Home Equity Loan Primer

Glancing at the home equity loan offers from just three years ago is like looking at the ads from a bygone era. “Put the equity in your home to work. Pay off your credit cards with a low interest loan at prime. Deduct our interest from your taxes. Get easy approval on a credit line, where you use only what you need.” Back at the height of the housing bubble, homeowners couldn’t go to the mail box without an enticing come on for a HELOC, Home Equity Line of Credit.

Home equity loans are second mortgages, subordinate to the first mortgage which was used to buy the home. They come in two basic flavors. The first is a simple home equity loan where a fixed amount of cash is backed by equity in your home. Like a first mortgage it can have points and fees. The loan pays out a lump sum and is for a fixed amount of time. It’s a smart choice for paying down a substantial amount of high interest credit card debt, or borrowing to make a home improvement such as installing a solar power system A HELOC is a credit line that a borrower would draw upon as needed such as for an emergency repair. The credit line can be accessed through plastic or a check.

A typical process for a lender is to appraise your home, calculate a fixed percentage of its worth, subtract your first mortgage and make the rest available to you as a loan or credit line. As home values shot up during the bubble, lenders fell over themselves to offer home equity loans. The problem on the lender side occurred when loans were offered up to 100% of a home’s value. When the real estate market plunged, banks were left with equity loans that were only backed by paper. Let’s look at just one lender, the Bank of America. In the third quarter of 2009, it wrote off $1.97 billion in noncollectable home equity debt, up $130 million from the second quarter.

For our parents’ generation, those with second mortgages were considered to be in debt to their eyeballs, a fate to be avoided at all costs. This attitude started to change in 1996. That year credit card interest payments were no longer allowed as tax deductions, but the mortgage write off was left in place.  Interest on home equity loans could still be deducted, up to $100,000 a year for couples filing jointly.

Today home equity loans aren’t as easy to obtain as just a couple of years ago:

  • The rates have jumped to now more than two points over prime.  Many loans now have a floor like 5% below which the interest will not fall.
  • The percentage of allowed total mortgage debt has dropped, anywhere from a low of 55% to a high of 80%
  • Credit criteria have stiffened. It’s not enough to have home equity. Borrowers have to document income and show solid credit scores.

HELOCs have their own pitfalls:

  • Some have advance period terms, where you can only draw upon the money for a set period of time, say five years. The repayment period, the next 5-10 years would be used to pay back the loan.
  • Balloon payments are the bane of many HELOCs. A large fee at the end of the loan’s term is typically used to entice the borrower into refinancing the debt.
  • Just because you have a HELOC now, doesn’t mean  you can continue to count on it. Lenders have used computerizing appraising models to suddenly cancel or cut home equity lines when home values in a neighborhood have fallen.

Borrowers have often made mistakes:

  • One of the worse is called reloading, where a home equity loan is used to free up credit on other lines like bank cards that are once again used for day to day expenses or additional purchases. Borrowers in this trap  can easily fall into a downward spiral of spending chased by more borrowing.
  • Many people over borrowed, getting too far into debt with no realistic plan of meeting increasing payments. In looking at the records of one loan modification firm, I noticed that fully 95% of the borrowers seeking modification on the first mortgages were also burdened by substantial home equity loans at higher interest rates.

Still if you do have home equity, and you’re considering restructuring your debt, home equity loans remain a good choice because as secured loans, home equity lines will usually carry far lower interest than unsecured lines like credit cards or personal loans. According to homeowner / licensed real estate agent Leslie Lunsford, home equity credit was an important tool in maintaining her real estate investments. “The variable rate was low, moving within a narrow range. Accessing the credit only as needed was very convenient.”

Be sure to shop wisely, comparing terms. You’re not bound to get a home equity line from your first mortgage lender, but if you have a solid payment record it’s a good place to start.  Make sure that if you get a HELOC for emergencies, you’re not paying for the privilege, even if you don’t draw on your credit line. Be careful when signing paperwork. Leave no pages blank and understand everything you’re signing. Home equity lines have become yet another tool that scam artists are using to strip distressed borrowers from the equity in their homes.

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