The benefit of HELOCs and home equity loans is that they give homeowners easy access to cash.
If you have a large expense that you must pay for immediately, then a Home Equity Line of Credit (HELOC) may be the ideal solution. These versatile loans can be used to pay for medical or educational expenses, debt consolidation, home renovations or any other expense that you may encounter. They can be issued quickly and usually have very flexible terms. Read on to find out how these loans work and how they can benefit you.
Definition of HELOC
A home equity line of credit, or HELOC, is a line of credit secured by your home. This gives you a revolving credit line to use for large expenses or to consolidate higher-interest rate debt on other loans. A HELOC often has a lower interest rate than some other common types of loans, and the interest may be tax deductible. You should consult a tax professional to keep updated on tax rules regarding HELOC's and their interest.
Variable Interest Rates
HELOCs almost always charge a variable rate of interest and are similar to credit cards in that they only charge interest on the outstanding balance that has been used. You can draw on your line of credit at any time, but you can never exceed the balance limit that you agreed to when you initially signed the closing paperwork. (2) Most lenders will provide you with either a book of checks or a debit card (or both) that you can use to access the funds in your HELOC.
Fixed Interest Rates
Some lenders also allow borrowers to lock in a fixed interest rate on their HELOCs for an additional fee. As of the first quarter of 2019, the average HELOC interest rate was about 5.5%. The rate that is locked in is almost always higher than the current interest rate charged by the HELOC, but it can be worth it to pay the fee for this if interest rates are rising. Conversely, it can cost borrowers more if they lock in a rate and then interest rates fall. (4) It should also be noted that most states will not permit HELOCs to charge more than 18% interest per year.
History of HELOCs
Traditional 30-year mortgages first appeared after World War II, but it was another 30 years or so before home equity loans and lines of credit became common. For a long time, having any type of second mortgage on a home was a sign of financial desperation. But in the 1980s, the banking industry successfully erased that image with aggressive marketing campaigns that touted the advantages of home equity loans and lines of credit. (1) One of the most common slogans was, “That ‘unused’ home equity in your house? Put it to work for you.” Of course, this was just a euphemism for borrowing.
This easy-to-obtain form of credit quickly ballooned from $1 billion outstanding in the 1980s to over $1 trillion before the Subprime Mortgage Meltdown of 2008. However, the number of homeowners who are at least a month behind in their home equity loan or HELOC payments rose over 50% above the average that has been tracked by the American Banker Association since about 1990. The number of delinquent borrowers rose by 45% before the Subprime Mortgage Meltdown.
This crisis led many lenders to freeze, suspend, reduce or restrict their borrowers’ HELOCs in order to avoid further losses and foreclosures. While these restrictions were eventually lifted as the economy recovered in subsequent years, this effectively “yanked the carpet” out from under the financial plans of many borrowers, who were counting on these loans to pull them through tough economic times.
How HELOCs Work
Home equity lines of credit are, as their name says, simply lines of credit that are secured by a portion of the equity that you have accumulated in your home. In most cases, you can borrow up to 85% of the value of your home minus the amount of your primary mortgage.
For example, if your home is worth $200,000 and you owe $110,000 on your first mortgage, then you could take out a home equity line of credit for $60,000 ($200,000 x 85% = $170,000 minus $110,000.)
Most HELOCs also charge many of the same fees that you will pay for any other type of mortgage loan, including origination fees, which can be as much as one or two percent of the HELOC balance. There can also be an application fee of $100 or more. Then there is the cost of a title search along with appraisal fees that can run you another $150 - $300. Finally, there are attorneys' fees that cover the costs that come with preparation of the documents needed to create the HELOC. Some lenders also charge additional ongoing fees, such as an annual membership or participation fee or an additional fee for each transaction. Borrowers are therefore advised to read the fine print on their paperwork before signing on the dotted line so that they are not taken by surprise when these fees are charged. (5)
HELOCs have two periods of time written into them: the draw period and the repayment period. The borrowing and repayment schedules for a HELOC can vary, but a 30 year term is quite commonplace. But some lines must be repaid in as little as 10 years. A 30 year HELOC may have a drawing period of 10 years and a repayment period of 20 years, while others require repayment by the end of the drawing period.
If you sell your home, then you'll have to repay the outstanding balance on your HELOC before transferring ownership of your home to another party. If the total of the HELOC and the first mortgage are less than the sale price of your home, then this is easily accomplished. But if you are upside down on your home, meaning that you owe more on it than its worth, then you'll either have to come up with the difference out of pocket or else negotiate a short sale with the lender.
How You Qualify
Lenders use several formulas to determine how much your HELOC can be. They will use your credit score, gross monthly income and expenses as well as the loan to value ratio, your home's equity and your borrowing history to determine the rate of interest that they will charge you. They may also require you to furnish recent tax returns and bank or investment statements. Many lenders were previously very generous with the credit limit that they would extend to you; they would often allow HELOCs equal to the entire value of your home. But the Subprime Mortgage Meltdown of 2008 put an end to this, and most lenders will now cap the amount of a HELOC at 80% or 85% of the value of your home, minus the outstanding balance on your first mortgage. The terms and closing costs that lenders offer can vary substantially from one institution to the next, so it is a good idea to shop around and compare the rates and terms offered by each lender to get the best deal.
