The Home Buyer's Korner

Information presented should be used for educational purposes only.

July 8th, 2015

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The Home Buyer’s Korner

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Home Equity Loans or HELOC

images (3)After being nearly shut down with the collapse of housing prices during the Great Recession, lenders are once again offering attractive second lien/home equity loans against the value of your home.

While still only a fraction of its pre-crash levels—the latest estimates for home-equity lending is estimated at $60 billion, compared with its peak of $430 billion in 2006. Rising home values in recent years are putting more equity in borrowers’ hands, while a gradually stabilizing economy is giving lenders more confidence to lend.

If you’re thinking about securing one, here are a few other things you’ll need to know.

You’ll need equity, of course. Equity is the percentage of a home’s value, less any current mortgage or liens. So, if your home is valued at $650,000 and you still owe $570,000 on your mortgage, you have $130,000 in equity, or 20 percent and more commonly known as a loan-to-value ratio.

Generally speaking, lenders today want you to have at least an 80 percent loan-to-value remaining after the home-equity loan. That means you’ll need to own more than 20 percent in equity before most lenders are willing to offer a home equity/second lien mortgage.

There are two main types of home-equity loans. The first is the standard home-equity loan, where you borrow a single lump sum. The second is a home equity line of credit, or HELOC, where the lender authorizes you to borrow smaller sums as needed, up to a certain fixed amount. The type you choose depends on why you need the money.

If you’re looking at a single, major expense—such as replacing the roof on your home—a standard home-equity loan is usually the best way to go. You can get these in either as fixed or adjustable-rate terms and repaid over a predetermined length of time, generally they come in 15, 20, 25 and even 30 year amortization schedules. You’ll also be required to pay some closing costs, like an appraisal fee, doc preparation fees and title search, but they’re much less than you would see on a first lien mortgage.

If you need to access various amounts of money over time, such as if you’re doing a home improvement project over a few months, for example, or to support a small business you’re starting—a home equity line of credit (HELOC) may be more suitable to your needs.

With a HELOC, you’re given a predetermined limit to borrow against as you wish. You only pay interest on what you actually borrow and you don’t have to begin repaying the loan until a certain period of time, known as the draw, which is typically after 10 years has elapsed. With HELOC’s there are seldom any closing costs, although you may be required to pay an annual fee. Interest rates are offered as adjustable rate terms and you don’t get the predictability offered as with a fixed-rate home-equity loan, though many lenders often conversion option to a fixed rate once the draw period ends.

Home Equity loans aren’t particularly useful for borrowing small amounts of money. Lenders typically don’t want to be bothered with making small loans and $10,000 is about the smallest you can get, but more commonly lenders will required a minimum of $25,000.

If you don’t need quite that much, opt for a HELOC and only borrow what you need. Remember however, you still may be charged an annual fee for the duration of the draw period.

Even if you plan to use only a fraction of your line of credit, say $5,000 out of a $20,000 HELOC, you’ll still need to have enough equity in your home to cover the full amount. So if the smallest home-equity loan or line of credit your lender will allow is $20,000, you’ll need to have at least $20,000 in home equity over and above the 20 percent equity you’ll need left after taking out the loan.

It’s easy to forget sometimes, but a home-equity loan or line of credit is a type of mortgage, just like the primary home loan you used to fund the purchase of your home. And as a mortgage, it offers certain advantages and disadvantages.

One of the advantages is that the interest you pay is usually tax-deductible for those who itemize deductions, the same as regular mortgage interest. Federal tax law allows you to deduct mortgage interest on up to $100,000 in home equity debt or $50,000 apiece for married persons filing separately. There are certain limitations though, so check with a tax adviser to determine your own eligibility.

Additionally, because it is a mortgage secured by your home, the rates tend to be lower than you’d pay on credit cards or other unsecured loans. They do tend to be somewhat higher than what you’d currently pay for a full mortgage, however.

Remember that you’re borrowing against your home and you’re putting your home at risk if you fail to make the payments, just like a first lien mortgage. The difference is that in a foreclosure, the primary mortgage lender is paid off first, and then the home-equity lender is paid off out of whatever is left. So, you want to treat a home-equity loan with the same care you do with first lien mortgage.

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