Home Equity Loans and Home Equity Lines of Credit—HELOC

One of the biggest perks of home ownership is the ability to build equity over time. You can use that equity to secure low-cost funds in the form of a “second mortgage”—either a one-time loan or a home equity line of credit (HELOC).

There are advantages and disadvantages with each of these forms of credit, so it’s important to understand their pros and cons before proceeding. You may also have other options as well.

Equity Loan Basics

Home equity loans and HELOCs both use the equity in your home—that is, the difference between your home’s value and your mortgage balance—as collateral. Since the loans are secured against the equity value of your home, home equity loans offer extremely competitive interest rates—usually close to those of first mortgages. Compared to unsecured borrowing sources, like credit cards, you’ll be paying less in financing fees for the same loan amount.

But there’s a downside to using your home as collateral. Home equity lenders place a second lien on your home, giving them rights to your home along with the first mortgage lien if you fail to make payments. The more you borrow against your house or condo, the more you’re putting yourself at risk.

Equity Loan Eligibility

Banks underwrite second mortgages much like other home loans. They each have guidelines that dictate how much they can lend based on the value of your property and your creditworthiness. This is expressed in a combined loan-to-value (CLTV) ratio.

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

Like other mortgages, your eligibility for a loan and interest rate depend on your employment history, income, and credit score. The higher your score, the lower the risk you pose of defaulting on your loan and the lower your rate.

Home Equity Loans

A home equity loan comes as a lump sum of cash. It’s an option if you need the money for a one-time expense, like a wedding or a kitchen renovation. These loans usually offer fixed rates, so you know precisely what your monthly payments will be when you take one out.

Home equity loans usually aren’t the answer if you only need a small infusion of cash. While some lenders will extend loans for $10,000, many won’t give you one for less than $25,000. What’s more, you have to pay many of the same closing costs associated with a first mortgage, such as loan-processing fees, origination fees, appraisal fees, and recording fees.

Lenders may require you to pay “points”—that is, pre-paid interest—at closing time. Each point is equal to 1% of the loan value. So on a $100,000 loan, one point would cost you $1,000.

Points lower your interest rate, which might actually help you in the long run. But if you’re thinking about paying off the loan early, that upfront interest doesn’t exactly work in your favor. If you think that might be the case, you can often negotiate for fewer, or even no, points with your lender.

HELOCs

Home equity lines of credit are a bit different. They are a revolving source of funds, much like a credit card, that you can access as you choose. Most banks offer a number of different ways to access those funds, whether it’s through an online transfer, writing a check, or using a credit card connected to your account. Unlike home equity loans, they tend to have few, if any, closing costs, and they usually feature variable interest rates—though some lenders offer fixed rates for a certain number of years. 

There are pros and cons to the flexibility that credit lines offer. You can borrow against your credit line at any time, but untapped funds do not charge interest. In that way, it’s a nice emergency source of funds (as long as your bank doesn’t require any minimum withdrawals).

Especially now—if you’ve lost your job because of the Coronavirus, need cash, and have equity in your home—taking out a HELOC may be a good option. Many banks are still offering them, though Wells Fargo and JPMorgan Chase were two frontrunners, announcing application freezes for new HELOCs in May 2020. (The freezes don’t affect those who already have HELOCs.) 

The Phases of HELOCs

Most home equity credit lines have two phases. First, a draw period, often 10 years, during which you can access your available credit as you choose. Typically HELOC contracts only require small, interest-only payments during the draw period, though you may have the option to pay extra and have it go toward the principal. 

After the draw period ends, you can sometimes ask for an extension. Otherwise, the loan enters the repayment phase. From here on out, you can no longer access additional funds and you make regular principal-plus-interest payments until the balance disappears. Most lenders have a 20-year repayment period after a 10-year draw period. During the repayment period, you must repay all the money you’ve borrowed, plus interest at a contracted rate. Some lenders may offer borrowers different types of repayment options for the repayment period. 

HELOCs have many attributes that make them different than a standard credit line and also offer advantages. However, the interest-only payments in the draw period mean payments in the repayment period can almost double. For example, payments on an $80,000 HELOC with a 7% annual percentage rate would cost around $470 a month during the first 10 years when only interest payments are required. That jumps to around $720 a month when the repayment period kicks in.

