Home Equity Loan - Home Equity Line of Credit

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Home Equity Loan or HELOC

With torrid growth in U.S. housing market in recent years, many Americans have seen the value of their homes skyrocket. As a result, you may of heard quite a bit about debt consolidation through "home equity loans" or "home equity lines of credit."

A home equity loan or line of credit is a way of borrowing money against a home's equity. How does a home equity loan differ from a home equity line of credit? First of all, a home equity loan is offered as a one time lump sum. Monthly payments are made to repay the loan, just like a first mortgage, and the interest rate is fixed. It should be mentioned that once you receive the lump sum you can no longer borrow from the loan.

A home equity line of credit, or HELOC, is like a credit card, which allows you to borrow against the limit set by the lender. Once you repay the principal amount owed, that money can be borrowed again. Here is an example: You have a HELOC with a limit of $20,000. You spend $10,000 on a new car, which leaves $10,000 in your line of credit. Now, let's say you pay back $6,000 of the $10,000 you spent on a car. You would now have $16,000 available for you to borrow. An added benefit to a HELOC is that you only pay interest on what you have spent.

Though a home equity line of credit is more flexible than a home equity loan, there are several draw backs which may make it a less attractive option for some. The interest rate you pay on your credit line will move up or down with the prime interest rate, plus whatever was added to that percentage as a condition of receiving the line of credit. This will continue throughout the life of the loan. The size of each payment may also vary depending upon whether the credit line is in the draw period or the repayment period.

While in a draw period, you are allowed to borrow against the line of credit. Here is the catch, the monthly payment minimum will only cover the interest owed, you will have to pay more in order to also pay down the principal owed, as well. During the repayment period, you cannot borrow against the credit line and must repay what is left over. The length of the repayment and draw period will vary from one lender to another, so this is something you must have made clear to you before agreeing to the terms of the HELOC.

Whether you choose a home equity loan or line of credit, if you sell the home the entire balance must be payed. To see if your current housing situation makes it possible for you to exercise one of these options, you might want to calculate your loan to value ratio (LTV) first. This is the ratio, usually expressed as a percentage, between any debts you may have against your home and your home's fair market value. For example, if your house is worth $100,000 and you have made mortgage payments consistently over the years, so now you owe $70,000. That would make your loan to value to ratio is 70% ($70,000 is 70% of $100,000). In our example, this is a pretty good situation to be in for someone considering a home equity loan or HELOC, because lenders typically look to see if loan to value ratio is 80% or less.

Unlike the example above, figuring out the fair market value of home is a lot more difficult. Like when applying for a first mortgage, the lender will get an appraisal of the home's current fair market value. Armed with the current value of your home, the lender can figure out how large a home equity loan or home equity line of credit you can receive.

Let's say, thanks to the growth in the housing market, the new value of the home in our example is $200,000:


Current fair market value of home                           $200,000
Lenders want 80% value to loan ratio                             x .80
Total amount a lender might want to offer you       $160,000
Subract first mortgage debt                                       - $70,000
Possible equity Loan of HELOC amount                  $90,000

Once your home's equity loan and credit line potential has been estimated, you can consider the things you might do with the extra money.

Eventhough home equity interest rates are usually higher than rates on first mortgages, they typically have lower rates than credit cards and car loans. This is what has made debt consolidation through home equity loans so popular among home owners with appreciating property. In addition, there are tax benefits to converting the equity in your home to cash over using credit cards and securing car loans. A home equity loan or home equity line of credit are tax deductible. Meaning, the interest you pay on your home equity loan can be deducted from your income taxes. It should be mentioned that interest on 3rd, 4th, 5th, etc. home is not tax deductible.

The boom in the housing market has also encouraged predators and scam artists to come out of the wood work. In total, millions of dollars have been lost from the homes of thousands of Americans due to scams and predatory lending practices. Though the government has attempted to protect home owners by passing various laws, protecting yourself by becoming aware of the tactics used by predators is your best defense.

If you believe you were taken advantage of by a predatory lender, contact the http://www.ftc.gov on-line.
Or the toll free number 1-877-FTC-HELP (382-4357)

The snail mail address is:

Consumer Response Center
Federal Trade Commission
600 Pennsylvania Ave. NW
Washington, D.C. 20580

Updated: Nov 2005