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Over the years the distinction between a Home Equity Loan and a Home Equity Line of Credit has led to a lot of confusion among consumers.
In this discussion we will inform you of both types of loans, go over there advantages for you, go over there disadvantages for you--and conclude with our thoughts and helpful advice.
Remember that a HEL and HELOC are both loans! When you hear financial gurus and the like speaking of Home Equity Loans be sure to find out if they are talking about a "Home Equity Loan" or a "Home Equity Line of Credit" as they are both considered Home Equity Loans.
I hope I have not confused you further. Hopefully the following discusion will clear up any confusion you may have.
A Home Equity Loan (sometimes abbreviated HEL but also could include a HELOC) is a type of loan in which the borrower uses the equity in their home as collateral. These loans (HEL & HELOC) are often used to finance major expenses such as home repairs, medical bills or college education.
A home equity loan would create a “lien” against your (borrower's) house, and would reduce your home equity.
Most lenders who offer "Home Equity Loans" (HELs & HELOC) require that you have at least a good credit history and many require an excellent (740 and higher credit score) credit history.
• You also must have a reasonable loan-to-value and combined loan-to-value ratios meaning your housing and other debt cannot be too high.
• Home equity loans come in two types:
1) CLOSED END--HEL
2) OPEN END--HELOC
We will begin our analysis by looking at the
closed end or Home Equity Loan (HEL) and then proceed to the open end or Home
Equity Line of Credit (HELOC).
This type of loan is for a specified loan amount and is often called a “Home Equity Loan”, (HEL), or 2nd Mortgage and usually has a fixed rate.
A home-equity loan, also known as a second mortgage is a closed end loan that is set at a specified amount, a specified term and a specified interest rate that is either fixed or variable. A HEL lets homeowners borrow money by leveraging the equity in their homes.
Home-equity loans exploded in popularity in 1990’s as they provided a way for consumers to somewhat circumvent that year's tax changes, which eliminated deductions for the interest on most consumer purchases. With a home-equity loan, homeowners can borrow up to $100,000 and still deduct all of the interest when they file their tax returns.
With a home-equity loan or home equity line of
credit, homeowners can borrow up to $100,000 and still deduct all of the
interest when they file their tax returns.
Home-Equity Lines of Credit (Open End)
A home-equity line of credit (HELOC) is a variable-rate loan that works much like a credit card and, in fact, sometimes comes with one. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it via a credit card or special checks. Monthly payments vary based on the amount of money borrowed and the current interest rate.
• Like fixed-rate loans, the HELOC has a set term. When the end of the term is reached, the outstanding loan amount must be repaid in full.
• OPEN END—loan is for an unspecified amount and is often called a “Home Equity Line of Credit” or HELOC and usually has a “variable” rate.
In the mortgage industry it too is looked upon as a 2nd mortgage (assuming it was the 2nd in recording—if your house was paid off at the time of the loan it would be in the 1st position) although many consumers may not look at the loan as being a 2nd mortgage.
• With a home-equity loan or home equity line of
credit, homeowners can borrow up to $100,000 and still deduct all of the interest
when they file their tax returns.
• Like fixed-rate loans, the HELOC has a set term. When the end of the term is reached, the outstanding loan amount must be repaid in full.
There are some similarities and specific differences between a home equity loan (Closed End) and a home equity line of credit (HELOC) or Open End Loan.
• Both closed end (HEL) and open end (HELOC) loans are secured against the value of the property, just like a traditional mortgage. Both are also considered "Home Equty Loans" which tends to add to the confusion.
• Home Equity Loans (Closed End) and Lines of Credit (Open End) are usually, but not always, for a shorter term than first mortgages.
• In the United States, it is often possible to deduct home equity loan interest on your personal income taxes up to a limit.
• If you obtain either type of loan and you currently don’t have a mortgage on your property the loan would be considered a 1st position loan.
• Home-equity loans come in two varieties - fixed-rate loans or closed end and lines of credit or open ended - and both types are available with terms that generally range from five to 15 years with some lenders offering loans up to 30 years.
• Another similarity is that both types of loans must be repaid in full if the home on which they are borrowed is sold.
A (HELOC) Home Equity Line of Credit or Open End loan is a line of revolving credit with an “adjustable interest rate” whereas a (HEL) Home Equity Loan or Closed End is a “one time lump-sum loan”, often with a fixed interest rate.
