HELOCs/HELOANs generally require less paperwork and time
than refinancing your primary mortgage, and have little or no closing costs.
You can tap the equity in your home by using a second mortgage, either a home equity line of credit (HELOC) or a home equity loan (HELOAN). The important differences between these two types of second mortgages are covered below. They are also frequently used in combination with a first mortgage when a borrower is purchasing a home and putting down less than 20%. Both HELOCs and HELOANs are priced primarily using the borrower’s credit score and the combined loan-to-value.
Differences between a HELOC and a HELOAN
|rate||The HELOC has an interest-only payment option tied to the prime rate and adjusts monthly whenever the prime rate moves||The HELOAN has a fixed interest rate and fully amortizing payments that include principal and interest|
|draw||The HELOC has the option of using as much, or as little, of the available credit as you choose||The full amount of the HELOAN must be taken at close of escrow|
|payment||If you pay down a portion of the HELOC, your payment drops proportionately. You may choose to run the line back up later.||Paying down a portion of the HELOAN will not change the payment, and once a portion has been paid down, you can not run the balance back up again.|
A HELOC is a better choice:
- If you want a resource you can tap at any time: you only pay for the money you are using. The interest only option keeps the payments low.
- If you want flexibility: you can pay the HELOC down partially, and lower the payment proportionately, or pay it down to a zero balance; you can then run the line back up in the future as needed.
- If an adjustable rate and a changing payment are not a concern. HELOC interest rates adjust monthly and have been 10% or higher for about half of the last thirty years. If your HELOC is not large, or you have the savings to pay it down, this may not be a concern.
- If you are able to pay your credit line down—through bonuses, a refinance after an extensive remodel, the sale of a property, or a liquidity event.
A HELOAN is a better choice:
- If you want the stability of a fixed interest rate.
- If you want the predictability of a fixed monthly payment.
Using a HELOC or HELOAN in a purchase transaction or refinance
There are two reasons to use a HELOC/HELOAN when either purchasing or refinancing.
- One is to avoid mortgage insurance when you don’t have a 20% down payment for a purchase, covered in Mortgage Insurance vs. Piggyback.
- The second reason is to bring the first mortgage amount down, usually from a jumbo to a conforming loan amount in order to get a lower interest rate. This becomes increasingly compelling as the necessary home equity piece gets smaller.
For example, if you are purchasing a house for $550,000 with 20% down, you would have a loan balance of $440,000. As I write this, the conforming loan limit is $417,000, and conforming rates are about half a point lower than jumbo or high-balance conforming (although the spread has been narrowing). You could put down an additional $23,000 to bring your $440,000 loan down to the conforming amount of $417,000, or you could get a second mortgage for $23,000 and have a conforming first mortgage of $417,000. Even though the home equity piece in the future might have a much higher rate, the amount of the second mortgage in this example is so small relative to the first mortgage that you will save a substantial amount of money. As the home equity portion becomes larger relative to the first mortgage, you have to use your judgment and your lender’s input to decide whether it makes sense to employ this strategy.
It is easy to be enticed by the low payment of an interest-only HELOC, however this low payment can come at a steep price in the future. Most HELOCs allow the interest only payment to be made for ten years. After the ten year period, either the entire balance becomes due, or the outstanding balance converts to a fully amortizing 15 year loan. Before the financial crisis, when money was easy, borrowers figured that they would have no problem either getting a new HELOC or refinancing their first mortgage and paying off the HELOC balance when the initial interest-only period was up. Now, however, with property values and/or incomes having dipped, and underwriting standards much more strict, these options are often not available.
An Important Note about HELOCs:
It is easy to be enticed by the low payment of an interest-only HELOC, however this low payment can come at a steep price in the future. Most HELOCs allow the interest-only payment to be made for ten years. After the ten year period, either the entire balance becomes due, or the outstanding balance converts to a fully amortizing 15 year loan. Before the financial crisis, when money was easy, borrowers figured that they would have no problem either getting a new HELOC or refinancing their first mortgage and paying off the HELOC balance when the initial interest-only period was up. Now, however, with property values and/or incomes having dipped, and underwriting standards much more strict, these options are often not available.
If you currently have a HELOC that will convert to a 15 year fixed, or are considering getting one, be aware of how much the payment can change after the interest-only period. For example, a homeowner who owes $100,000 on a HELOC with a 3.5% interest rate would see monthly payments rise from $292 to $715 when the interest-only loan converts to a 15-year amortizing mortgage. Also, although the loan is amortizing over fifteen years, the interest rate can still adjust monthly, and even a small rise in rates can make that $715 payment considerably higher. If interest rates were to rise by just three percentage points, to 6.50%, payments on the HELOC in the example would go up an additional $150, almost tripling the interest-only payment.
If you currently have a HELOC, get a copy of your loan agreement – your lender can provide it if you don’t have it – and find out what happens after the interest-only period. Then work with an experienced loan officer or financial advisor on a strategy that will protect you if you are faced with either a loan coming due, or a sharp increase in your monthly payment.
Tax deductibility of HELOC and HELOAN payments
The interest on HELOCs or HELOANs, when used for a primary residence or second home, are tax deductible, subject to the standard IRS limits and rules on the deductibility of home mortgage interest. Whenever you have tax questions related to real estate finance, we recommend that you speak to a CPA or financial advisor who is familiar with your particular situation and state and federal tax law.