging its feet on agreeing to a subordination. If the lender doesn’t agree, I lose the deal. I’m wondering why the lender does not believe it to be in its interest to help when I am trying to improve my financial situation. Can you give me some insight into the line of thinking here?

Answer: Unfortunately, many would-be refinancers are in your uncomfortable position. They have a second mortgage, such as a home equity line of credit, on their property. These loans are known as “seconds” because the lender is in second position to be paid off when the home is sold, after the primary lender has been paid.

For a refinance to proceed, these HELOC lenders have to agree once again to be subordinated into second position. Some lenders balk because they don’t believe their borrowers have sufficient equity to cover both loans (even though, as you note, a lower payment on the first mortgage could make it more likely that the borrower could make payments on the second).

But a bigger problem seems to be lack of staff and lack of priority. Lenders are so busy trying to meet the demand for refinancing that other concerns, including subordination, often fall to the bottom of their to-do list.

That means you have to be extremely vigilant if you don’t want your refinance deal to fall apart. Call your new lender and your HELOC lender every few days to track the progress of your subordination. If there are problems or missing paperwork, promptly address those issues.

If your rate lock is within two to three weeks of expiring and your subordination still hasn’t been approved, call your HELOC lender and politely ask that your request be given top priority.

If you can’t get through to the subordination department’s main line, ask the phone reps if there is a fax number or e-mail address you can use. If all else fails, take your problem to the bank’s chief executive. You’ll find the name and address online.

Dear Liz: My wife and I maintain a largely untapped home equity line of credit as a source of emergency funds in the event of a job loss, medical needs, etc. With so many financial institutions seemingly on the verge of bankruptcy, what happens to our ability to draw on our line of credit should the bank go under?

Answer: Your line of credit is one of the bank’s assets. If your bank fails, the bank that takes over would add your loan to its books.

That said, the new bank may have different standards for how much of your equity you can borrow and may cut back or freeze your line of credit. That could happen even if your bank doesn’t fail, since many lenders are reducing their risk exposure by cutting back on lines of credit, particularly in areas where home prices are falling rapidly.

You’re probably safe, for now, if the balance you owe on your mortgage plus your home equity credit limit total less than 60% of your home’s current value. If your “loan-to-value” exceeds that limit, however, you would be smart to look for alternative sources of emergency funds. The best: cash in the bank.

If you missed the low rates a few months ago, get your refi application in now. Last week’s Fed announcement that it would buy even more mortgage-backed securities promptly drove rates on 30-year fixed-rate loans below 5%. (For current rates from major lenders, click HERE.)

That’s great news for folks who still have good credit, a job and some equity in their properties.

If you’re struggling, though, you may find help via a new government Web site that explains the new Making Home Affordable programs.

You’ll find simple quizzes to help you decide if you may be eligible for Home Affordable Refinancing (which can help those who have too little equity to qualify for regular refinancing) or Home Affordable Modification, which can help you keep your home if your payments are too high.

You’ll also find links to HUD-approved housing counselors, checklists to help you get organized and resources to consult for more help.

You may also want to read:

• Refi’ing with a HELOC? Bird-dog your lenders
• When to walk away from a mortgage
• Facing foreclosure? 9 options

Suze Orman has told her fans to stop paying down their credit card debt, no matter how expensive, and instead put the extra money toward building up their emergency funds.

Steve Rhodes, founder of GetOutOfDebt.org, recently echoed that advice (hat tip to CreditMattersBlog.com).

A Wall Street Journal columnist recently suggested borrowing against credit cards and using the cash to boost your emergency fund.

I know a few folks–homeowners and business owners–who tapped big lines of credit and stuffed the money into savings. They’re now patting themselves on the back for their foresight, even though carrying the debt is costing them hundreds of dollars a month.

Has the world gone mad? Not quite, when you consider:

• Most American households don’t have enough liquid savings to cover a typical stretch of unemployment, which in this recession is creeping toward 12 weeks (3 months).
• Half of households told MetLife pollsters that they were one month (or two paychecks) away from not being able to meet their financial obligations. More than a quarter–28%–would fall behind after missing a single paycheck.
• In the past, many would have turned to their credit cards or home equity lines of credit to pay their bills, but lenders are slashing access to that credit. Bankers are freezing or lowering limits on home equity lines of credit across the board, and one banking analyst has predicted that card card issuers will cut total limits by more than half in coming months.