With a (HELOC) home equity line of credit, you “the borrower” can choose when and how often to borrow against the equity in the property (open end feature), with the “lender setting an initial limit” to the credit line based on criteria similar to those used for closed-end loans (HEL).
Like the closed-end loan or HEL, it may be possible to borrow up to 100% of the value of a home, less any liens. These lines of credit are available up to a term of 30 years, usually at a “variable interest rate”. The minimum monthly payment can be as low as only the interest that is due.
Typically, the interest rate is based on the Prime rate plus a margin.
There are some differences between a Home Equity Loan (Closed End) and a Home Equity Line of Credit (HELOC) or Open End Loan.
A HELOC differs from a conventional home equity loan in that the borrower is not advanced the entire sum up front, but uses a line of credit to borrow sums that total no more than the credit limit, similar to a credit card.
HELOC funds can be borrowed during the "draw period" (typically 5 to 25 years). Repayment is of the amount drawn plus interest. A HELOC may have a minimum monthly payment requirement (often "interest only"); however, the debtor may make a repayment of any amount so long as it is greater than the minimum payment (but less than the total outstanding).
The full principal amount is due at the end of the draw period, either as a lump-sum balloon payment or according to a loan amortization schedule.
Another important difference from a conventional loan is that the interest rate on a HELOC is “variable”. The interest rate is generally based on an index, such as the prime rate. This means that the interest rate “can change” over time.
Homeowners shopping for a HELOC must be aware that not all lenders calculate the margin the same way. The margin is the difference between the prime rate and the interest rate the borrower will actually pay.
HELOC loans became very popular in the United States in the early 2000s, in part because interest paid was (and is) typically (depending on specific circumstances) deductible under federal and many state income tax laws.
This effectively reduced the cost of borrowing funds and offered an attractive tax incentive over traditional methods of borrowing (such as credit card debt).
Another reason for the popularity of HELOCs is their flexibility, both in terms of borrowing and repaying on a schedule determined by the borrower. Furthermore, HELOC loans' popularity growth may also stem from their having a better image than a "second mortgage," a term which can more directly imply an undesirable level of debt.
However, within the lending industry itself, a HELOC is categorized as a second mortgage.
Because the underlying collateral of a home equity line of credit is the home, failure to repay the loan or meet loan requirements may result in foreclosure.
As a result, lenders generally require that the borrower maintain a certain level of equity in the home as a condition of providing a home equity line.
Traditional mortgages in the United States are usually non recourse loans, while mortgages in countries such as Canada are generally recourse loans. "Nonrecourse debt or a nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable."
A HELOC may be a recourse loan for which the borrower is personally liable.
This distinction could be important if you were
to go through foreclosure since the borrower may remain personally liable for a
recourse debt on a foreclosed property.
How You Can Benefit
• Home-equity loans provide an easy source of cash.
• The interest rate on a home-equity loan-- although higher than that of a first mortgage--is much lower than on credit cards and other consumer loans.
• Some of the top reasons consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances, pay tuition and medical expenses.
• Interest paid on a home-equity loan is also tax deductible.
• By consolidating debt with a home-equity loan, you get a single payment, a lower interest rate and tax benefits.
* When you consolidate debt and pay it off over the term of your HEL or HELOC it may take longer to pay off the debt-It depends on the amount, term and how diligent you are at paying off the HEL and HELOC.
How Your Lender Would Benefit
• Home-equity loans are a dream come true for a lender, who, after earning interest and fees on the borrower's initial mortgage, earns even more interest and fees.
• If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan.
• The lender also gets to repossess the property, sell it again and restart the cycle with the next borrower.
• From a lender perspective, it's a rather attractive arrangement if done properly.
The Right Way to Use a Home-Equity Loan
• Make sure your budgeting and cash flow is adequate to cover the loan and won’t make your financial situation worse.
Home-equity loans can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, its low interest rate and tax deductibility of paid interest makes it a sensible alternative to debt consolidation and other solutions that could adversely affect your credit and finance position.
• Fixed-rate home-equity loans can help cover the cost of a single, large purchase, such a new roof on your home or an unexpected medical bill.
