Home Equity Loans and Lines of Credit

If you’ve ever asked yourself "What the heck’s a HELOC," then you’ve come to the right place.

There are two types of home equity borrowing: home equity lines of credit and home equity loans.

- A HELOC, or Home Equity Line of Credit, is the right to borrow money from a lender up to a certain amount of money. The "line" is a credit line guaranteed by your house, meaning that if you can’t live up to the terms of the line, then the lender has a right (after a few nasty letters) to foreclose on your house. Typically HELOCs (pronounced HEE-lock) have floating interest rates that can change periodically.

For example, a borrower might obtain a $75,000 HELOC at "prime plus one." This means that the interest rate is one percentage point higher than the Prime Rate. If Prime is 5.5%, then the HELOC is 6.5%. Remember: The rate is tied to the Prime and could change as much as at every billing date. (The change can be dramatic; e.g., in June of 2006, the Prime was 8 percent, whereas in June of 2003, it was 4.25 percent.)

Who should get one: Someone who might need extra cash for home improvements, or is looking at borrowing money to buy a different house (in addition to a mortgage).

Who shouldn’t: Do not use a HELOC to splurge for things like vacations or to finance other consumer debts, like credit card purchases (unless you then plan to tear those cards up!). HELOCs are guaranteed by your house, which means the stakes are very high.

- Home Equity Loans are when a lender gives you a set amount of money and you pay it back over a fixed payment schedule. Typically these loans have fixed interest rates. This is a better option for someone who wants to lock in a fixed interest rate, either because they think interest rates are going to increase or because they like the certainty of knowing what their payment schedule will be.

A home equity loan also is a better option than a home equity line if you know exactly how much money you need to borrow and when you want to borrow it.

How to get one: You can get a home equity loan or line either from a mortgage broker or from a bank directly. These loans are also called "second mortgages" because they are typically obtained after the home has been purchased with a first mortgage loan.

Taxes and Interest

Are HELOCs tax deductible? Sort of. Like first mortgage interest payments, home-equity borrowing differs from credit card debt in that you can deduct the interest on your tax return. But this only applies if you itemize your deductions. Also, the tax deduction on interest is limited to loan amounts up to $100,000, with some restrictions.

What determines the interest rate? The Loan to Value and your credit score determine the interest rate of a home equity loan or line. If your credit score is excellent (760+), you may be able to get an interest rate at the prime lending rate, or possibly lower. A good credit score (700-760) will likely get you an interest rate that is about the same as the prime rate. Poor credit will likely result in rates of 1-5 points higher than the prime rate. Except in some cases, you should be able to avoid fees such as application or appraisal fees, though you might get hit with an annual fee or a small "recording” fee.

The Good News

Home equity lines can be used by the borrower to pay for anything. You literally get a checkbook for the HELOC and you can write checks to your heart's content until you've maxed out the line's limit. Although HELOCs were originally designed for homeowners to pay for home improvements and other house-related projects, nowadays borrowers use home equity lines for almost anything. Most HELOCs also have online Internet access so you can pay bills online using your HELOC just like you would with a regular online checking account.

HELOCs and home equity loans can also be used as second mortgages at the time of purchase. Frequently they are the second purchase mortgage for 10, 15, or 20 percent of the purchase price when buying a home. Home buyers can avoid buying mortgage insurance (PMI) if they take out two loans instead of one, with no single loan exceeding 80 percent of the purchase price. HELOCs can fill this gap, wherein the first mortgage is frequently 80 percent of the purchase price and the HELOC is the second mortgage.

Like a credit card balance, you can pay down a HELOC at any time, without penalties.

The Not-So-Good-News

Home equity lines are serious stuff, since they’re secured by your house. If you can’t meet the payment obligations such as your minimum monthly balance, your homeownership is in jeopardy.

Real Life Example

Bonnie is buying a $300,000 home and has $30,000 saved for her down payment. She needs to borrow the remaining $270,000. She works with a mortgage broker to take out a first mortgage for 80 percent of the purchase price ($240,000) and a Home Equity Loan for 10 percent ($30,000). The terms of the home equity loan are fixed at 6 percent. On closing, she ends up with a $30,000 home equity loan, in addition to her $240,000 mortgage. She may pay a slightly higher interest rate on the Home Equity Loan than on her first mortgage, but that interest is tax deductible, whereas the Private Mortgage Insurance premiums she would have had to pay with a mortgage greater than 80 percent would not have been.

Real Life Example

Harriet wants to remodel her kitchen because she loves to cook. Also, she has heard that a modern kitchen will help her resale value when she sells the house. (She has used the My Esimator tool on Zillow, and knows that in her area kitchen remodels are good investments.)

Harriet goes to her local bank where she has a checking and savings account and gets a HELOC. The bank orders an appraisal to see if the house value justifies the HELOC. It will also check to see how much equity Harriet has in the house. Her house appraises for $400,000 and she has a mortgage with $50,000 remaining on it, so the bank knows there is $350,000 of equity there – plenty to support a $25,000 home equity line of credit.

Harriet uses the $25,000 line to buy a new refrigerator and oven, and to pay the contractor who does her remodel.