Home Equity Loans
By: Kirk Haverkamp
Updated and reviewed: May 17, 2013
If you’re a homeowner in need of money, and have accumulated equity in your property, you may be able to convert this equity into cash. People choose to draw on their home equity because loan rates are significantly lower than other types of borrowing, like personal loans or credit cards. There are also tax advantages associated with home equity loans, because the interest may be tax deductible within certain limitations. Another reason that home equity loans are appealing is that closing costs are relatively low.
Home equity loans are also known as second mortgages because they are subordinate to your primary mortgage. If you can’t afford to make your mortgage payments and subsequently default, the first mortgage gets paid off first from any proceeds of a sale. As a result, there is much more risk for lenders who give you a home equity loan.
Understanding the different types
There are two types of second mortgages: the home equity loan, which is also known as a HEL, and the home equity line of credit, which is also called a HELOC.
A home equity loan is a fixed-rate loan, where the lender will give you a lump sum of money, and you pay it back during a specified period of time. Payments are higher than they would be with a HELOC, because each month, you’re paying interest and principal. They are most appropriate if you’re borrowing for a project where you know exactly how much money you’ll need, and you like the consistency of a steady monthly payment. One great advantage of a HEL over a HELOC is that you will continue to build equity in your home each month as you pay the loan back.
A HELOC offers much more flexibility than its second mortgage counterpart. A lender will give you a line of credit, which you can draw from on an as-needed basis. It functions a lot like a credit card, except that the interest rate is lower. HELOCs have a variable interest rate that is tied to an index, like the prime rate or the LIBOR, and will change every month. You’ll be allowed to take money out during the draw period, which is generally about 10 years. Most banks allow you to pay interest only during the draw period. However, if you choose that path and don’t pay down your principal, it will continue to accumulate. At the end of the draw period, you’ll be required to pay back any remaining principal either as a lump sum, or on an amortized basis, and will no longer be able to withdraw any additional funds.
There are some major drawbacks with HELOCs. One is that if you make payments of only interest, you’re not building any home equity. The second is that, because the interest rate is variable, you have no idea how to budget for the HELOC expense.
How much can you borrow?
Most banks will allow you to borrow up to 80 percent of the available home equity in your property. To calculate that amount, determine the current value of your home. Your next step is to subtract the value of your current mortgage. Divide the number by 80%, and bingo … you now have the maximum amount of home equity that you may be qualified to borrow against.
Advantages and disadvantages of home equity loans
Both home equity loans and HELs offer several advantages when compared to other types of borrowing. First, the application process is much quicker than with a traditional loan. Some banks may even approve you on the spot if you don’t want to borrow too much and you have a good credit report.
Second, home equity loans can be amortized for up to 30 years, which can make your monthly payments much easier to manage. Third, interest is generally tax-deductible, and interest rates are lower than with other comparable borrowing opportunities. Finally, if you have a large amount of equity accumulated in your home, you have access to a significant sum of cash.
So far, everything sounds good. But there are many risks associated with home equity loans. The biggest drawback is that if you can’t make your payments, a bank could foreclose on your property. If you make late payments, you may be hit with hefty fees. Banks will report your tardiness to the credit reporting agencies, and your credit rating could take a big hit. And even though mortgage rates for home equity loans are lower than credit card rates, they will be significantly higher than rates for traditional mortgages.
Another risk that’s associated with HELOCs is that when the rate adjusts, you may not be prepared for the higher payments. Say, for example, that you borrow against your line of credit to send your child to college when interest rates are low – in the 4 to 5 percent range. Then you find yourself in an environment where interest rates are rising, and you’re now paying 7 to 8 percent interest. If you’re not prepared, you could find it difficult to make the higher monthly payment.
Finding the best home equity loan
Shopping for a HEL or a HELOC is just like shopping for any other item – you need to speak to a variety of different sellers to see who’s offering the best rates and the lowest costs for your needs. Don’t forget to check with the bank where you have your first mortgage or any other banking relationship, because many banks give discounts to established customers. Some will extend the discount to you if you open a checking or savings account at the time of your home equity loan application. Also, don’t neglect checking with your local credit union. They may waive costs for members, and some offer slightly lower rates than traditional banks.
Tips for getting the best home equity loan you can qualify for.
- Pay off debts before applying. This will raise your FICO credit score. A higher score can get you a lower rate.
- Don’t borrow more than you need, even if you qualify for more. The more you borrow on a home equity loan, the more interest you’ll pay. With a HELOC, you may be tempted to draw more money than you really need, just because it’s available.
- Don’t say yes to the first offer. Even if you think the rate and terms are amazing, it pays to shop around with other lenders. You can also use your first offer as leverage to see if another bank will meet or even beat it.
