What is a 'Home Equity Line Of Credit - HELOC'

A home equity line of credit (HELOC) is a line of credit extended to a homeowner that uses the borrower's home as collateral. Borrowers are pre-approved for a certain spending limit, based on household income and credit score, and may draw on this limit at their discretion. Interest is charged at a predetermined variable rate, which is usually based on prevailing prime rates.

Once there is a balance owing on the loan, the homeowner can choose the repayment schedule, as long as minimum interest payments are made monthly. The term of a HELOC can last anywhere from less than five to more than 20 years, at the end of which the entire remaining balance must be paid in full.

You only pay interest on what you actually borrow and there are no closing costs. You may borrow up to $100,000 (($50,000 if you are married filing separately) and deduct the interest from your income taxes.

BREAKING DOWN 'Home Equity Line Of Credit - HELOC'

 

HELOCs Are Hot Again

When real estate values were surging in the 2000s, it was common for people to borrow against the equity in their residences. That slackened with the bursting of the housing bubble in 2007. But now, many regions of the United States, home values are continuing to rebound, swelling the home equity available to homeowners. In 2015, they drew $156 billion from home equity lines of credit (HELOC), which was the largest dollar amount since the Great Recession. The average HELOC established was a record $119,790.

How Much Can You Borrow?

The loan-to-value ratio for most secondary loans like HELOCs is usually set at 80%, although this can be higher in some instances for those who qualify.  LTV is calculated by dividing the remaining loan balance of a mortgage by the present market value of the residence. Suppose you are five years into a 30-year mortgage plan on your home. A recent appraisal places the value of your house at $250,000, and you still have $195,000 left on the original $200,000 note. If there are no other debts registered with the house, you have $55,000 in home equity. Your LTV is 78%.

Basically this means you can borrow up to 80% of the appraised value of your home, minus the amount you still need to pay on your primary mortgage.  Of course, the actual amount that is granted depends on the borrower’s financial condition and credit score. There are even some loans that can exceed 100% of the LTV ratio, but most financial planners caution borrowers against this form of loan, as they come with a high possibility of foreclosure, and any interest on a balance that exceeds the home's value cannot be tax-deductible.

Lenders are required to disclose how interest is calculated, the consequences of non-repayment, the terms and interest rate charged by the loan and other pertinent details such as the borrower’s right of rescission.

How HELOCs Work

As a form of revolving credit, a home-equity line of credit works much like a credit card and, in fact, sometimes comes with one. Borrowers can withdraw money when they need it via this credit card or special checks.

HELOCs are often considered a type of home-equity loan. However, a home-equity loan works like a conventional fixed-rate mortgage. You borrow a set amount at a set interest rate and make equal payments for the entire loan term, which can last anywhere from five to 30 years. In contrast, a HELOC’s loan term has two parts: a draw period and a repayment period. The draw period, during which you can withdraw funds, might last 10 years and the repayment period might last another 20 years, making the HELOC a 30-year loan. Once the draw period ends, you cannot borrow more money.

During the HELOC’s draw period, you do have to make payments, but they tend to be small, often amounting to paying back just the interest. During the repayment period, payments become substantially higher, because you now are paying back principal. 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 – the collateral for the loan, remember.

If You Can't Pay It Back

While losing the home is a risk if you can’t pay back your home equity line of credit, it isn’t a foregone conclusion. 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.

Don’t Wait to Get Help

Most mortgage lenders and banks don’t want you to default on your home equity 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 line of credit: the terms, the interest rate, the monthly payments or some combination of the three to make the HELOC more affordable.

The federal government has programs in place to help struggling borrowers with their first mortgage and their home equity lines of credit. 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. Homeowners who are underwater on both their mortgage and their HELOC, which means they owe more than the home is worth, may qualify for the Federal Housing Administration’s Short Refinance Program. Through that program, the outstanding debt is aligned more closely with the current value of the house.

Why Use a Home Equity Line of Credit?

Because the interest they charge is tax-deductible, HELOCs are an attractive way to pay off other loans. HELOC rates are only slightly higher than first mortgage rates (around 4.07% in 2016) making them much lower than those on unsecured debt or other personal debt.

In particular, a HELOC is a good choice if you aren’t sure how exactly much you’ll need to borrow or when. Generally, the line of credit gives you ongoing access to cash for a set period (sometimes up to 10 years). You can borrow against your line, repay it all or in part, and then borrow that money again later, as long as you’re still in the HELOC's introductory period. This can be a convenient way to cover short-term recurring costs, such as the quarterly tuition for a four-year degree at a college.

Renovation projects are popular too: In fact, one of the most common reasons people take out a home equity line of credit is to pay for home improvements like a new bathroom or upgrades to the kitchen. With both easily costing tens of thousands of dollars to complete, HELOCs offer financing that doesn't incur the double-digit interest rates of credit cards. And the interest you pay is also fully deductible if the money is used on a residence. Tapping equity in the home to improve the home seems appropriate, especially since the revamps are going to boost the property's value. But do determine if the return on investment of your project is in the 70% to 80% range first.

You may want to go back to college or further fund your a private enterprise to increase your income. If the HELOC provides a better rate than a student loan or small business loan and it doesn’t over-leverage you, then it's a good option to consider.

When Not to Use a Home Equity Line of Credit

Whatever the rationale for a HELOC, bear in mind that, like any line of credit, it is revocable. If your financial situation worsens or your home’s market value declines, your lender could decide to lower your credit line or close it altogether. So while the idea behind a HELOC is that you can draw upon the funds as you need them, your ability to access that money isn’t a sure thing.“HELOCs are best used for shorter-term goals, say 12 to 20 months, as the [interest] rate can fluctuate and is generally tied to the prime rate,” says Richard Airey, a loan officer with Finance of America Mortgage in Portland, Maine.

Here are some situations where you might want to avoid a HELOC.

  • Buying a Car: With HELOC rates nearly half the rates offered on auto loans, it is tempting to use the cheaper money to buy wheels. Not a good idea. A car is a depreciating asset. With an auto loan, you pay down a portion of your principal with each payment, ensuring that, at a predetermined point in time, you completely pay off your loan. However, with most HELOC loans, you are not required to pay down principal right away, opening up the possibility of making payments on your car longer than the useful life of the car.
  • Paying Off Credit Card Debt: It seems to make sense to pay off expensive debt with cheaper debt. However, in some cases, this debt transfer may not address underlying behavioral issues. Before considering a HELOC loan to consolidate credit card debt, honestly examine the reason it became so unmanageable in the first place; otherwise you may be trading one problem for an even bigger problem (that is, using running up the balances on your newly replenished credit card limits all over again). Using a HELOC to pay off credit card debt can only work if you have the strict discipline to pay down the principal on the loan within a couple of years. Otherwise, a home equity loan (whose payments include both interest and principal from day one) might be a better choice.
  • Paying for a Vacation: Any time you use debt to pay for a vacation or to fund leisure and entertainment activities, it means you are living beyond your means. Although it is cheaper than paying with a credit card, it is still debt. If you generally can’t control your spending or you rely heavily on debt to fund your lifestyle, borrowing from home equity can only exacerbate the problem. At least with credit cards, you are only risking your credit.

Finding the Right 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."

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. 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 a 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 his 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.

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