• A HELOC provides a convenient way to cover short-term, recurring costs, such as the quarterly tuition for a four-year degree at a college if you can’t finance your or your child’s tuition in a more effective manner.
Use Caution When Considering A HELOC or HEL
• The main pitfall associated with home-equity loans whether a HEL or HELOC is that they sometimes seem to be an easy solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending and sinking deeper into debt.
• Many homeowners used this strategy over a number of years and when the real estate market tumbled they were left in a position of negative equity or no equity and lost or had difficulty maintaining their property and/or standard of living.
• Don’t put yourself in a position where you are depending on second mortgages to finance your living conditions as it is a bad long-term strategy and if done wrong could be a bad short term strategy.
• Unfortunately, this scenario is so common the lenders have a term for it: reloading, which is basically the habit of taking a loan in order to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases.
• Reloading leads to a spiraling cycle of debt that often convinces borrowers to turn to home-equity loans offering an amount worth 125% of the equity in the borrower's house.
• This type of loan often comes with higher fees because, as the borrower has taken out more money than the house is worth, the loan is not secured by collateral.
• Furthermore, the interest paid on the portion of the loan that is above the value of the home is not tax deductible. Look at your total financial situation prior to refinancing to see whether refinancing really makes sense for your current situation (be aware that refinancing with a HEL or HELOC will affect your net worth).
If you are contemplating a loan that is worth more than your home, it might be time for further analysis of your credit and finances. If you were you unable to live within your means when you owed only 100% of the value of your home--moving the amount you owe up another 25% with no tax deductibility could potentially devastate your and possibly your family’s finances and living conditions.
Another unwise use of an HEL or HELOC may arise when homeowners take out a home-equity loan to finance home improvements. While remodeling the kitchen or bathroom generally adds value to a house, improvements in other areas of your home or yard may be worth a lot to you but potential purchasers and the market would not really care.
If you're going into debt to make cosmetic changes to your house, try to determine whether the changes add enough value to cover their costs as it could be a factor when you ultimately decide to sell.
Paying for a child's college education is another popular reason for taking out home-equity loans and it should be used as a last resort or at least after all of your other reasonable options have been exhausted.
If, you (borrowers) are nearing retirement, you should be especially careful about obtaining a HEL, HELOC or any other form of long-term debt as the potential to disrupt your retirement goals become highly likely.
Be sure to ask yourself how the loan may affect your ability to accomplish your financial goals. It may be wise for near-retirement borrowers to seek out other options that would not adversely interfere with their financial goals.
Should You Tap Your Home's Equity?
• Your home can be leveraged for cash. Despite the risk involved, it is easy to be tempted into using home equity to splurge on expensive luxuries and many have done it in the past and now find themselves in a difficult financial position.
By following the trend of the moment—and not sound financial advice—many have used their home to obtain many luxuries only to lose them in the future—and in many cases lose their home as well.
• Reloading was a popular trend in the 1990’s and 2000’s, however the recent real estate market meltdown has curbed and halted many of the excesses of those eras. If your goal is to improve the living conditions of you and your family it is important that you make wise financial moves regardless of what is going on around you.
• Be sure to look at your total finances on a regular basis and make improvements and adjustments where necessary.
• Be sure to do a careful review of your financial situation before you borrow against your home and make sure you can comfortably repay the debt in the time frame you and lender agree to.
Make sure that you understand the terms of the loan and have the means to make the payments without affecting other bills and your emergency fund. If the amount of cash you need is small consider using your emergency fund and then rebuilding it over time if that appears to be a good option for you.
HELOC Freeze of 2008
In 2008 major home equity lenders including Bank of America, Countrywide Financial, Citigroup, JP Morgan Chase, National City Mortgage, Washington Mutual and Wells Fargo began informing borrowers that their home equity lines of credit had been frozen, reduced, suspended, rescinded or restricted in some other manner.
Falling housing prices have led to borrowers possessing reduced equity, which is perceived as an increased risk of foreclosure in the eyes of lenders. On January 27, 2010 a federal judge refused to dismiss a class action lawsuit against Chase for freezing HELOC loans.
Courts have held that a bank may freeze a HELOC in instances where a home's value decreases substantially, which is deemed by courts as a 50% reduction in value.