The jump in payments at the onset of the new repayment period can result in payment shock for many unprepared HELOC borrowers. If the sums are large enough, it can even cause those with financial hardships to default. And if you default on the payments, you could lose your home.

Why Take Out a Second Mortgage?

Homeowners can use their home equity loan or HELOC for a wide range of purposes. From a financial planning standpoint, one of the best things you can do with the funds is to use them for renovations and remodeling projects that increase the value of your home. This way, you may increase available equity in your home while simultaneously making it more livable.

You can also use the money to pay off other high-interest rate debt in an alternative type of debt consolidation. This could be especially helpful for paying off high rate credit card balances. You’re effectively replacing a high-cost loan with a secured, low-cost form of credit.

Of course, you can also borrow to fund an overseas vacation, a new sports car, or possibly your child’s education. Whether it’s worth eroding your equity for is up to you, and is something to which you’ll want to give some serious thought.

Equity Loan Tax Deductions

There’s another advantage to tapping your equity if it’s for home-renovation projects. The IRS lets you write off some of the interest on home equity credit, as long as you itemize deductions.

Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers were able to deduct interest on up to $1 million of mortgage debt, and there were no restrictions on the usage for deductions. The TCJA instituted new limits and restrictions, which run through the end of 2025.

As of 2020, couples can deduct the interest on up to $750,000 of eligible mortgage debt (or up to $375,000 if you file separately) if the debt is used on the home. The deductions can be applied for first mortgages, second mortgages, home equity loans, and home equity lines of credit, if the debt is used to “buy, build, or substantially improve” the home against which it was secured. 

Home Equity and HELOC Pros and Cons

Even if property values stay flat or rise, every new loan stretches your budget. If you lose your job, for example, it’ll be harder to keep current on your payments. Because a new lender has another lien on your home, there’s a higher chance you could face foreclosure if you fall behind for a long enough period.

Home Equity Loans vs. Refinancing

Second mortgages aren’t the only way to tap the equity in your home and get some extra cash. You can also do what’s known as a cash-out refinance, where you take out a new loan to replace the original mortgage.

When your new loan is bigger than the balance on your previous one, you pocket the extra money. As with a home equity loan or HELOC, homeowners can use those funds to make improvements to their property or consolidate credit card debt.

Refinancing does have certain advantages over a second mortgage. The interest rate is generally a bit lower than that of home equity loans. And if rates have dropped overall, you’ll want your primary mortgage to reflect that.

But refis have drawbacks too. You’re taking out a new first mortgage, so closing costs tend to be a lot higher than HELOCs, which typically don’t have steep upfront fees. And if refinancing means you have less than 20% equity in your home, you may also have to pay private mortgage insurance or PMI. PMI can usually be canceled when a borrower reaches 20% home equity, though most homeowners choose to keep it. Overall, it doesn’t hurt to have your loan officer run the numbers for each option, so you can better understand which one is best for your situation.

Getting a Loan

Loan options and fees vary significantly from one lender to the next, so it pays to shop around. In addition to traditional banks, you can also reach out to savings and loans, credit unions, and mortgage companies. You may also want to use a mortgage broker, who essentially does the shopping for you and gets paid by the lender.

In general, don’t just talk to one lender. Most borrowers like to get approximately three quotes. This is where a mortgage professional can help in comparing offers. If you already have multiple accounts at a bank, ask about better rates or special promotions for existing customers.

Shopping for a loan from a traditional lender—a bank or mortgage company—depends on the amount you’re seeking. Generally, for loans under $100,000, a small community bank or credit union will offer the best deal. For larger loans ($150,000 or more), talk to local and national banks along with mortgage brokers. As with traditional mortgages, mortgage brokers can often offer the best deals on home equity loans because of their relationships with multiple lenders and investment pools. For “in-between” loans of $100,000 to $150,000, “you just have to shop,” says Casey Fleming, mortgage broker and author of The Loan Guide: How to Get the Best Possible Mortgage.

Don’t be fooled by low teaser rates. Have the lender send the documentation that shows the interest rate and closing costs for your specific loan. With home equity loans, upfront fees can be steep, usually anywhere from 2% to 5% of your loan amount. 

