Understanding Home Equity Loans, HELOC

Equity is the difference between the selling price of your home in the current market and the amount that you owe on the mortgage. For example if your house is worth $200,000 and the amounts that you still owe on the mortgage is $50,000, then subtracting one from the other the equity in your house is $150,000. If there is no mortgage on your house then the entire sale price is that equity. It is not like having cash in your bank account or having money in mutual funds which you can easily liquidate and access. You know you have money in the form of your property but there is no ready and quick way to use it. Or is this?

In order to use and get access to the money that is lying as built-up equity in your property you either have to sell it completely to use it entirely or refinance it take a percentage of the equity. When you refinance you can take out a mortgage for the amount that the house is actually worth while paying off the 1st mortgage completely. You can do what you wish with the rest of the money.
However, there is a 3rd way in which you can free up some of the equity in your house. This is where home equity loans come in.

How to Use Home Equity Loans

Home equity loans are good options for homeowners who want to borrow relatively smaller amount than what the equity in the property’s worth and maybe do not need the money all at one. One such purpose is for remodeling.

For example if you have built in equity of  $150,000 in your house and you only want to borrow $50,000 to bring in some improvements or even for some other expenses such as a wedding, paying for your child’s education. Whatever the reason you can use a home equity loan also known as home equity line of credit or HELOC.

This is an appropriate term because this kind of loan that is taken from the built in equity in the property is essentially a line of credit secured by a 2nd mortgage on the property.

Usually the line of credit is opened by the lender with a maximum loan amount limit. You are allowed to either borrow money as you need it or you can withdraw all of it in one sweep. That way it can sit is a savings account or be invested.

The one thing that you need to keep in mind and be careful about is that certain home equity loans have a clause which give the lender the right to cancel the line of credit at any time for any reason that he deems fit.

This could seriously interfere with any purpose that you had for the money you are borrowing on the line of credit. So sometimes it is a good idea to withdraw the entire sum and put it away somewhere it can earn some interest. However, withdrawing the entire sum means that you will accrue interest on the entire balance.

The gap between the interest that you pay for the HELOC and the interest that you can earn on your money with investors is called opportunity cost of money.

Equity loans are also often used for debt consolidation purpose and are therefore also called debt consolidation loans. If you are burdened by consumer debt which has a high interest rate such as revolving balance on a credit card, you can use a home equity line of credit to consolidate all your high interest loans into one payment which is likely to bear a lower rate of interest. As with the primary mortgage, the 2nd mortgage for the home equity loan will have different interest rates with different mortgage lenders. Since this is essentially line of credit, you can expect interest rates to be higher than that of regular mortgage.

Different variations of a HELOC

As with other mortgage loans a HELOC comes with several variations. You can choose a fixed rate mortgage or go with an adjustable-rate loan. You can choose to withdraw your money in one go or withdraw from an ATM card as you need it. You can write checks on a line of credit or make withdrawals from the bank. There are many options and choices and your lender will be able to customize your HELOC according to your needs and requirements.. Also choose how you want to pay back the loan. You can either be a fully amortized monthly payment, or you can make interest-only payments with a balloon payment becoming due when the loan is due.

However, in all cases the home equity line of credit is secured by a lien on your home. If you cannot pay the amount you borrow lender will foreclose I see on your home to recover his money. Which is why home equity lines of credit should be consider it carefully. As mentioned before the interest rate on the home equity line of credit is liable to be higher then your 1st mortgage.

In order to get the best possible interest rate on a HELOC it is a good idea to take it from the mortgage lender who currently holds the 1st mortgage on your home. Also you are likely to get the best interest rate if the home equity line of credit does not exceed 75% of your current home value. For example if your home is worth $200,000 and you have a 1st mortgage of $100,000 remaining on it. To obtain the most favorable financial terms in this case the limit of your home-equity line of credit will have to be 75% of $200,000 which is $150,000 less the amount you still owe on it which is hundred thousand dollars which gives you a home equity line of credit of $50,000.

It goes without saying that people with a shining credit history and a good credit score over 700 – 750 can Up to 80% of their homes fair market value for the HELOC. If getting the maximum home equity loan is important to you then maybe you should consider improving your credit score before you approach the lender.

As we mentioned right in the beginning, the 1st step that you need to take when you consider taking a mortgage loan is to calculate how much you can afford to borrow. The same holds true for the home equity line of credit. The reason is that your other kinds of debts such as credit cards, personal loans, student loans etc. are all unsecured debts.

