Home equity borrowing

If you need to borrow, a home equity loan usually offers the best rates, plus the advantage of tax savings.

Home equity loans let you borrow using the equity you’ve built up in your home as collateral. You can often borrow more money at a lower interest rate than with other types of loans. Most of the other interest you pay, on car loans or personal loans, for example, isn’t deductible. You can choose between:

• Home equity loans, sometimes known as second mortgages
• Home equity lines of credit

Attractions of home equity borrowing

• These loans may be easier to arrange than other loans
• The rates are usually lower than on unsecured loans

Dangers of home equity borrowing

• You risk losing your home if you default on the payments
• Even if the value of your house decreases, the amount you’ve borrowed stays the same
• You may have to pay substantial closing costs

Home equity loans

With a home equity loan, you borrow a lump sum, usually at a variable rate of interest although some fixed-rate loans are available. You pay off the debt in installments, in the same way you repay your mortgage, with some of each payment going toward the interest you owe and the rest toward the principal, or loan amount. At the end of the payment period, the loan is retired.

You may have to pay closing costs on your loan, just as you did for your first, or primary, mortgage. But lenders may offer loans with no up-front expenses as part of a promotional deal. You might also be offered a teaser rate, or a period of low interest as an incentive to borrow. If that’s the case, the lender has to tell you the actual cost, or annual percentage rate (APR), and when the temporary rate ends.

Home equity lines of credit

Home equity lines of credit, sometimes referred to as HELOCs, are actually revolving credit arrangements, which you can use in much the same way you use a credit card. Your credit line, or limit, is fixed, and you can write checks or do online transfers for any amount up to that limit. Whatever you borrow reduces what’s available until you repay. Then you can use the repaid amount again.

The terms of repayment vary and are spelled out in your agreement. In some cases, you begin to repay principal and interest as soon as you borrow, or activate the line. In others, you pay interest only, with a balloon, or one-time full payment of principal due by some set date if the principal is still outstanding. Or, you may make interest-only payments for a specific period, and then begin to pay principal as well. There may or may not be a prepayment penalty, but some lenders require you to keep a HELOC for a specific period.

Most home equity credit lines have an access period, often five to ten years, during which you can borrow, and a longer payback period. The longer you take to repay, the more expensive it is to borrow.

What you can borrow

As a general rule, you can borrow up to 80% of your equity in your home with a home equity loan. For example, if you had a $75,000 mortgage on a home appraised at $250,000, your equity would be $175,000. In most cases, you’d be able to borrow up to $140,000, or 80% of $175,000. However, if your home loses some of its value during the loan period, you still owe the full amount you borrowed.

Some home equity lines of credit, especially those offered without closing costs or other up-front expenses, are capped at a fixed amount, such as $50,000. Others have much larger lines of credit, based on your equity and your home’s value.

Beware the risk

While home equity borrowing has a lot of advantages, it has one serious drawback: If you default, or fall behind on repayment, you could lose your home through foreclosure. That means the lender has the right to take over the property and sell it to recoup what you owe. If you still have a first, or primary, mortgage, the debt you owe that lender is covered first, with the home equity lender entitled to what remains of the foreclosure sale price.

That risk is the chief reason most experts caution against using home equity borrowing — lines of credit in particular — to pay day-to-day expenses or nonessential costs. If you’re using the money to make improvements in your home, pay tuition bills, or meet other major expenses, and include loan repayment as a regular item in your budget, home equity borrowing can be a wise choice. But if you’re in the position of not being able to repay, you’re exposing yourself to losing everything you’ve invested in your home, destroying your credit, and having no place to live.

Buyer beware

You can protect yourself against paying inflated rates on home equity loans if you check the rates a number of different lenders are quoting before making a deal — especially if you’re shopping for a loan when you’re financially stressed.

Finding a loan

Banks offer home equity loans, and so do credit unions, mortgage bankers, brokerage firms, and insurance companies, though their availability is affected by housing prices and interest rates as well as whether you qualify to borrow.

You can start by checking rates and terms advertised online and making some phone calls to see what’s available. But before you commit yourself, you should get a description — in writing — of the anticipated APR, the term, the fees, and any other conditions of the loans that seem most promising.

Setting the rate

Each lender sets the terms and conditions of loans it makes, though the basic elements are usually similar. If a home equity line of credit has a variable rate, it must be tied, or pegged, to a specific public index rather than to some internal index that the bank controls.

The lender adds a margin, expressed as basis points, or hundredths of a percentage point, to the index to determine the new rate each time it’s adjusted. It may happen once a year or sometimes more often.

Reverse mortgages

For older people with home equity but limited income, a reverse mortgage may be an alternative to selling. A reverse mortgage allows you to borrow against the value of your home, either by receiving a monthly check, having access to a line of credit, or some combination. The loan doesn’t have to be repaid until you die or the home is no longer your primary residence. But to maintain the loan agreement in good standing, you’re required to stay up to date with home maintenance, taxes, and insurance.

You can arrange for commercial reverse mortgages through individual lenders but most borrowers use the Home Equity Conversion Mortgage (HECM) program of the Federal Housing Administration (FHA). The amount you can borrow depends on your home’s appraised value, the current interest rate, the age of the youngest borrower, and the cost of the loan. In addition, FHA lenders impose caps on the amount they will lend.

While interest rates quoted on reverse mortgages can be similar to those for other mortgages, there are additional fees and charges that can make them more expensive than other types of loans. Lenders must provide a Total Annual Loan Cost disclosure form that estimates the average annual cost as an interest rate, or percentage of the loan. Borrowers must also be counseled by a HECM-approved counselor. You can find a list at www.hud.gov or by calling 800-569-4287.

Regulations enacted in 2013 to protect both borrowers and the FHA require a financial assessment of the applicants before a loan is approved and an escrow account in some cases to cover required tax payments and insurance. The rules also limit the amount that can be withdrawn in the first year of the loan.

While a reverse mortgage may be a good idea, this approach also has some potentially serious drawbacks. It’s a decision you should consider carefully before acting. It’s also a good idea to seek expert advice from your professional legal and tax advisers.

This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.