HEL and HELOC Considerations

If you are considering a home improvement project, tapping the equity built up in your home may be one way for you to finance the work. Keep in mind that since 2008, home prices have fallen and have even plunged in some markets where values have retreated by 50 percent or more.

Still, if you have lived in your home for many years, perhaps 10 or 15 years or longer, then you may still have enough equity remaining to borrow. Your lender will send out an assessor to determine your home’s current value and based on that information and your creditworthiness, let you know how much you can borrow.

Home Values

One example of what the lender may allow you to take out is if your home is valued at $250,000 and your mortgage balance is now $120,000. You won’t have $130,000 to work with, but your lender may allow you to borrow as much as 80 percent of your equity, which in this case amounts to $104,000. If you anticipate your home improvement project will cost about $50,000, then you’re well within the parameters set by the bank. And, you should be able to withstand any further drop in home values. Consult with a professional to gauge your market’s pricing trends.

Now the decision on how to borrow comes down to essentially two types of borrowing options: a home equity loan or a home equity line of credit. A HEL and HELOC have one similarity: these lending vehicles tap your home’s equity and both are treated as second mortgages. But, there are some important distinctions which we will address as follows.

Home Equity Loan (HEL) — A HEL is simply a loan that is based on a portion of the equity built up in your home. Like your first mortgage, this second mortgage is for a certain number of years, for a fixed sum and may be offered at a fixed or adjustable interest rate. If you borrow $50,000, you may be given 15 years to pay back your loan and pay 5 percent interest based on May 2011 interest rates.

Home Equity Line of Credit (HELOC) — A HELOC works differently from a HEL, although you may also eventually take out the $50,000 you planned to borrow. Instead of receiving the money in one lump sum, you have an account set up allowing you to draw down that money. You don’t pay the loan back until you begin drawing down the loan although you may be charged an annual service fee if your $50,000 balance remains untapped. You may also be required to draw on funds within five or 10 years. After this draw period has ended, then you may be able to renew your HELOC, although terms and rates may vary. Your bank will also give you a repayment period where you’ll need to pay back what you borrowed.

Considerations

Why would a homeowner choose one option over the other? That’s mostly due to preference. With a HELOC, you have access to $50,000, but you aren’t obligated to tap those funds at once or in entirety. If its turns out that your total project cost you $42,000, you can leave the remaining $8,000 untapped and enjoy a lower monthly payment. With a HEL you have the entire $50,000 on hand. Yes, you can return the excess funds as well, therefore the differences simply come down to personal preferences and work that you want to have done on your home. Closing costs are higher with a HEL, but in both cases the interest should be tax-deductible. See IRS Publication 936 for more information and consult a tax advisor.

Resources

Federal Trade Commission; What You Should Know About Home Equity Lines of Credit; April 6, 2011

LendingTree.com: Home Equity Loan vs. Home Equity Line of Credit

Internal Revenue Service: Publication 936
 

Additional “Home Equity” Information:

• how your home can become a bank

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