Common Home Equity Uses
A home equity line of credit is a form of revolving credit in which your home serves as collateral. Because a home often is a consumer's most valuable asset, many homeowners use home equity credit lines only for major items, such as education, home improvements, or medical bills, and choose not to use them for day-to-day expenses.
With a home equity line, you will be approved for a specific amount of credit. Many lenders set the credit limit on a home equity line by taking a percentage (say, 75%) of the home's appraised value and subtracting from that the balance owed on the existing mortgage.
Appraised value of home $200,000
Percentage of appraised value = $ 150,000
Less balance owed on mortgage - $ 80,000
Your Potential line of credit $ 70,000
In determining your actual credit limit, the lender will also consider your ability to repay the loan (principal and interest) by looking at your income, debts, and other financial obligations as well as your credit history.
Many home equity plans set a fixed period during which you can borrow money, such as 10 years. At the end of this "draw period," you may be allowed to renew the credit line. If your plan does not allow renewals, you will not be able to borrow additional money once the period has ended.
Some plans may call for payment in full of any outstanding balance at the end of the period. Others may allow repayment over a fixed period (the "repayment period"), for example, 10 years.
Once approved for a home equity line of credit, you will most likely be able to borrow up to your credit limit whenever you want.
Typically, you will use special checks to draw on your line. Under some plans, borrowers can use a credit card or other means to draw on the line.
There may be other limitations on how you use the line. Some plans may require you to borrow a minimum amount each time you draw on the line (for example, $300) or keep a minimum amount outstanding.
Some plans may also require that you take an initial advance when the line is set up.
Use Caution When Shopping For A HELOC Loan
If you decide to apply for a home equity line of credit, look for the plan that best meets your particular needs. Read the credit agreement carefully, and examine the terms and conditions of various plans, including the annual percentage rate (APR) and the costs of establishing the plan.
Remember, though, that the APR for a home equity line is based on the interest rate alone and will not reflect closing costs and other fees and charges, so you’ll need to compare these costs, as well as the APRs, among lenders.
Variable Interest Rates
Home equity lines of credit typically involve variable rather than fixed interest rates. The variable rate must be based on a publicly available index (such as the prime rate published in some major daily newspapers or a U.S. Treasury bill rate).
In such cases, the interest rate you pay for the line of credit will change, mirroring changes in the value of the index. Most lenders cite the interest rate you will pay as the value of the index at a particular time, plus a "margin," such as 2 percentage points.
Because the cost of borrowing is tied directly to the value of the index, it is important to find out which index is used, how often the value of the index changes, and how high it has risen in the past. It is also important to note the amount of the margin.
Lenders sometimes offer a temporarily discounted interest rate for home equity lines--an "introductory" rate that is unusually low for a short period, such as 6 months.
Variable-rate plans secured by a dwelling must, by law, have a ceiling (or cap) on how much your interest rate may increase over the life of the plan. Some variable-rate plans “limit” how much your payment may increase and how low your interest rate may fall if the index drops.
Some lenders allow you to convert from a
variable interest rate to a fixed rate during the life of the plan, or let you
convert all or a portion of your line to a fixed-term installment loan.
How Much Will It Cost Me?
Many of the costs of setting up a home equity line of credit are similar to those you pay when you buy a home. For example:
* A fee for a property appraisal to estimate the value of your home
* An application fee, which may not be refunded if you are turned down for credit
* Up-front charges, such as one or more "points" (one point equals 1 percent of the credit limit)
* Closing costs, including fees for attorneys, title search, mortgage preparation and filing, property and title insurance, and taxes.
In addition, you may be subject to certain fees during the plan period, such as annual membership or maintenance fees and a transaction fee every time you draw on the credit line.
You could find yourself paying hundreds of dollars to establish the plan. And if you were to draw only a small amount against your credit line, those initial charges would substantially increase the cost of the funds borrowed.
On the other hand, because the lender's risk is lower than for other forms of credit, as your home serves as collateral, annual percentage rates for home equity lines are generally lower than rates for other types of credit.
The interest you save could offset the costs of establishing and maintaining the line. Moreover, some lenders waive some or all of the closing costs.
How will I repay my home equity line of credit?
Before entering into a plan, consider how you will pay back the money you borrow. Some plans set a minimum monthly payment that includes a portion of the principal (the amount you borrow) plus accrued interest.