Ready to learn more?
There are more home equity topics to be discovered on our blog.
The Difference Between HELOCs and Home Equity Loans
While HELOCs are essentially a revolving line of credit, home equity loans provide the borrower with a single lump sum up front. Most home equity loans charge a fixed rate of interest and must be repaid according to a preset schedule. Borrowers will immediately begin paying interest on the entire amount of the loan, unlike with HELOCs, where borrowers only pay interest on the amount that they have actually borrowed. HELOCs also generally charge lower interest rates than home equity loans. As of the first quarter of 2019, the average annual percentage rate on home equity loans was about 8.75%.
As mentioned previously, HELOCs charge a variable rate of interest that is tied to a major financial index, such as the Prime Rate index that is published in The Wall Street Journal. Then there is an additional amount, called a margin that is added on to the monthly payment that goes to the lender. (And this additional spread makes these loans one of the most lucrative types of financial products that banks and credit unions offer to the public.) There is a series of equations that you can make to manually determine your monthly payment, but if numbers are not a friend to you, there are many HELOC calculators available online such as at www.gobankingrates.com.
This crisis led many lenders to freeze, suspend, reduce or restrict their borrowers' HELOCs in order to avoid further losses and foreclosures. While these restrictions were eventually lifted as the economy recovered in subsequent years, this effectively "yanked the carpet" out from under the financial plans of many borrowers, who were counting on these loans to pull them through tough economic times.
Total amount of outstanding HELOC balances today.
Total amount of outstanding HELOC balances at its all time high.
As of Wednesday, March 27, 2019, the total amount of outstanding HELOC balances was over $343 billion dollars. (8) This is close to the high of $364 billion that was outstanding in 2005. The HELOC market shrank to a fraction of the 2005 high in the wake of the Subprime Mortgage Meltdown but has risen steadily ever since.
Tax Treatment of HELOCs
Trump’s new tax laws have substantially impacted the tax rules for HELOCs. Under the old tax laws, all HELOC interest was tax-deductible in the same manner as your first mortgage. But Trump’s new laws have changed that. Under the new laws, you can only deduct interest on a HELOC of $750,000 or less. However, if you had a HELOC of up to $1 million before the new tax laws took effect, then you can still deduct all of the interest charged by your HELOC and are not subject to the new limitation.
There is also a substantial additional limitation on deducting HELOC interest under the new laws. The HELOC must be used to either build or improve your home in order for its interest to be deductible. The interest that is paid for HELOCs that are used to consolidate debt or pay medical or educations expenses is nondeductible. This rule applies to new and existing HELOCs that were taken out before December 15 of 2017, without any type of grandfathering clause.
Advantages & Disadvantages of HELOCs
Home equity lines of credit can be incredibly useful financial tools for those who know how to use them-and are able to make the additional payments that come with them. If you have a large amount of high-interest credit card debt or other consumer debt such as car loans, personal loans or other similar obligations, then a HELOC can be a lifesaver. The interest that it charges will usually be much lower than the interest that you are charged on your credit cards and other debt. The trick is to cut those cards up and not acquire any more personal debt.
Another good time to take out a HELOC is if you need to make major home improvements, such as an addition onto your current home or putting in a new kitchen or bathrooms. You may be able to increase the value of your home more than the amount you used with your HELOC, thus allowing you to make a profit. Just remember that you will have two mortgage payments to make until the HELOC has been paid off.
By far the biggest disadvantage that comes with HELOCs is the fact that you are securing this type of loan with your home. If you become unable to make the monthly payments on your HELOC, then the lender can retaliate by foreclosing on your home. And the variable interest rates that HELOCs charge mean that your payments will increase when interest rates increase, so you need to be prepared to make a larger payment than you are making now if interest rates are rising.
Furthermore, if you become unable to make even the interest payments on your HELOC, then it will hurt your credit score. If you are foreclosed upon, you may have difficulty getting another home loan or will be forced to settle for a loan that charges exorbitant interest.
Finally, if you are unable to control your spending, then applying for a HELOC can be disastrous. If you are just going to run your credit cards back up by buying luxury goods and perishable items such as expensive meals, then you can quickly find yourself upside down on a monthly basis, as you won’t be able to make your HELOC payment on top of your other credit card payments.
Important Laws & Rules Regarding HELOCs
Federal law allows you to cancel any signed agreement for debt financing within three business days of signing the agreement. This is referred to as the “Three-Day Cancellation Rule. You can cancel for any reason as long as the debt is backed by your primary residence. This does not apply to vacation or rental homes. Saturdays are counted as business days, but not Sundays or public holidays. This rule gives you until midnight of the third business day to cancel after you have:
Signed the credit contract
Received the Truth in Lending Disclosure From outlining the terms of the loan contract
Received two copies of the Truth in Lending Act explaining your right to cancel
If you decide to cancel, you must notify the lender in writing. A verbal cancellation is not valid, either by phone or face to face. A written notice of cancellation must therefore either be delivered in person, mailed or electronically filed before the deadline in order to be valid.
Exceptions to the Three-Day Cancellation Rule include:
When you will use the loan to add on to or modify your current residence
When you refinance existing debt with the same lender and don't borrow more money
When you are borrowing from a state agency
In these cases, you will most likely have other rights of cancellation under state or local laws.