Home Equity Lines of Credit (HELOCs) & Home Equity Loans

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 to each of these forms of credit, so it’s important to understand the pros and cons of each before proceeding.

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.

Because the loans are secured against the 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 far 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 the right to eventually take over your home if you fail to make payments. The more you borrow against your house or condo, the more you’re putting yourself at risk.

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, or CLTV, ratio. 

Let’s suppose you’re working with a bank that offers a maximum CLTV 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).

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.

Let's take a look at the differences between these two types of “second mortgages.”

Home Equity Loans

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

Home equity loans 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’re a revolving source of funds, much like a credit card, that you use as you see fit. 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 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 a later date without having to apply for a new loan. In that way, it’s a nice emergency source of funds, as long as your bank doesn’t require a minimum draw when you close the loan.

But HELOCs can get some borrowers into trouble. Regardless of your intentions when you open the credit line, it’s easy to spend the available funds on things you don’t need. And whatever you do use, of course, you have to pay back with interest.

Most home equity lines have two phases: During the draw period – typically 10 years – you can access your available credit as you see fit. Many HELOC contracts require small, interest-only payments during this period, though you may have the option to pay extra and have it go against 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. During the 20-year repayment period, you must repay all the money you’ve borrowed, plus interest at a variable rate. Some lenders give borrowers the option of converting a HELOC balance to a fixed interest rate loan at this point. 

Even so, the monthly payment can almost double. According to a study conducted by TransUnion, the payment on an $80,000 HELOC at 7% annual percentage rate will cost $467 a month during the first 10 years when only interest payments are required. That jumps to $719 a month when the repayment period kicks in.

That jump in payments at the onset of the new period has resulted in payment shock for many an unprepared HELOC borrower. If the sums are large enough, it can even cause those in financial straits to default. And if they default on the payments, they could lose their homes.

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’re rebuilding the equity in your home while simultaneously making it more livable.

You can also use the money to consolidate high-interest rate debt, including 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 or that new sports car you’ve been eyeing. Whether it’s worth eroding your equity in order to make discretionary purchases is something to which you’ll want to give some serious thought.

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 those loans, as long as you itemize deductions.

As of 2018, couples can deduct the interest on up to $750,000 of eligible “acquisition debt” (or up to $375,000, if you file separately). Those are the mortgages and home equity loans used to “buy, build or substantially improve” the home against which it was secured. 

Taxpayers used to be able to deduct interest on up to $100,000 of home equity loans that were used for other reasons, like paying down credit cards. But as of 2018, that’s no longer an option through the end of 2025, a change due to the tax legislation passed in Dec. 2017. 

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 the lender has a lien on your home, there’s a chance you could face foreclosure if you fall behind for a long enough period.

Second mortgages aren’t the only way to tap the equity in your home to 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 primary mortgage insurance, or PMI. That’s something you may not have to worry about if you simply have a second mortgage tacked onto your original loan. 

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.

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 can also use mortgage brokers, who essentially do the shopping for you and get paid by the lender.

First, never talk to only one lender. You need at least three options, and you might also need the help of a mortgage professional to help you compare the 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 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. 

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 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 steady employment history 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. 

To avoid some 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. 

Sometimes, even if you're granted a loan you can encounter financial problems later on that make it difficult to pay it back. Interestingly, while losing the 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 Springboard, 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. That’s because in order to foreclose, the lender has to pay your first mortgage off before auctioning the property. While a lawsuit may seem less scary then foreclosure proceedings, it can still hurt your credit. Not to mention, lenders can 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 those struggling to make payments. The important thing is 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: 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 may mean you pay more in the end, but the monthly payments will drop.)

The federal government has programs in place to help struggling borrowers with their first mortgage and their home equity debt. In order to take advantage of the government’s Second Lien Modification Program, you had to have modified your first mortgage under the Home Affordable Mortgage Program or HAMP. The Second Lien Modification Program, in conjunction with HAMP, enables borrowers to lower the payments on the home equity line of credit. HUD publishes helpful information on these and other programs.

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. Of late, the number of thieves fraudulently acquiring these accounts and siphoning out thousands of dollars by stealing identities and fooling lenders has increased.

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. Identity-theft experts have found that victims learn about the crime only when the financial institution calls them about the late payment, they receive written notification of a late payment, or a marshal shows up at their home to evict them.

While they often prey on people who have already taken out HELOCs, anyone with equity in their home can 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, check your HELOC statements regularly and examine your credit reports for any inaccurate information.

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

But 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. So use home equity debt wisely, if you conclude it's the best option for you.