There are two types of home equity loans: a second mortgage and a home equity line of credit. A second mortgage is normally a lump sum loaned to the borrower at a fixed rate and is repaid to the lender with fixed payments. The home equity line of credit (HELOC) allows the borrower to draw funds as needed and offers various repayment option at variable interest rates.
HELOC is an excellent way to protect borrowing ability. In general, it is better to set up a HELOC as soon as possible to use in the case of an emergency. For example, a HELOC can be used to help someone get through a period of unemployment. However, if that person waits until he or she becomes unemployed, it might be impossible to get a HELOC. The same holds true for retirement, therefore, it is better to have it set up before one retires. A HELOC can also be used to pay for expensive items such as college, home renovations, medical bills or car purchases. However, a HELC may not be in the best interest for someone who cannot control his or her borrowing and may use it for everyday spending when it is not an emergency.
A HELOC is a secured loan using the borrower’s home as collateral. Interest paid on the HELOC is usually income tax deductible, unlike interest on a car loan or credit card. An added bonus is that the HELOC interest rate is often lower than rates on credit cards or personal loans.
The interest rate for a HELOC is normally variable and is based on an index plus a margin amount such as two percentage points. Common indices are the prime rate or the U.S. Treasury Bill. Although HELOC interest rates fluctuate with the index, most plans have rate ceilings and floors. Some plans also offer an initial interest rate discount for a period of time.
Generally, a line of credit amount is 75% (although up to 100% is not unusual nowadays) of the value of the home minus the mortgage balance. The homeowner may have a checkbook or a credit card to draw money from the HELOC. Some HELOC plans require the borrower to take an initial advance, keep a minimum amount outstanding, or to borrow a minimum amount each time he or she borrows.
Payments made to a HELOC can be interest only or interest plus a small portion of principal. These two options do not lead to full repayment of principal at the end of the draw period, which is usually ten years. At the end of the draw period, the homeowner is no longer allowed to draw money from the HELOC, and in some cases, will be required to repay all that he or she has borrowed. Some plans offer a repayment period that gives the borrower time to repay after the draw period has expired. Full repayment is also required if the home is sold. Some HELOC plans can be renewed. Another option is to make amortized payments that will have the HELOC paid off before a balloon payment has to be made.
Lastly, there are costs in setting up a HELOC. The homeowner will have to pay for his or her property to be appraised. When submitting an application, a fee is charged which may or may not be refunded if the borrower is rejected for the line of credit. There may be closing costs; other fees can include attorney fees, title search, mortgage preparation and filing, title and home insurance, and taxes. A HELC may be subject to an annual maintenance fee and transaction charges. Some plans also have up-front charges and/or points.
It is important to shop around and compare several HELOC plans before signing a contract. With so many options, HELOC plans can vary greatly. Homeowners should compare interest rates (the index and margin amount), costs for the start-up and maintenance, and determine how they will repay the loan.
A HELOC allows homeowners to protect their ability to borrow in times of need. Henssler Financial believes, in many cases, it is wise to establish a HELOC before it is needed. If money must be borrowed during an emergency or for large expenditures such as home improvements or financing a car, we recommend using a HELOC. However, it is important for the borrower to use the HELOC responsibly. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.
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