If you are thinking about making some big purchases and you own a home, you may be interested in obtaining a home equity loan or a home equity line of credit, which is also known as a HELOC. A home equity loan and a home equity line of credit are both forms of credit against the equity of the borrower's home. Since many people have first mortgages on their homes already, the loan or line of credit is typically secured by a second mortgage on the borrower's home. The loan and the line of credit both constitute liens on, or claims against, the property. There are advantages and disadvantages to both forms of credit.
Home Equity Loan
A home equity loan is a loan secured by a mortgage on the borrower's home. It is a lump sum outlay, and the borrower makes regularly scheduled amortized payments to pay off the loan. If you know you'll need a set sum of money, such as to pay for a large remodeling project, or you want to borrow a set sum at a fixed interest rate, a home equity loan could be the right loan product for your needs.
Pros
The advantages are:
- You know how much you borrowed.
- You can get a fixed interest rate, so that you can lock in at an attractive interest rate.
- You can often deduct the interest that you pay on the loan on your federal income taxes.
- Payments are amortized over the agreed loan repayment period, which means the regular payment amount and the date when the loan will be repaid in full are both known up front and, therefore, predictable.
Cons
The disadvantages are:
- You cannot get more money from the loan.
- You have tied up the equity in your home, so you may not get another loan against your home.
- If you don't need the full amount of your loan immediately, you'll still be paying interest on the full amount you borrowed.
- Your loan terms may include pre-payment penalties, which means it may cost more than your total loan balance to pay the loan off early.
Home Equity Line of Credit
A home equity line of credit is a revolving line of credit which is "pay as you go" type lending. You only borrow the amount of money that you need or want at any time, up to the limit of your line of credit.
Pros
The advantages are:
- The money is available for emergencies.
- You only pay interest on the amount you actually borrow.
- You have the flexibility of a line of credit up to a limit without having to actually take out the maximum you think you might need. For example, you may have a $ 50,000 line of credit but may only take a draw of $ 5,000 at first and then make payments based on the $ 5,000 you took out rather than the full $ 50,000 credit limit.
- You can often deduct the interest that you pay on the loan on your federal income taxes.
- Your lender may offer you the option to lock in the rate for a certain part of your loan balance. For example, if you use a large amount for a substantial home improvement, and you know it will take some time to pay back the amount.
- The loan payments can be flexible—depending on the terms of your loan, only a small monthly minimum payment might be required, just like a credit card, and you can choose how much to pay each month.
Cons
The disadvantages are:
- The line of credit is interpreted like a credit card for credit rating purposes.
- Your lender can lower the limit on your line of credit. For example, you might have arranged for a $ 50,000 draw amount, but your lender might reduce your limit, based on factors such as decreasing property values. You might not have the credit available when you need it the most, such as when you've lost your job or need a new furnace in the middle of winter.
- The interest rate is often tied to the prime rate plus something like 1% to 2%. There is often an introductory rate, which could be attractive, but the rate probably will be higher overall than a fixed term loan.
- There could be a draw period, with a payment period of so many years to pay off the remaining balance. For example, the draw period might only be 5 years; then the terms provide for a repayment period or a balloon payment. You should consider how you would make a balloon payment and the possibility that you might not be in a position to qualify for a new loan.
- You might be charged a yearly account fee.
- Because this is an open-ended consumer credit plan with a security interest in your dwelling, it is easy to become immersed in debt.
- Like a home equity loan for a fixed amount, you'll likely have to pay off any outstanding balance or close your account if you refinance your mortgage. This is so the lender on your refinanced first mortgage will be "first in line" for payment in case of foreclosure.
- Like credit card payments, the regular payment amounts are usually unpredictable, as they may vary from one payment period to the next based on changes in the amount you've borrowed, your interest rate and the length of your repayment period.
Questions for Your Attorney
- What is the security for a home equity line of credit?
- Does my payment history on a home equity line of credit affect my credit rating?
- Can the lender on a home equity line of credit change the amount available without my consent?