Still, carrying expensive credit card debt–or adding more to your pile if you don’t absolutely need to–is a risky proposition, to say the least. You’re paying unnecessary interest, courting damage to your credit scores and putting yourself further at risk of the whims of your lenders, which can jack up your rates or change your terms at any time.

Furthermore, you need to be suspicious of any “one size fits all” advice, because everybody’s financial situation is unique.

The key in knowing what to do know is to gauge your total financial flexibility–your ability to pay your bills and cope with setbacks based on your available resources.

Here’s what I recommend:

Take stock of your own situation. See how much unused credit you have on cards and your home equity line. Check your FICOs. Get an idea of how much your home is worth and what the sales trend is–flat, declining, sharply declining. Figure out how much money you’d need to survive for at least three months and compare that against your cash stash and your access to credit.

Gauge your risk. If you don’t have much equity and home prices in your area are plummeting, you’re at high risk of having your HELOC frozen or the limit lowered. If your credit scores aren’t good to excellent (FICOs of 720 or above), or you’re using more than 50% of your available credit card limit, you’re at greater risk of having your limits cut and not being able to fight back by persuading the lender to rescind its decision or transferring your balances elsewhere. If you have only a few cards or lines of credit, you’re more vulnerable than if you have several accounts at different lenders. As I said last week and in my MSN column yesterday, diversifying our credit has become as important as diversifying our investments.

Make a plan. If your credit scores are great, you have tons of accessible home equity and there’s plenty of space on your credit cards, your financial flexibility is high–which means you needn’t panic and change your debt-repayment plan. Otherwise:

• If things are a little tighter, you might consider opening an escape hatch or two: another credit card if you can resist the urge to run up more debt, or a line of credit at your bank.
• If you have accounts that have already been frozen–the lender’s told you that you can no longer draw on the account–paying the minimums and stashing your cash may make sense, since you won’t free up any additional credit by paying the debt down.
  
• If you have a HELOC that’s at risk and you planned on tapping it in the next year–for college tuition, say, or to finish a remodeling job–get the money now.
  
• If you’re already on the edge, you have little financial flexiblity and a layoff would push you over, then by all means, conserve cash now. Pay the minimums on your debt. Think about the expenses you’d cut if you lost your job, and trim them immediately so you can put the extra cash into savings.
• If you’re really in deep, now may be the time to consider consulting a bankruptcy attorney–who can give you truly individualized advice, rather than generalizations that can turn around and chomp you on the butt.

Dear Liz: We have about $800 extra each month after paying bills, but we aren’t sure we’re doing the right thing with it. Should we pay down our adjustable-rate, maxed-out home equity line of credit? Or do we put it toward our savings, which has only $5,000 right now?
Answer: Before doing either, make sure you’re saving adequately for retirement. You may be tempted to cut back in this uncertain market, but the costs of retirement are so great that you need to start saving early and not stop if you want to have a sufficient nest egg. Your human resources department at work probably has tools to help you.
If you’re convinced you’re on track there and you don’t have any credit card debt, the next step normally would be paying down that home equity line. In today’s environment, however, you might find your lender lowering your limit as soon as you start to reduce your balance. Rather than freeing up credit that you could use again in an emergency, paying down your HELOC may actually reduce your overall financial flexibility.
This might not be an issue if you have tons of equity. If your current mortgage balance and your line of credit total less than 60% of your home’s current value, you may not need to worry about your lender reducing your credit limit.
If your loans total more than 60%, however, or if housing values are falling fast in your area, consider instead building up your savings.

Dear Liz: The balance of my mortgage and the limit on my home equity line of credit totaled 80% of my home’s value a year ago. Since then, the home’s value has dropped at least 30%. Can the bank reduce my equity line? If so, by how much? I have high credit scores.

Answer: Yes, your lender typically can reduce your line of credit when your home’s value falls. Since the drop-off in price has been so steep and your “loan to value” was already fairly high, you’re definitely at risk of having the limit reduced. “Loan to value” means the mortgage balance plus the limits on any other home equity loans or lines of credit as a percentage of the home’s current worth. Most lenders these days are wary if loan-to-value exceeds 80%. Some have trimmed limits when loan-to-value ratios exceed 60%.

If you were planning on tapping your line of credit in the near future, do it now while the money is still available. If your line of credit does get trimmed, you could shop around to see whether other lenders would give you more credit, but expect to have some trouble finding one these days that is willing to take a chance.