- Know what you’re getting into. Take the time to upgrade your mortgage vocabulary. You’ll be a lot better off if you understand terms like spread, LIBOR, amortization, floor, and ceiling when you talk to prospective lenders.
- Get it in writing. Lenders may quote you rates over the phone, but unless it’s written down, it’s no guarantee. Once you submit your application, the lender will send you a quote that contains all the terms of your loan. Read it carefully, to confirm that it’s exactly what you applied for.
- Understand the differences between a Home Equity Loan and a HELOC. For example, home equity loans are usually fixed-rate, while HELOCs are usually adjustable-rate loans. That can make a big difference when it comes time to start paying them back.
- Avoid prepayment penalties. Paying down your mortgage ahead of schedule can save you money, as long as you don’t get hit with prepayment charges. Whenever possible, try to get a loan with no prepayment penalty so you won’t get hit with extra charges if you pay if off early.
- Know your terms. This is particularly important with a HELOC, since the terms will dictate how your rate varies over time. Make sure you know which index your rate is tied to, what the margin is and how frequently the rate will adjust. Most important, know your “life cap” – the maximum your interest rate can increase over the life of the loan.
Home equity loans offer tax advantages – but if you don’t fully understand how they work, you can get in big trouble with the IRS.
The most important thing to know is that, according to IRS rules, there are two types of mortgage debt – home acquisition and home equity. Your home equity loan can fall into either category, depending on what you do with the money. When you use it for home-related expenses, like buying, renovating, or constructing a residence, you can call it home acquisition debt. When you use the money for any other purpose, it’s home equity debt.
You’re allowed to deduct mortgage interest on up to $1 million of home acquisition debt, but only up to $100,000 of home equity debt. But it’s not all that straightforward – there are additional limitations. First, you’re not allowed to deduct interest on home equity debt that exceeds the market value of the home. Second, once you hit $1 million in home acquisition debt, the rest will count as home equity debt. Third, if you and your spouse file separate tax returns, both limits are halved. Finally, all these limits apply to the total mortgage debt, regardless of how many homes or mortgages you own.
Even if you clearly understand these rules, it’s a good idea to check with your tax advisor or professional tax preparer. The Tax Code is complicated, and making a simple error on your home equity deduction could activate a red flag for an audit on your entire return.
During the mortgage crisis, many people decided to stop paying their mortgages. Defaulting on your home equity loan can have far-reaching consequences, and it’s ill advised. If you fall behind on your payments, or skip them, your lender could take action. The first step it may take is to give you additional time to find money for the missed payments. But if the lateness continues, you will leave no choice for the bank but to take legal action.
It may be a modicum of good news for you that the second lien holder is not able to foreclose on the property without paying off the first mortgage holder. However, if you have accumulated substantial home equity, the lender could sell your property, and pay off both loans with the proceeds of the sale. It’s more likely, however, that there wouldn’t be enough equity if you find yourself in this predicament, so your lender has two other choices: work with you on a forbearance plan, or negotiate a settlement.
A forbearance plan is a temporary reduction of your monthly payments. If you’re undergoing a short-term challenge, this may be the best choice. However, your interest will generally accrue during this entire period and, once the forbearance period is over, you may be required to make larger payments to make up the difference.
If your problems are greater than a short-term reduction would solve, your lender may offer to take a lump sum to close out your loan. This is called a settlement offer. This may be the best possible outcome for a homeowner who wants to keep his house, but can’t afford the second lien payments. No matter what happens, though, your credit score will take a huge hit, and it may be some time before you can get any type of mortgage again.
Home Equity Loan Fraud
Leading up to the mortgage crisis, home equity loan fraud was rampant. Some fraudulent lenders were charging excessive fees at closing. Others were offering multiple refinances to the same borrower. Still others would ask you to sign over your deed to them if you were struggling to make payments, and then evict you from your home once you did. Thanks to aggressive government crackdowns, these schemes are no longer active.
The Federal Housing Administration (FHA) has enacted several rules and regulations that make the homeowner less vulnerable to home equity loan fraud. They now require that the borrower must receive specific information on interest rates and fees. As a result, it’s less likely that a lender can take advantage of an uneducated borrower. The FHA also has a list of fees that the lender may not charge a borrower. If your lender tries to tack these on to the loan, you can file a complaint directly with the FHA.
Unfortunately, identity fraud thieves have discovered a whole slew of possible targets in the home equity loan arena. If a criminal is able to get his hands on vital personal information, like your Social Security number, birth date, and/or passwords to your bank accounts, he can do severe damage. Once a thief has this information, he can set up telephonic banking privileges on your account, then transfer money from your HELOC into his own personal bank account. Once that happens, the criminal – and the money – disappears forever.
Most people will never encounter home equity loan fraud, but if you choose to tap your equity with a HEL or a HELOC, it’s better to be safe than sorry.
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