A Guide To Home Equity Loans and HELOCs

For most homeowners, their home is their biggest source of savings; most of their wealth is locked inside the value of their home. That equity, the portion of your house that you own outright (home price minus mortgage equals equity), can serve as collateral for loans that let you tap into it. 

There are two main ways to get cash for your home equity while you still live there: a home equity loan (HEL) and a home equity line of credit (HELOC). People often use the terms interchangeably, but they aren’t the same. These two debts come with very different features, but have one very important thing in common: If you don’t pay them back on time, you can lose your home.

Equity Loan Basics

A home equity loan or HELOC uses the equity in your home as collateral – the difference between the value of your home and the balance of your mortgage. Because home equity loans are secured by the equity value of your home, they offer very competitive interest rates-often close to first mortgage rates. The financing fees for the same loan amount will be lower than those for unsecured borrowing such as credit cards.

Using your house as collateral, however, comes with a downside. The home equity lender places a second mortgage lien on your home, giving them a claim to your home along with the first mortgage lien if you fail to make payments. Borrowing against your condo or house puts you at greater risk.

Equity Loan Eligibility

Like other home loans, banks underwrite second mortgages. According to their guidelines, each of them can lend a certain amount based on the value of your property and your creditworthiness. Loan-to-value (CLTV) is expressed as a percentage.

If your home is worth $300,000, and your bank offers a maximum CLTV ratio of 80%, let’s say you’re looking at a loan with a minimum CLTV ratio of 65%. You may qualify to borrow an additional $90,00 in the form of a home equity loan or HELOC if you currently owe $150,000 on your first mortgage ($300,000 x 0.80 = $240,000 – $150,000 = $90,00).

If you are considering a mortgage, your eligibility and interest rate are determined by your employment history, income, and credit score. As your credit score increases, your default risk reduces, and your rate decreases.

Home Equity Loan Basics

HELs are nonrevolving, secured loans. You borrow a specific amount of money one time, using your home equity as collateral. These work just like mortgage loans because they are; in fact, your HEL counts as a second mortgage (the first mortgage is the one you used to buy the property). 

While you can use the proceeds from a HEL any way you want, these loans work best when you’re using them to make home improvements that will increase your home’s value. Otherwise, they’ll be more like personal loans that come with losing your house as a consequence of default.

HELs act like mini-mortgages. You borrow a fixed amount in a single lump sum and pay that back over time with interest. HELs normally come with fixed interest rates, so your monthly payment won’t change over time. Your rate will depend on your credit score and on the lender you choose. 

HELs can be a good choice when you need to make major home repairs or renovations. If you use the money to “substantially improve” your home, you may be able to deduct some or all of your HEL interest on your income tax return. Qualifying expenditures include things like:

  • Putting on a new roof
  • Building an addition
  • Resurfacing your driveway
  • Fully remodeling your kitchen

Keep in mind that the improvements have to be made on the home that’s tied to the loan.

Equity Changes

Two key factors come into play when you’re calculating your home equity: your mortgage balance and the value of your property. Your mortgage balance is easy to figure out; you can find it on your statement or simply ask your lender. 

Home value is a little trickier. It does not equal the amount you paid for your house. Rather, it’s based on the current market value of your home—the amount you could sell it for today. You can get a rough estimate of that by looking at comparable for-sale properties in your neighborhood online.

Subtract your mortgage balance (including any other home equity loans you have) from your estimated home value to get your approximate current equity. Lenders may let you borrow a total of up to 85 percent of your home value (depending on your credit history). 

For example, if your house is currently worth $400,000 and you owe $200,000 on your mortgage, you could borrow up to $140,000 more against your home equity (85 percent of $400,000 = $340,000 – $200,000 = $140,000). The catch: If property values decline, you could end up owing more than you could sell your house for, putting you in a precarious financial position.

HELOCs

HELOCs are revolving loans. They work more like credit cards than mortgages, but your house is still on the line. These flexible lines of credit allow you to borrow money as necessary, up to your limit. 

You can borrow small amounts over time rather than a big lump sum all at once, giving you both more flexibility and control than you’d have with a regular home equity loan. HELOCs usually have twenty-five-year terms, split into two distinct parts: the draw period and the repayment period. 

During the draw period, which usually lasts five to ten years, you can borrow money whenever you want up to your limit. You only have to make interest payments in this period, but you can pay down the balance if you want to; then, you’ll be able to re-borrow that money. When the draw period ends, you’ll switch to the repayment period. 

Some HELOCs come fully due as soon as the draw periods end, but most amortize the final balance over fifteen or twenty years. 

These loans usually come with variable (adjustable) interest rates, though some are fixed and some come with an option to convert to a fixed rate. Those variable rates normally start lower than fixed rates do (similar to adjustable-rate mortgages), then increase as they adjust. 

You’ll only be charged interest on the amount you borrow, not the whole HELOC, and that interest does compound (meaning you can pay interest on interest). Like HELs, if you use these funds to substantially improve the home the loan is tied to, the interest you pay may be tax-deductible.

The Phases of HELOCs

When you get your HELOC, the lender will give you a line of credit, a total amount available for you to borrow; it works similarly to the limit on your credit card. HELOCs can feel like giant change jars, money that’s just sitting there waiting to be spent. 

If you don’t carefully plan and budget how you will use this money, you can easily fall into an overspending trap that leaves you with a large debt that’s secured by your home. Don’t use your HELOC to cover everyday expenses—this is not the loan to get if you’re having trouble making ends meet. If you’re unable to make the payments, the lender will foreclose on your house.

Many HELOCs also offer interest-only payments during the draw period, which can leave you with an unexpectedly large loan balance when it’s done, especially if you’ve been using the HELOC like a credit card. 

Once the draw period is up, payments get calculated as they would for any other amortizing loan for most HELOCs. In some cases, though, your HELOC balance could be due in a lump sum as soon as the draw period ends. Make sure you fully understand your repayment terms before you sign the loan documents.

In addition to their many features, HELOCs also offer many advantages over conventional credit lines. Due to the interest-only payments in the draw period, repayments in the repayment period can almost double. With a 7% APR on an $80,000 HELOC, payments during the first 10 years would cost around $470 per month. When the repayment period begins, that amount rises to $720 per month.

Many unprepared HELOC borrowers experience payment shock at the start of the new repayment period. The amount can even cause those with financial hardship to default if it is large enough. Losing your home is possible if you fail to make payments.

Why Take Out a Second Mortgage?

A home equity loan or HELOC can be used for many different purposes. Financially speaking, one of the best ways to use the funds is for renovations and remodeling projects that will increase the value of your home. Increasing your home’s equity in this way can make it more livable while increasing its equity.

In addition to paying off other high-interest rate debt, the money can also be used to pay off other debt. Paying off credit cards with high interest rates could be a good use of this. A secured, low-cost form of credit effectively replaces a high-interest loan.

Additionally, you can borrow money for an overseas vacation, a new sports car, or maybe even your child’s education. Eroding equity is something you’ll have to think about carefully and whether it’s worth it to you.

Equity Loan Tax Deductions

Another advantage of borrowing against equity is that you can renovate your home more easily. You can write off some of the interest on a home equity credit if you itemize your deductions, according to the Internal Revenue Service (IRS).

There was no restriction on deducting interest on up to $1 million of mortgage debt before the Tax Cuts and Jobs Act (TCJA) of 2017. As part of the TCJA, new restrictions and limits were instituted through the end of 2025.

In 2020, couples will be able to deduct up to $750,000 in eligible mortgage debt (or up to $375,000 if you file separately) if the debt is used to pay for the home. A first mortgage, a second mortgage, a home equity loan, and a home equity line of credit can be deducted if the debt was used to purchase, build, or substantially improve the home against which it was secured.

Home Equity and HELOC Pros and Cons

Each new loan, no matter how high or low the property value is, strains your budget. Losing your job, for example, will make it harder to make your payments on time. If you fall behind for a long enough period, a new lender has a greater chance of foreclosing on your home.

Pros

  • Low cost compared to many other types of loans
  • The ability to borrow large amounts of money
  • Use of the funds for the home could result in tax breaks
  • Home equity loans with fixed interest rates are safe

Cons

  • If you use your home as collateral, you reduce its value
  • In a down market, those with high combined loan-to-value (CLTV) ratios have a higher risk of going underwater with their loans

Home Equity Loans vs. Refinancing

The equity in your home can be accessed in other ways than a second mortgage. The other option is to do a cash-out refinance, in which you replace your original mortgage with a new loan. Whenever your new loan exceeds the balance of your previous loan, you pocket the difference. A HELOC or home equity loan can be used by homeowners to make improvements to their properties or consolidate their credit card debt.

There are certain advantages to refinancing over a second mortgage. Generally, the interest rate on a primary mortgage is lower than on a home equity loan, so if rates are down overall, your primary mortgage should reflect that.

Disadvantages of refinancing

There are also disadvantages to refinancing. Closing costs tend to be higher for a new first mortgage than for a HELOC, which has lower upfront costs. When refinancing, you may also be required to pay private mortgage insurance (PMI) if you have less than 20% equity in your home. In most cases, PMI can be canceled when the borrower has 20% equity in the home.

If you want to better understand which loan option is best for you, have your loan officer run the numbers for each one.

Getting a Loan

Lenders differ significantly in their loan options and fees, so it pays to shop around. You can also reach out to savings and loans, credit unions, and mortgage companies in addition to traditional banks. Mortgage brokers, who work on behalf of the lender and are paid by them, may also be useful.

