Home Equity Loans
A home equity loan is a lump sum of cash. It’s an option if you need the money for one-time big-ticket expenses, such as a kitchen renovation or a wedding. Generally, these loans offer fixed rates. This enables you to know the specific amount of your monthly payment.
Home equity loans usually are not the correct loan if you only need a small infusion of cash. Many lenders will not write these loans for less than $35,000. In addition, many of the closing costs that come with a first mortgage apply to a home equity loan. These may include loan-processing fees, origination fees, appraisal fees, and recording fees. Points, which equal 1% of the loan value, may also need to be paid at the closing time.
Home equity lines of credit are somewhat different. HELOCs are a revolving source of credit, much like a credit card, so you obtain the funds when and if you choose. A majority of banks have different ways for you to access those funds, whether it’s writing a check, through an online transfer, or using a credit card associated with our account. Generally, HELOCs feature variable interest rates and have few, if any, closing costs. Some banks do offer fixed rates for a specific period.
HELOCs offer flexibility. Untapped funds do not charge interest, and you can borrow against your credit line at any time. As long as your bank does not require minimum withdrawals, it may be an excellent source of emergency cash.
Taking out a HELOC loan now may be a good option – if you’ve lost your job because of the coronavirus, need cash, and have equity in your home.
Home equity loans and HELOCs can sometimes get borrowers into trouble. Despite a borrower’s intentions, it can be easy to spend available funds on nonessentials—or, during the global pandemic, on things you do need, but with no end in sight for your financial challenges.
The Phases of HELOCs
Most home equity credit lines have two phases. First, a draw period, often 10 years, during which you can access your available credit as you choose. Typically, HELOC contracts only require small, interest-only payments during the draw period, though you may have the option to pay extra and have it go toward the principal.
After the draw period ends, you can sometimes ask for an extension. Otherwise, the loan enters the repayment phase. From here on out, you can no longer access additional funds, and you make regular principal-plus-interest payments until the balance disappears. Most lenders have a 20-year repayment period after a 10-year draw period. During the repayment period, you must repay all the money you’ve borrowed, plus interest at a contracted rate. Some lenders may offer borrowers different types of repayment options for the repayment period.
HELOCs have many attributes that make them different from a standard credit line and also offer advantages. However, the interest-only payments in the draw period mean payments in the repayment period can almost double. For example, payments on an $80,000 HELOC with a 7% annual percentage rate (APR) would cost around $470 a month during the first 10 years when only interest payments are required. That jumps to around $720 a month when the repayment period kicks in.
The jump in payments at the onset of the new repayment period can result in payment shock for many unprepared HELOC borrowers. If the sums are large enough, it can even cause those with financial hardships to default. And if you default on the payments, you could lose your home.
The special attributes of a HELOC can make it an interesting product to be aware of, particularly in times of crisis. Following the 2008 crisis, HELOCs offered a debt relief option but led to doubled payments beginning around 2018.
|How Home Equity Loans and HELOCs Compare|
|Home Equity Loan||HELOC|
|Disbursement||Lump-sum amount||Revolving credit line for a preapproved amount; contract may require a minimum draw at closing|
|Repayment||Fixed monthly payments||Typically interest-only payments during draw period, followed by full monthly payments|
|Interest Rates||Usually fixed||Generally adjustable, though banks may cap your rates or offer a fixed rate for a specific period of time|
|Points||Lenders may charge upfront “points” that lower your interest rate||Does not use points|
|Closing Costs||Similar to a first mortgage; typically 2% to 5% of loan amount||If applicable, closing costs tend to be smaller than those of one-time loans|
|Pros||Predictable repayment costs||Flexibility to draw on credit line whenever you need it; no interest payments on money you don’t need|
|Cons||Usually higher interest than HELOCs because of fixed-rate feature; lack of flexibility||Some borrowers may be tempted to use loans for nonessential purchases|
|Best For||One-time needs where you know exactly how much you need||Situations where you need access to funds at different times|
Why Take Out a Second Mortgage?
Homeowners can use their home equity loan or HELOC for a wide range of purposes. From a financial planning standpoint, one of the best uses of the funds is for renovations and remodeling projects that increase the value of your home. This way you may increase available equity in your home while simultaneously making it more livable.
Borrowers should be careful of cross collateralization, as it will affect real estate lending terms.
You can also use the money to pay off other high-interest rate debt in an alternative type of debt consolidation. This could be especially helpful for paying off high-rate credit card balances. You’re effectively replacing a high-cost loan with a secured, low-cost form of credit.
Of course, you can also borrow to fund an overseas vacation, a new sports car, or possibly your child’s education. Whether it’s worth eroding your equity is up to you and something to which you’ll want to give some serious thought.
Equity Loan Tax Deductions
Tapping your equity for home renovation projects has another advantage. The Internal Revenue Service (IRS) lets you write off some of the interest on home equity credit as long as you itemize deductions.
Before the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers were able to deduct interest on up to $1 million of mortgage debt, and there were no restrictions on the usage for deductions. The TCJA instituted new limits and restrictions, which run through the end of 2025.7
As of 2020, couples can deduct the interest on up to $750,000 of eligible mortgage debt (or up to $375,000 if you file separately) if the debt is used on the home. The deductions can be applied for first mortgages, second mortgages, home equity loans, and home equity lines of credit if the debt is used to “buy, build, or substantially improve” the home against which it was secured.8
Home Equity and HELOC Pros and Cons
Even if property values stay flat or rise, every new loan stretches your budget. If you lose your job, for example, it’ll be harder to keep current on your payments. Because a new lender has another lien on your home, there’s a greater chance that you could face foreclosure if you fall behind for a long enough period.
- Lower cost than many other types of loans
- The ability to borrow a relatively large amount of cash
- Potential tax breaks if you use the funds on the home
- The safety of fixed interest rates on home equity loans
- When you use your home as collateral, you shrink the amount of equity in your home.
- If the real estate market takes a dip, those with higher combined loan-to-value (CLTV) ratios run the risk of going “underwater” on their loan.
Home Equity Loans vs. Refinancing
Second mortgages aren’t the only way to tap the equity in your home and get some extra cash. You can also do what’s known as a cash-out refinance, where you take out a new loan to replace the original mortgage. When your new loan is bigger than the balance on your previous one, you pocket the extra money. As with a home equity loan or HELOC, homeowners can use those funds to make improvements to their property or consolidate credit card debt.
Refinancing does have certain advantages over a second mortgage. The interest rate is generally a bit lower than that of home equity loans, and if rates have dropped overall, you’ll want your primary mortgage to reflect that.
Drawbacks of refinancing
Refis have drawbacks too. You’re taking out a new first mortgage, so closing costs tend to be a lot higher than HELOCs, which typically don’t have steep upfront fees. And if refinancing means you have less than 20% equity in your home, you may also have to pay private mortgage insurance (PMI). PMI can usually be canceled when a borrower reaches 20% home equity, though most homeowners choose to keep it.9
Overall, it doesn’t hurt to have your loan officer run the numbers for each option, so you can better understand which one is best for your situation.