But, unlike with typical installment loan agreements, the portion of your payment that goes toward principal may not be enough to repay the principal by the end of the term.
Other plans may allow payment of interest only during the life of the plan, which means that you pay nothing toward the principal.
If you borrow $10,000, you will owe that amount when the payment plan ends.
Regardless of the minimum required payment on your home equity line, you may choose to pay more, and many lenders offer a choice of payment options.
Many consumers choose to pay down the principal regularly as they do with other loans. For example, if you use your line to buy a boat, you may want to pay it off as you would a typical boat loan.
Whatever your payment arrangements during the life of the plan--whether you pay some, a little, or none of the principal amount of the loan--when the plan ends, you may have to pay the entire balance owed, all at once.
You must be prepared to make this "balloon payment" by refinancing it with the lender, by obtaining a loan from another lender, or by some other means. If you are unable to make the balloon payment, you could lose your home.
If your plan has a variable interest rate, your monthly payments may change. Assume, for example, that you borrow $10,000 under a plan that calls for interest-only payments. At a 10% interest rate, your monthly payments would be $83. If the rate rises over time to 15%, your monthly payments will increase to $125.
Similarly, if you are making payments that cover interest plus some portion of the principal, your monthly payments may increase, unless your agreement calls for keeping payments the same throughout the plan period.
If you sell your home, you will probably be required to pay off your home equity line in full immediately. If you are likely to sell your home in the near future, consider whether it makes sense to pay the up-front costs of setting up a line of credit.
Also keep in mind that renting your home may be prohibited under the terms of your agreement.
Lines Of Credit Versus Traditional Second Mortgage Loans or HELs
If you are thinking about a home equity line of credit, you might also want to consider a traditional second mortgage loan or Home Equity Loan. This type of loan provides you with a fixed amount of money, repayable over a fixed period.
In most cases, the payment schedule calls for equal payments that pay off the entire loan within the loan period.
You might consider a second mortgage instead of a home equity line if, for example, you need a set amount for a specific purpose, such as an addition to your home.
In deciding which type of loan best suits your needs, consider the costs under the two alternatives. Look at both the APR and other charges. Do not, however, simply compare the APRs, because the APRs on the two types of loans are figured differently:
The APR for a traditional second mortgage loan takes into account the interest rate charged plus points and other finance charges.
The APR for a home equity line of credit is based on the periodic interest rate alone. It does not include points or other charges.
Disclosures From Lenders
The federal Truth in Lending Act requires lenders to disclose the important terms and costs of their home equity plans, including the APR, miscellaneous charges, the payment terms, and information about any variable-rate feature.
And in general, neither the lender nor anyone else may charge a fee until after you have received this information.
You usually get these disclosures when you receive an application form, and you will get additional disclosures before the plan is opened.
If any term (other than a variable-rate feature) changes before the plan is opened, the lender must return all fees if you decide not to enter into the plan because of the change.
When you open a home equity line, the transaction puts your home at risk. If the home involved is your principal dwelling, the Truth in Lending Act gives you 3 days from the day the account was opened to cancel the credit line. This right allows you to change your mind for any reason.
You simply inform the lender in writing within the 3-day period. The lender must then cancel its security interest in your home and return all fees--including any application and appraisal fees--paid to open the account.
What if the lender freezes or reduces your line of credit?
Plans generally permit lenders to freeze or reduce a credit line if the value of the home "declines significantly" or, when the lender "reasonably believes" that you will be unable to make your payments due to a "material change" in your financial circumstances.
If this happens, you may want to:
Talk with your lender. Find out what caused the lender to freeze or reduce your credit line and what, if anything, you can do to restore it.
You may be able to provide additional information to restore your line of credit, such as documentation showing that your house has retained its value or that there has not been a "material change" in your financial circumstances.
You may want to get copies of your credit reports (go to the Federal Trade Commission's website for information about free copies) to make sure all the information in them is correct. If your lender suggests getting a new appraisal, be sure you discuss appraisal firms in advance so that you know they will accept the new appraisal as valid.
Shop around for another line of credit. If your lender does not want to restore your line of credit, shop around to see what other lenders have to offer. You may be able to pay off your original line of credit and take out another one. Keep in mind, however, that you may need to pay some of the same application fees you paid for your original line of credit.
Learn how to apply the— “Keys to Success”—in your life