Home Equity Lines of Credit (HELOCs) have undergone changes in the last few years, since the economic downturn. This is not unique to HELOCs; the whole mortgage world has experienced upheavals. Lending requirements have become more stringent. Some loan products that were available before, such as 100% financing and no document loans, have all but disappeared. For borrowers who still have equity in their homes, far fewer lenders offer home equity lines of credit than did a few years ago.
If you own a home, it used to be the case that offers to refinance or to open a HELOC were pouring into your mailbox. Now, the market has changed. Influenced by the steep drop in housing prices in many parts of the country, as well as loan portfolios filled with bad loans, many lenders have decided that holding secondary position loans is too high-risk a product for them to offer.
This does not mean that HELOCs do not exist. They do. They may be the best loan product for you, depending on your financial goals, your credit rating, income, and equity position.
Flexibility-- HELOCs are a very flexible loan product. When you open a HELOC, you are issued a revolving line of credit. Your home serves as collateral. The lender issues you a credit card or checkbook, to make purchases as you see fit and as your needs arise, up to the maximum dollar amount approved. You can use as much or as little of that credit line, whenever you decide to do so. You then make payments on only the balance of the credit line you used. Some HELOCs require a minimum balance or set a minimum amount for individual borrowing transactions.
Low Costs-- The closing costs for a HELOC are less expensive than costs you pay on a standard loan. Title and escrow costs are less. The lender’s administrative fees are lower. You do not need to purchase mortgage insurance. There are some no-cost HELOCs available, but if there is no cost, you are likely going to borrow at a higher interest rate. Costs vary from lender to lender, so make sure to compare.
Interest Rates-- While HELOC interest rates are usually higher than what you would pay were you to refinance your primary mortgage, the interest rate is going to be much lower than you can find on an unsecured loan. By paying off higher interest debt, such as credit card debt, with the lower interest funds from your HELOC, you save yourself money.
Payment Flexibility-- HELOCs allow you to make payments only on the interest for a number of years. Conversely, a standard mortgage requires you to pay principal and interest each month for the life of the loan.
No Mortgage Insurance-- In a standard mortgage, if your loan-to-value (LTV- The amount you owe on your mortgage divided by the current market value of your home) is greater than 80%, you are required to buy private mortgage insurance (PMI). If your combined loan-to-value (CLTV) of your first mortgage and your HELOC exceed 80%, you will not have to pay PMI.
Tax Benefits- HELOC interest is tax deductible, should you itemize your tax returns. As long as your total mortgage balance does not exceed $1,000,000, the entire interest on your HELOC, is tax deductible.
Using Your Equity-- The more that you borrow on your home, the greater the risk you take. If you default on your HELOC, you could lose your home to foreclosure. If the value of your home drops, the additional money you borrowed on your HELOC can compromise your ability to sell your home and pay off all the loans you have on the property.
Also, if you use your HELOC to pay off unsecured debt, you turn your unsecured debt into secured debt. The most negative consequences of defaulting on unsecured debt (collection efforts, judgments, levies, and liens) are still far less severe than the loss of your home that you face if you default on your HELOC.
Interest Rates-- The interest rate on a HELOC is higher than the rate you can find, were you to refinance your primary mortgage.
Adjustable Rates-- Most HELOCs, but not all, come with an adjustable interest rate. Having an adjustable rate is not a bad thing, when rates are at a historic low, but it will lead to a higher payment should rates start to rise. Avoid taking on debt at an adjustable rate, if you are at risk of not being able to make the payment should the rate adjust upward.
Credit Rating-- Credit restrictions on a HELOC can be more stringent than on a standard loan. Most HELOCs currently available require a credit score of 720 or greater.
Lenders Available- Far fewer lenders offer HELOCs than did so a few years ago. In some cases, lenders that offer HELOCs only offer them to borrowers whose first mortgage is also carried by the lender.
If you decide that a HELOC is your best choice, you should shop around for the best deal you can find. While shopping around, here are some issues you should be aware of, so you can make a fully informed decision and accurately compare the various products available.
1. Interest Rates-- Your interest rate is likely the most important component in selecting your HELOC. Be aware that sometimes the lowest rate available will have higher fees.
Most HELOCs come with an adjustable interest rate. While it is possible to find a fixed-interest HELOC, your interest rate will be much higher. Most adjustable-rate HELOCs offer you the ability to convert to a fixed rate loan.
Be wary of offers that come with a low introductory rate that adjusts upward thereafter. They may be a good deal, but do the math. See how high the rate will adjust after the introductory period ends. Also see if there are any fees that you will pay when the loan adjusts.
Make sure to review the caps on adjustments. You want to know how high the interest rate can go over the life of the loan, how much it can adjust at any one time, and how often it will adjust. Because you may want to keep the HELOC open for a long time, it is important to know exactly how high your rate and monthly payment could be in a worst-case scenario.
2. Costs-- Loan costs vary from lender to lender. Compare the fees each lender includes in any quote you seek. Some lenders charge administrative fees, some don’t. Fees you should compare include transaction fees, yearly maintenance fees, and inactivity fees (a fee that some lenders charge if you do not use your credit line within a required time period).
3. Appraisal costs-- Some lenders require appraisals for all HELOC applications. Some lenders may not require a formal appraisal, if an online search shows that you are in a very strong equity position. If you are in a strong equity position, ask if the appraisal can be waived.
4. Lending Caps -- Different lenders are willing to lend you different amounts of money. The total amount you owe on your home compared to the value of your home is called the LTV (loan-to-value). When you have two loans, the total debt is referred to as the CLTV (combined loan-to-value). 90% CLTV is the most liberal CLTV maximum available for a HELOC. Some lenders cap CLTV at 80%, some at 85%. The state you live in can also restrict the CLTV maximum and different states have different CLTV caps. Condominiums have stricter borrowing caps than single-family residences.
5. Payment Terms-- Some HELOCs allow you to pay interest only payments for a period of time, as long as the first ten years the HELOC is open in some cases. All HELOCs require that you pay off the principal balance at some point. Compare what different lenders offer.
Some HELOCs require a balloon payment at a specified time. Make sure to know if your HELOC has a balloon payment or not. At the end of the loan term, usually 10 to 20 years, you will have to repay any remaining balance. Be prepared for this. If you are not prepared and cannot pay the balance or refinance your home, you are at risk for losing your home.
6. Pre-payment Penalty- Most HELOCs allow you to pay down the principal balance earlier than you required without charging you a penalty. Still, it is important to clarify with any prospective lender if there is a pre-payment penalty or not.
A HELOC could be a great option for you, if you need money for a major expenditure that you are not quite sure how much it is going to cost. A HELOC is a smart, flexible way to finance a home-improvement project. The HELOC's flexibility is also a strong benefit when you plan to spend large sums of money periodically, such as paying college tuition costs at the start of each college year.
Exercise discipline, when accessing your credit line. Don’t treat the HELOC checkbook or debit card as a license to spend money; resist the temptation to use it, unless it is for a necessary expenditure. Otherwise, you risk eating up your equity and reducing your financial security. You could lose your house if you default on the loan payments. If you know that spending discipline is not your strength, you probably are better off with a standard mortgage.
Pay attention to changes in your interest rate, if you have an adjustable rate HELOC. If you notice that rates are rising, you may want to convert the HELOC into a fixed rate.
Like any financial product, HELOCs have pluses and minuses. Take the time to educate yourself, weigh the pros and cons, and make an informed decision, so you find the loan product that best fits your needs.