If you have equity in your home, you can borrow against it. During the housing bubble in the 2000s, homeowners used home equity loans and home equity lines of credit to finance all manner of purchases.
A home equity loan, once called a second mortgage, is a fixed-rate term loan often at a rate higher than your primary mortgage. A home equity line of credit or HELOC carries a variable interest rate and provides you with a credit line that you can access, using the equity in your home as collateral.
Today, consumers and banks are far more cautious about these lines and loans. Here's what to think about when looking for a home equity line of credit:
Be realistic. Decide what you need a HELOC for and if it actually makes sense for you to use. A HELOC may have little to no fees to set up and no annual fee to keep. The interest rate, however, is variable. And once you borrow money from the credit line, you will be expected to make minimum payments.
- Common uses. While spending money on home improvements makes the most sense, some people use a HELOC to pay for college, consolidate debt or just as an extra emergency resource.
- Variable rates and fees. Home equity lines of credit often have variable interest rates, based on the prime lending rate or other variable reference rate, so payments can vary from month to month and year to year depending on how much cash you borrow.
- Deductible interest. In most cases, interest is deductible on borrowings up to 100% of the value of the home securing the line, or $100,000 total (whichever is less). Talk to your accountant about determining what you can write off. The rules are messy.
Determine the value of your home and how much equity you own.
- A fair appraisal. Lenders will require your home to be appraised, a service that can cost you around $400. Examine recent selling (not asking) prices of homes in your neighborhood to get a realistic expectation of your home value it may have changed since you bought it.
- Own enough. Figure out how much equity you have in your home. The after-effects of the housing bubble and financial crisis are making it difficult for those with less than 20% equity in their home to open a line of credit.
- Know your debt level. Lenders will be looking closely at your other debt (car loans, credit cards, etc.) in addition to your FICO score and overall debt-to-income ratio. If you have decent home equity, but a lot of other debt, you might be surprised by the bank's response. Be sure to ask what the standards are for being awarded a line of credit for a specific amount. If you're delinquent on any debt you owe (called a "credit event"), some lenders can reserve the right to reduce the available line of credit.
Pay attention to the repayment period.
- When and how to pay. Before drawing down from the line of credit, find out what payments will be expected and when. HELOCs are like credit cards: they command a minimum payment. Ask what methods of access to your funds are available: by convenience check, card, phone, or online.
- Longer repayment. If available, look for HELOCs that allow for a repayment period that is longer than the draw-drown period; for example, allow yourself 10 years to draw on the account with 15 years to repay. In some cases, if you've drawn more than 50% from the account, additional constraints kick in. Remember that you don't have to draw on the full amount of the line of credit.
What not to do when looking to open a HELOC.
- Don't skip the fine print. Be wary of contracts that include minimum draw requirements, early termination fees, or annual fees. Shop around and get quotes from different lenders in your area.
- Don't waste your credit. HELOCs can be helpful in recovering from singular debt-inducing events like a divorce or a period of unemployment. Similarly, it may be more difficult if you are unemployed or self-employed to acquire a HELOC. If you've been delinquent on any debt for more than 30 days within the past year, you may risk rejection.
- Don't wait on your appraisal. Thirty-five days from application to close is the typical window for HELOCs. Be sure to schedule your home appraisal up front or risk having to repeat the process and cough up another $400 fee.