Home Equity Loans: The Types, Pros and Cons
When real estate prices were on the rise, it seemed like everyone had tapped into their home’s equity. But now, of course, with homes in a freefall you don’t hear much about home equity loans. They’re still around, at least for those with money in their properties.
“Homes aren’t valued as much as before and lending guidelines have become tougher,” says Richard Scholtz, a mortgage broker based in Seattle, Wash. “It used to be common to get a stated income home equity loan for up to 100 percent loan to value. Then regulations tightened and you needed full documentation and the loan would be up to 90 percent. Now it's full doc and they’re lending up to 75 percent.”
Here are some things to consider if you’re thinking about a home equity loan:
Fixed 2nd vs. HELOCs
It used to be that when you got a second on your house it was kind of like a “junior first mortgage.” It gave you a fixed amount of money in one lump sum that you paid back over 10 to 30 years. But about 30 years ago, the Home Equity Line of Credit (HELOC) was introduced. “You take a draw or use a charge card assigned to that account and you only pay on what you use,” says Miami mortgage broker Steve Milton. “It’s flexible. If you get it to pay for some work on your house, but you decide you don’t want to do it, there’s no real loss.”
On top of that, HELOCs, which are often interest only, have been significantly cheaper recently. “You can get them for one point over prime, about 4.5 percent,” says Scholtz. “A fixed-rate second goes for about 8.5.”
The Piggyback Loan
During the real estate boom, home equity loans were often called “piggyback” loans because they helped carry a home purchase, and they’re still used today for this purpose. Say you need 20 percent down to purchase a home but all you have is 10 percent. If the home’s value and your income and credit rating warrant it, you could get a HELOC for the other 10 percent, which would keep you from having to pay mortgage insurance.
The Big Draw
As property values have declined recently, so have the credit limits of many homeowners’ HELOCs. “There are plenty of people who have received notices over the past year that their credit limits have been sharply cut,” says Scholtz. “What I’ve seen is some people who may be planning to use the money in the account six months to a year from now just draw it all out and put it in the bank. True, they’re making a higher payment now but they’re afraid the lender will cut their limit down before they need the money.”
Many HELOCs are offered with little or no fees and it pays to shop around if you’re in the market. Other issues to watch for: Is there a pre-payment penalty if you wipe out your balance or sell your home before the loan’s term? Most of these are variable, interest-only loans but it pays to start adding to the principal early on. Interest rates are cheap now, but when the economy improves, rates will rise and so will your payment.