Home Equity Line of Credit



KEY TAKEAWAYS

  • Home equity can be a great source of value for homeowners to access cash for renovations, large purchases, or alternative debt repayment.
  • Home equity loans and lines of credit are secured against the value of your home equity, so lenders may be willing to offer rates that are lower than for most other types of personal loans.
  • A home equity loan comes as a lump sum of cash, often with a fixed interest rate.
  • A home equity line of credit is a revolving source of funds, much like a credit card, that you can access as you choose.

There are advantages and disadvantages with each of these forms of credit, so it’s important to understand their pros and cons before proceeding. You may also have other options as well.

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 higher chance you could face foreclosure if you fall behind for a long enough period.


Pros

  • Lower cost than many other types of loans

  • The ability to borrow a relatively large amount of cash

  • Flexibility to use the money for virtually any purpose

  • Potential tax breaks if you use the funds on the home

  • The safety of fixed interest rates on home equity loans

Cons

  • 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

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 or PMI. PMI can usually be canceled when a borrower reaches 20% home equity, though most homeowners choose to keep it.


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.


When You Can't Pay Back Your Loan

Sometimes, even if you're granted a loan you can encounter financial problems later on that make it difficult to pay it back. While losing your home is a risk if you can’t pay back your home equity loan or line of credit, it isn’t a foregone conclusion. However, even if you can avoid losing your home you will face serious financial consequences.


According to credit.org, a U.S. Department of Housing and Urban Development (HUD)-approved counselor, lenders typically pursue a standard lawsuit to get the money rather than going straight to foreclosure. The reason is mainly because, to foreclose the lender has to pay your first mortgage off before auctioning the property. While a lawsuit may seem less scary than foreclosure proceedings, it can still hurt your credit. Not to mention, lenders may be allowed to garnish wages, try to repossess other property, or levy your bank accounts to get what is owed.

If the real estate market takes a dip, those with higher combined loan-to-value ratios run the risk of going “underwater” on their loan.

Most mortgage lenders and banks don’t want you to default on your home equity loan or line of credit, so they will work with those struggling to make payments. It's important to contact your lender as soon as possible. The last thing you should do is avoid the problem. Lenders may not be so willing to work with you if you have ignored their calls and letters offering help for months.


When it comes to what the lender can actually do, there are a few options. Some lenders will offer certain borrowers a modification of their home equity loan or line of credit. Modifications can include adjustments to the terms, the interest rate, the monthly payments, or some combination of the three, to make paying off the loan more affordable. (Note that extending the term of the loan will lower the monthly payments, but it may mean you pay more in the end.)


There is some protection if you are struggling due to the Coronavirus pandemic and your mortgage is backed by the government. Government mortgage loans have a moratorium on foreclosures and evictions that is in place until December 31, 2020. The government has also encouraged all loan servicers to help prevent foreclosures via mortgage modifications and other relief options.


The Bottom Line

There may come a time in your life when access to extra cash becomes a necessity. If so, a second mortgage is a compelling option. Because they’re secured against the equity value of your home, lenders are willing to offer rates that are lower than for most other types of loans.


Just because you can use your home as an ATM doesn’t mean you should. An extra loan means an extra loan payment each month. And if you find yourself unable to hit your due dates, you’re putting your home in jeopardy. Use home equity debt wisely, if you conclude it's the best option for you.


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