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 (HELC) allows the borrower to draw funds
as needed and offers various repayment option at variable interest rates.
HELC
is an excellent way to protect borrowing ability. In general, it is better to
set up a HELC as soon as possible to use in the case of an emergency. For example,
a HELC 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 HELC. The same holds true for retirement, therefore, it is better to
have it set up before one retires. A HELC 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
HELC is a secured loan using the borrower's home as collateral. Interest paid
on the HELC is usually income tax deductible, unlike interest on a car loan or
credit card. An added bonus is that the HELC interest rate is often lower than
rates on credit cards or personal loans.
The
interest rate for a HELC 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 HELC 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 HELC. Some HELC 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 HELC 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 HELC, 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 HELC plans can be renewed.
Another option is to make amortized payments that will have the HELC paid off
before a balloon payment has to be made.
Lastly,
there are costs in setting up a HELC. 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 HELC plans before signing a contract.
With so many options, HELC 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
HELC allows homeowners to protect their ability to borrow in times of need. The
Henssler Financial Group believes, in many cases, it is wise to establish a HELC
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 HELC. However, it is important for the borrower to use the HELC responsibly.