Which means that if you do not make the payment the lender can sue you and have a judgment passed against you pay back the money. However, in the case of a home equity line of credit if you do not pay back the money that you borrow, you stand to lose your home to foreclosure. A home equity line of credit should be given as you thought as you did when you were 1st taking out a mortgage on your home and maybe even more because you are actually adding on to your existing debt.

Even though you will have a surplus of cash through a home equity line of credit, it does have to be paid back with interest to the lender. Which also brings up another cautionary pointer. If the sum total of your 1st mortgage balance and the amount of home equity line of credit exceed 75% to 80% off the home’s fair market value, expect higher loan origination fee and a higher interest rate as well as other closing costs.

Can You Get 100% HELOC?

Getting 100% Home Equity Loan

As mentioned before it is usually the norm that home equity loans are made out of 75% or 80% of the property’s fair market value on the 1st mortgage after subtracting the balance owed. The lenders calculate the risk of the property by dividing the property’s appraised value by the balance still owed on the 1st mortgage. This is known as loan to value ratio, LTV.

The lower this ratio is the lower is the risk for the mortgage lender. However, if you are borrowing more than 80% of the loan to value ratio then the lender is going to compensate his risk by charging a higher rate of interest. While it was possible to get even up to 125% of the loans home value when the real estate industry was boom, you will be hard-pressed to find 100% line of credit in today’s date. However, for academic interests sake, consider the consequences of taking 100% HELOC on your property.

You will have to pay much higher monthly payments as compared to 80% – 85% home equity loan. If the prevailing market rate on a mortgage 80% loan-to-value ratio is 8%, the mortgage lender might charge as high as 12 to 18 % on the HELOC.

Problems with Selling With 100% HELOC

If you want to sell your home and the home is worth about the same as when he took up the hundred percent home equity line of credit then you will probably not be able to sell your house because they are sick sick and costs involved in completing the setting procedure. You will have to find other sources of income to cover the expense of selling if unforeseen circumstances force you to do so. In an extreme situation you may even have to file for bankruptcy which will do long-term damage to your credit rating.


Income Tax Limitations of a HELOC

Not all kind of interest that you accrue on any debt is tax deductible. For example, the interest that is charged on student loans, credit card debt and even car loans is classified as consumer interest and is not tax-deductible. However, mortgage interest is as you already know deductible from the state and federal income tax returns. This is one of the advantages of taking a home equity line of credit. The interest that you pay on HELOC may be deductible for both federal and state income tax. However, the deduction is also dependent on a couple of factors.

Limitations on Tax Deduction for a HELOC

The 1st rule is that there is $100,000 limit on tax deductibility of home equity loans. While the home equity loan can be of any amount greater than $100,000, you will not be able to deduct anything beyond $100,000 will which will be declared as consumer interest.

The 2nd rule is that the amount of tax deduction from your home equity line of credit is that it cannot exceed the fair market value of your home at any given point.

These regulations can change with changes in income tax regulations. Therefore, it may be advisable to consult with a taxation accountant or tax attorney to get the exact information.

HELOC – Are You Taking on This Debt Burden for the Right Reasons?

Most of the people take out 100% line of credit on their homes to consolidate other high-interest debt. However, it is the sad and yet true fact that people who do not address any problems that they have with handling credit at the root and look for the quick solution of consolidating the debt by taking out a home equity line of credit simply run up the credit cards and other consumer debts again.

This causes of downward spiral in their financial situation and they end up even deeper in debt. Before you consolidate your credit card debt with a home equity line of credit make sure that you cannot do the same by consolidating it on the lower interest credit card some of which even now offer 0% interest rate for a certain period of time.

In the end it all boils down to what you need the 100% home equity line of credit for. If it is to pay off a debt with even higher rate of interest such as an unsecured loan or to pay for a medical emergency, then you might go ahead and do it. But if you’re doing it to provide finances for nonessential indulgences, you should think again. Even then, no matter what purpose or how urgent the need, you must always bear in mind that you are probably converting your unsecured debts into a secured debt which is backed by the security of your home.

If you do not pay the debt on your credit card, the lender can sue you in court. But if you are unable to pay once you have consolidated that debt with a home equity loan, it will be your home on the line and the lender can use foreclosure recover that money.

Before you consider consolidating your high interest debts and other consumer debts into home equity line of credit try and assimilate why you are in the situation that you are. If it is because of bad credit management and irresponsible usage of credit, then you need to address those problems separately.

Using home equity line of credit to consolidate those dates is temporary solution and it’s not advisable if you have a genuine problems with handling credit. Because you’ll just end up deeper in debt even after the consolidation.