Home equity loans and HELOCs

In short

You have probably looked at your house and wondered what it could do for you besides keep the rain off. A home equity loan and a HELOC both let you borrow against the part of the house you own. Your house is the collateral, which means the lender can take it if you stop paying. A home equity loan hands you one lump sum with a fixed payment. A HELOC, short for home equity line of credit, works more like a credit card with a limit, and its rate usually moves. Before you sign, add up every fee, ask what the rate can do, and picture the payment on your worst month. Then decide if the house is a risk you want to put on the table.

The whole of it

What it is

A friend of mine once said his house felt like a savings account he could not touch. He was wrong about that, and it took him a while to see how. The part of your home you own outright is called equity. It is the home's value minus what you still owe on your mortgage. A home equity loan and a HELOC both turn some of that equity into cash you can spend.

Both are loans secured by your house. Secured means the lender has a claim on the property if you fall behind. That claim is why the rates run lower than on most credit cards. It is also why the stakes run higher. A missed card payment hurts your credit. A missed payment on a loan against your home can end with a foreclosure. Think that over.

The two products differ in how the money reaches you. A home equity loan pays out all at once, and you repay it in equal monthly amounts over a set number of years. A HELOC gives you a credit limit. You borrow what you need, when you need it, during a set window called the draw period. Then the repayment period begins.

How it works

I once watched a neighbor start a kitchen remodel with a HELOC. He drew a little each week as the bills came in, and he paid interest only on what he had drawn. That is the appeal of the line. You are not charged on money you have not touched.

Lenders start with your home's value and subtract your mortgage balance. Then they limit how much of the value you can borrow against in total, counting your first mortgage and the new loan together. That limit is called the combined loan to value ratio, often shortened to CLTV. Each lender sets its own cap, so shop around.

A home equity loan usually carries a fixed rate. Your payment stays the same every month, which makes it easy to plan around. Fixed means fixed. A HELOC usually carries a variable rate, tied to an index such as the prime rate. When that index rises, your rate rises with it, and so does your payment.

A HELOC has two stages. During the draw period, you can borrow and repay and borrow again. Many lenders let you pay only the interest during this stage. When the draw period ends, you can no longer borrow, and you start paying back principal too. Principal is the amount you actually borrowed. The payment can jump sharply at that point, and plenty of people are caught off guard by it.

Both products come with closing costs, though they vary a great deal. You may see an appraisal fee, an application fee, or a yearly fee just for keeping a line open. Ask for the full list in writing before you commit.

The numbers, and where to find yours

If you are holding your last mortgage statement, you already have one number you need. Your principal balance is printed on it. The other number is your home's current value, which a lender will pin down with an appraisal. You can get a rough idea beforehand from recent sales of similar homes near you.

Some rules come from law rather than from lenders. The Truth in Lending Act requires lenders to disclose the annual percentage rate, the finance charge, and the terms of the loan. For a home equity loan or a HELOC secured by your main home, federal rules give you a right to cancel within a set number of days after signing. That window is the current figure, which the official source publishes each year business days, and the Consumer Financial Protection Bureau explains it on its website. Lenders must also give you a booklet on home equity lines, and the CFPB publishes the same guidance for free.

Whether the interest you pay is tax deductible depends on how you spend the money. The IRS says interest on home equity debt is deductible only when the funds are used to buy, build, or substantially improve the home that secures the loan. The IRS also sets a limit on the total mortgage debt that qualifies, which is the current figure, which the official source publishes each year. Read IRS Publication 936, Home Mortgage Interest Deduction, or ask a tax professional about your own case.

The rate on your offer is the last number to find. On a HELOC, look for the index, the margin, and the rate cap. The margin is the fixed amount the lender adds to the index. The cap is the most the rate can climb. Your account documents will show all three.

A worked example

Consider a woman named Maria, who owns a home worth 300,000 dollars. She still owes 180,000 dollars on her mortgage. Her lender allows borrowing up to 80 percent of the home's value in total.

First, find the total the lender will allow. 300,000 dollars times 0.80 equals 240,000 dollars. Next, subtract what she already owes. 240,000 dollars minus 180,000 dollars equals 60,000 dollars. That is the most she could borrow in this case.

Maria needs 25,000 dollars for a new roof. She chooses a home equity loan at a fixed 8 percent for 10 years. The payment formula uses a monthly rate of 8 percent divided by 12, which is 0.006667. It also uses 120 monthly payments. Run through the standard formula, the payment comes to about 303 dollars a month.

Now check her total cost. 303 dollars times 120 payments equals 36,360 dollars. Subtract the 25,000 dollars she borrowed. She pays roughly 11,360 dollars in interest over the life of the loan, before any fees.

Now suppose Maria had chosen a HELOC instead and drawn the same 25,000 dollars. If her rate started at 8 percent and rose to 10 percent, the interest alone on 25,000 dollars would climb. At 8 percent it is 25,000 times 0.08, which is 2,000 dollars a year. At 10 percent it is 25,000 times 0.10, which is 2,500 dollars a year. That is 500 dollars more each year, with no change in what she borrowed. She would want to know that going in.

Where it goes wrong

I have heard more than one person say they never thought the payment would change. It changed. The biggest trap in a HELOC is the switch from interest only payments to full payments. The bill can grow a lot on the day the draw period ends.

Another trap is treating the line like free money. Because you can borrow again and again, it is easy to keep drawing. The balance climbs a little at a time, and then you have a loan you did not really plan. Keep a written total of what you owe.

Home values can fall. If they do, you could owe more than the house is worth, and the lender may freeze or cut your line. You would still owe what you drew. That is a hard spot to be in.

The biggest risk stays simple. Your home secures the debt. If you cannot pay, you could lose the place you live. Do not borrow against it for things that will lose value fast, and never count on a raise you have not yet received.

Questions to answer before you leave this page

Do you know what your home is worth and what you still owe on it? Can you afford the payment if the rate goes up, or if the interest only period ends? What is the reason you are borrowing, and could you meet that need another way? Have you asked each lender for every fee in writing and compared the annual percentage rate on each offer? Do you know the rate cap, the margin, and the date your draw period ends? Would you be all right if your home lost value and the lender froze your line? And have you talked it over with someone you trust, so that you are not deciding alone?