Home Equity Loan and HELOC Basics
If you’ve owned your home for a while or have seen its value rise significantly, you may be thinking about taking out a loan against the equity, perhaps for home improvements, a new car, or some other purpose. You have two basic choices: a home equity loan or a home equity line of credit (HELOC).
A home equity loan is a lump sum loan that uses your house as collateral, just like your primary mortgage. With a home equity loan, you borrow against the value of your home decreased by the existing mortgage (the equity).
How much can you borrow? Most lenders won’t allow you to borrow more than 75% to 80% of the home’s total value, after factoring in your primary mortgage. However, even if you put no money down when you bought your house and haven’t paid a dime of principal back, any increased market value of your home may make a home equity loan feasible. For example, say you bought your house 12 years ago for $150,000 and it’s now worth $225,000. Even if you haven’t paid off any principal, you might qualify for a home equity loan of $30,000 — this would bring your total loan amount to $180,000, which is 80% of your home’s value of $225,000.
Interest rates on home equity loans. A home equity loan is sometimes called a “second mortgage” because if you default and your house goes into foreclosure, the lender is second in line to be paid from the proceeds of the sale of your house, after the primary mortgage holder. Because the risk of not getting paid the full value of the loan is slightly higher for the second lender, interest rates on home equity loans are usually higher than those on primary mortgages. But at least the interest is lower than on the typical credit card.
Loan term. The loan term of a home equity loan is usually much shorter than that on a primary mortgage — ten to 15 years is common. That means that your monthly payments will be proportionally higher, but you’ll pay less interest overall.
What Is a Home Equity Line of Credit?
The other major option in home equity borrowing is a home equity line of credit, or HELOC. A HELOC is a form of revolving credit, kind of like a credit card — you get an account with a certain maximum and, over a certain amount of time (called a “draw period”), you can draw on that maximum as you need cash.
The draw period is usually five to ten years, during which you pay interest only on the money you borrow. At the end of the draw period, you’ll begin paying back the loan principal. Your repayment period will usually be in the ten- to 20-year range, which means that, as with a home equity loan, you’ll pay less interest than you would on a traditional 30-year fixed mortgage, but your monthly payments will be proportionally higher. HELOCs sometimes have annual maintenance fees, which generally range between $15 to $75, and many have cancellation fees that can be several hundred dollars.
Similar to home equity loans, the amount of money you can borrow with a HELOC is based on the amount of equity you have. Usually that means you will be able to borrow some percentage of the home’s value, reduced by the existing mortgage — usually 75% to 80%. Unlike home equity loans, the interest rate on a HELOC is usually variable, so it can start low but climb much higher. HELOC interest rates are usually tied to the prime rate, reported in The Wall Street Journal, and the maximum rates are often very high — similar to the rates on a credit card.
What Can You Do With a Home Equity Loan or HELOC?
You can do whatever you want with a home equity loan or HELOC: finance your son’s education, take an extravagant trip, or buy a big screen television. Some people use it to consolidate debts that they’ve racked up on various credit cards.
However, the most prudent way to spend the cash is on improving your home. If you aren’t able to pay the loan back, you risk foreclosure, but if you used the cash to improve your home, you should see an increase in its value (if you followed the advice in Nolo’s article Do Home Improvements Really Add Value?). This gives you the option to refinance if you need to and, if the value of your home has gone up, you’ll be more likely to qualify for the loan. (For more information on how refinancing can lower your monthly payment, see Nolo’s article Refinancing Your Mortgage: When It Makes Sense.)
HELOCs work well if you are making improvements on your home and have ongoing expenses. Often borrowers get them as an added safety net, in case they need cash suddenly, but without real plans to draw on them otherwise.
You may just want to have this source of cash in your back pocket for emergencies — but make sure there’s no requirement that you draw some amount, as some lenders require this so that they’re assured of making a little money on the deal.
Tax Benefits to Home Equity Loans and HELOCs
A final benefit to using a home equity loan or HELOC to improve (or even purchase) your home is that the interest is tax deductible, just as it is on a primary mortgage, up to $1 million. You can deduct only up to $100,000 if you use the money for another purpose. (However, you can’t deduct more than the house’s fair market value.)
Also be careful if you’re subject to the Alternative Minimum Tax. In that case, your home equity loan or HELOC may be deductible only if it is used to purchase or improve the home.
How to Get a Home Equity Loan or HELOC
Shopping for a home equity loan or HELOC is just like shopping for a primary mortgage. You can either go to a mortgage broker or you can research loan options on your own. For more information on shopping for a mortgage, read Nolo’s article Where to Shop for a Mortgage.
With a home equity loan, expect to pay some of the typical fees you paid on a regular mortgage, but in much lesser amounts. (Some of these fees are based on the loan amount, which is probably lower than your primary mortgage.) At the very least, you’ll have to pay for an appraisal, which is the lender’s opportunity to evaluate how much your home is worth. You may find a home equity loan without any fees, but be careful: Usually it means these costs are rolled into the loan, perhaps in the form of a higher interest rate. Costs on HELOCs are usually (but variable interest rates mean the interest payments can be much higher).
To learn more about home buying, read Nolo’s Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo).