There's more interest in home equity lines of credit these days, an interest which is not surprising: The Federal Reserve says home values rose by $2.3 trillion in 2013 so there's a lot of new equity out there.
More real estate equity leads to several options: First, many homeowners who have been underwater now have higher home values and thus a greater ability to refinance your home. Second, some of the new-found equity can be taken out in the form of a home equity line of credit, or HELOC.
What Is a HELOC?
A HELOC is a loan which is secured by your home. Typically, but not always, a HELOC is a second mortgage. That means homeowners who already have a mortgage against their property add a second mortgage in the mix. If the borrower defaults (doesn't pay) the mortgages, the home can be foreclosed and sold. However, the lender with the second mortgage can't be repaid until the lender of the first mortgage is repaid in full. This makes second mortgages riskier for lendrs than first mortgages, which is why their interest rates are higher.
Imagine that you have a house worth $200,000, and you owe $100,000 against it. In that situation, you might be able to get a $50,000 HELOC. Combine the first loan ($100,000) with the HELOC and the combined loan-to-value ratio is $150,000 / $200,000, or 75 percent.
Home Equity Line of Credit Advantages
A big attraction with HELOC financing is that you only pay interest on the outstanding debt. If you borrow $10,000 against a $50,000 line of credit, you only pay interest on the amount of credit actually used.
Another advantage is that HELOC interest is generally tax deductible because the loan is secured by residential real estate. Speak with a tax professional for details.
With increased home equity and the clear attractions of HELOCs, it's not surprising that an increasing number of homeowners are looking at home equity loans. However, what is surprising is the way HELOCs are being used, which is to say with great caution.
Homes, Not ATMs
New figures from the Equifax National Consumer Credit Trends Report confirm that:
- The total number of new loans in January 2014 is 71,600, an increase of 10 percent from same time a year ago;
- The total outstanding balance of existing loans in March 2014 decreased 6.5 percent from same time a year ago;
- Of total severely delinquent balances, 69 percent are from loans originated from 2005-2007; and
- The total balance of severely delinquent loans in March 2014 is slightly more than $8 billion, a five-year low.
The Equifax figures show that more people are getting HELOCs but they're borrowing less. At the same time we're seeing fewer delinquencies, something which will encourage lenders to make more home equity lines of credit available because such financing has become less risky.
Home Equity Questions
While a home equity line of credit can be attractive, it's a form of debt and that raises a number of questions.
First, what are the terms of the loan? Does it have a fixed rate or an adjustable rate? If an adjustable what are the periodic and lifetime mortgage rate caps? What index is used with an ARM HELOC?
Second, what does it cost to set-up a home equity line of credit?
Third, how long does the HELOC last? The answer should be in two forms: How many years do you have to pay back the loan? What is the "draw" period? For instance, imagine that a HELOC has a 15-year term and a 10-year draw period. That means you can withdraw from the line during the first decade of the loan but not the last five years.
Fourth, what are the fees and charges, if any? For instance, is there an annual fee? Is there a charge per withdrawal? A prepayment fee?
Fifth, is there a minimum withdrawal size, say $500 or so?
There are a lot of ways to design a home equity line of credit so shop around for the loan option which works best for you.