Don’t rely on one lender only. Many borrowers like to obtain quotes from at least three lenders. A mortgage specialist can assist with comparing offers. Get better rates or special promotions at your bank if you have multiple accounts with them.

If you need a large amount, you’ll need to look for a traditional lender — a bank or mortgage company. Small community banks and credit unions are usually the best option for loans under $100,000. Mortgage brokers and local and national banks are good choices for larger loans ($150,000 or more).

Due to their relationships with multiple lenders and investment pools, mortgage brokers can usually offer the best rates on home equity loans. In the $100,000 to $150,000 range, “you just have to shop around,” says Casey Fleming, mortgage broker and author of The Loan Guide: How to Get the Best Mortgage.

Beware of low teaser rates. Get the lender to send you the documentation showing the interest rate and closing costs for your specific loan. Fees associated with home equity loans are usually steep, typically between 2% and 5% of the loan amount.

Make sure to carefully read all loan documents before signing on the dotted line to avoid heartache later. If you make a mistake, you do have recourse if you act quickly. The federal government requires you to give the lender written notice within three days of canceling either a home equity loan or a HELOC. By midnight of the third day (excluding Sundays), the notice has to be mailed or electronically filed.

Negotiating Fees

There are a lot of fees a lender might try to charge that aren’t set in stone. The origination fee, which covers the commission paid to the loan officer or broker, is one example of where lenders are willing to bend. You may also be able to haggle if you need to pay points on your loan. Just ask. 

The interest rate on your HELOC may be fixed through several options available to you from your lender. Typically, the longer the fixed rate period, the higher the interest rate. However, you also have a lower risk if rates go up, so choose the terms that are right for you. 

Your credit score and steady employment history are most likely to earn you the best terms. Before applying for a mortgage, you should make sure your credit reports are free of errors. Keeping this information secure may also be achieved by employing a credit monitoring service.

When You Can’t Repay Your Loan

You may have difficulty repaying a loan even if you’re granted one. Losing your home is a possibility if you can’t repay your line of credit or home equity loan, but it isn’t foreordained. You will still face serious financial consequences even if you are able to save your home.

Help from the mortgage lender

In general, lenders will work with people struggling to make payments on home equity loans or lines of credit since they don’t want you to default. If you are having trouble making payments, contact your lender immediately. Avoid ignoring the problem at all costs. If you ignored their calls or letters offering assistance for months, lenders may not be so willing to work with you.

In terms of what the lender can do, there are a few options. Lenders may offer certain borrowers a home equity loan or line of credit modification. To make paying off the loan more manageable, adjustments can be made to the terms, the interest rate, or the monthly payments. You may pay more in the end if you extend the loan’s term, although the monthly payments will be lower.

Government help due to COVID-19

As a result of the ongoing Coronavirus outbreak, you may be able to afford your mortgage. Over $46 billion has been provided to the US Treasury Emergency Rental Assistance (ERA) program by the Consolidated Appropriations Act of 2021. As part of ERA2, the program’s expansion, these funds are still being distributed to those in need under the America Rescue Plan.

On its website, the National Low Income Housing Coalition provides a searchable list of all the programs it offers.11 A few states have implemented their own moratoriums. Become familiar with your options by consulting the Treasury’s list of rent relief programs for your state.

The federal government has also encouraged all lenders to help prevent foreclosures by modifying mortgages and taking other relief measures. Find out if your mortgage loan qualifies for the moratorium program by contacting your mortgage service provider.

Don’t Fall Victim To Fraud

Due to the fewer documents needed for a HELOC compared with a regular mortgage, and the longer period during which you can borrow money, criminals can, unfortunately, use them to rob people. Through the theft of identities and deception of lenders, thieves could fraudulently acquire these accounts and siphon thousands of dollars out of them.

The process is as follows. Criminals use public records to gather personal information. To get funds, the scammers create a HELOC internet account and manipulate the customer account verification process. In some cases, they may hack into existing accounts.

In most cases, victims become aware of identity theft only when the financial institution calls them about the late payment, they receive written notification of late payment, or a marshal shows up to evict them from their home.

Homeowners with good credit and seniors who have paid off their mortgages are most likely to become victims, since lenders easily approve their applications. Be sure to watch your Bank of America HELOC statements closely and check your credit reports for incorrect information to reduce your risk.

Final Words

Having access to extra cash may become a necessity at some point in your life. Second mortgages can be a compelling option. You may be able to get a lower rate for this type of loan since it’s secured by your home equity.

You should, however, factor into your monthly budget the extra loan payment that comes with a home equity loan or HELOC. The bank also places a second lien on the property, so if you can’t make the payments, your home could be repossessed.

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