Negotiating Fees

Many of the fees a lender tries to charge aren’t set in stone. Some lenders, for example, are willing to bend on loan-origination fees, which cover the commission paid to the loan officer or broker. If they require you to pay points on your loan, they may be willing to haggle on that too. But you have to ask. 

Lenders may offer several options when it comes to locking in a fixed interest rate on your HELOC. The longer the period of time in which you get a fixed rate, the higher the interest rate they usually charge. But there’s also less risk on your part if rates go up. So think carefully about which terms work best for you. 

In general, you’ll get the best terms if you have a history of steady employment and an excellent credit score. As with any mortgage application, it’s a good idea to check your credit reports ahead of time and make sure they’re free of errors. 

Backing Out of a Loan

To avoid serious heartache later on, be sure to look over all the loan documents carefully before signing on the dotted line.

You do have some recourse if you realize you’ve made a mistake, as long as you act quickly. There’s a federally mandated three-day cancellation rule that applies to both home equity loans and HELOCs. But you have to notify the lender in writing. That notice has to be mailed or filed electronically by midnight of the third day (not including Sundays) or it’s void. 

When You Can’t Pay Back Your Loan

Sometimes, even if you’re granted a loan you can encounter financial problems later on that make it difficult to pay it back. While losing your home is a risk if you can’t pay back your home equity loan or line of credit, it isn’t a foregone conclusion. However, even if you can avoid losing your home you will face serious financial consequences.

According to credit.org, a U.S. Department of Housing and Urban Development (HUD)-approved counselor, lenders typically pursue a standard lawsuit to get the money rather than going straight to foreclosure. The reason is mainly because, to foreclose the lender has to pay your first mortgage off before auctioning the property. While a lawsuit may seem less scary than foreclosure proceedings, it can still hurt your credit. Not to mention, lenders may be allowed to garnish wages, try to repossess other property, or levy your bank accounts to get what is owed.

Most mortgage lenders and banks don’t want you to default on your home equity loan or line of credit, so they will work with those struggling to make payments. It’s important to contact your lender as soon as possible. The last thing you should do is avoid the problem. Lenders may not be so willing to work with you if you have ignored their calls and letters offering help for months.

When it comes to what the lender can actually do, there are a few options. Some lenders will offer certain borrowers a modification of their home equity loan or line of credit. Modifications can include adjustments to the terms, the interest rate, the monthly payments, or some combination of the three, to make paying off the loan more affordable. (Note that extending the term of the loan will lower the monthly payments, but it may mean you pay more in the end.)

There is some protection if you are struggling due to the Coronavirus pandemic and your mortgage is backed by the government. Government mortgage loans have a moratorium on foreclosures and evictions that is in place until December 31, 2020. The government has also encouraged all loan servicers to help prevent foreclosures via mortgage modifications and other relief options.

Beware of Fraud

Because the documents checked for obtaining a HELOC are fewer than for a regular mortgage—and because there’s an extended period in which you can borrow funds—criminals can, unfortunately, use HELOCs to rob you. Thieves may be able to fraudulently acquire these accounts and siphon out thousands of dollars by stealing identities and fooling lenders.

Here’s how it happens. Criminals get hold of your personal information through public records. Next, they establish a HELOC internet account and manipulate the customer account verification process in order to get funds, which of course they never repay. Some thieves may also hack into existing accounts. Identity-theft experts have found that victims learn about the crimes only when the financial institution calls them about the late payment, they receive written notification of late payment, or a marshal shows up at their home to evict them.

Anyone with equity in their home could become a victim, especially homeowners with good credit and seniors citizens who’ve paid off their mortgages (because lenders often readily approve their applications). To reduce your risk, watch your HELOC statements closely and follow your credit reports for any inaccurate information.

The Bottom Line

There may come a time in your life when access to extra cash becomes a necessity. If so, a second mortgage is a compelling option. Because they’re secured against the equity value of your home, lenders are willing to offer rates that are lower than for most other types of loans.

Just because you can use your home as an ATM doesn’t mean you should. An extra loan means an extra loan payment each month. And if you find yourself unable to hit your due dates, you’re putting your home in jeopardy. Use home equity debt wisely, if you conclude it’s the best option for you.