Second Trust Deeds: Home Equity Loans and Home Equity Lines of Credit

Looking back, I suddenly discovered I don't have a clear explanation of Home Equity Loans and Home Equity Lines of Credit in any previous article. It's time to remedy that.

A Home Equity Loan, or HEL (pronounced "heel") is a one time loan, much like a car loan. You get the money all at once, pay it back so many dollars per month, and when it's paid, it's over. The most common Home Equity Loan is probably the 30/15, which is like a fully amortized thirty year fixed rate loan except that it's got a balloon payment at the end of fifteen years, when the remaining balance is due. Since very few people do not sell or refinance much sooner than that anyway, the fact that it has a balloon just isn't important to most folks. I do not know why, but the rates for true thirty year fixed rate loans are much higher than for 30/15s. Fifteen and twenty year fixed rate Home Equity Loans are also pretty common, these being truly fixed rate loans without balloon payments, but the payments for those are significantly higher, so many people are not willing to consider them.

A Home Equity Line of Credit, or HELOC (pronounced hee-lock) works more like a credit card than anything else. At one point in time, I actually had a VISA card linked to a HELOC. There is an initial draw, which can be $0, and your monthly payments are based upon your actual balance. If there is no balance, no payments. The main difference is where credit cards are usually indefinite period and you can keep charging on the card as long as you pay your bills and stay within your limit, HELOCs usually only have a five year initial "draw period" when you can actually take more money, followed by what is most commonly a twenty year repayment period where you are making payments, but cannot draw any additional money. Unlike Home Equity Loans, HELOCs are variable interest rate loans based upon the prime rate on a certain day of the month. Also unlike Home Equity Loans, HELOCs are lines of credit, where you can take more money as long as you are within the draw period and under your limit. Also, so long as you are within the "draw" period, the minimum payment is usually based solely upon the interest accruing in any given month. It's only after the draw period ends that most of these loans begin to amortize as far as the minimum payment is concerned, but you can always pay extra.

With both Home Equity Loans and HELOCS, they are assumed to be Second Trust Deeds, with a different kind of mortgage in first position. But because the closing costs can be much lower than for a regular first trust deed, it need not necessarily be so - you don't have to have another mortgage in front of them. Indeed, sometimes with comparatively small mortgages (usually under $100,000) it can save you money by selecting a Home Equity Loan or HELOC instead. Even if the rate for the Home Equity Loan is a quarter of a percent higher than for a fixed rate first mortgage, it can save you money by saving you $2500 in closing costs. Often, you can find competitively priced second mortgages where the closing costs are zero. So if you can save $2500 on a $100,000 balance, it'll take you ten years to recover the difference in closing cost at a quarter of a percent per year, if you buy with a traditional first mortgage, and most people refinance within three years anyway. In such cases, it can make sense to choose a Home Equity Loan or Line of Credit instead.

Home Equity Loans and HELOCs are priced upon the degree of risk that lender is assuming. If you're taking out a $100,000 loan on a half million dollar "free and clear" property, you can expect better rates than someone taking out the same loan when there's a $300,000 loan already in place. One thing to be aware of is that because Private Mortgage Insurance is typically not available, lenders for Home Equity Loans and HELOCs have significantly greater equity requirements, and they are not typically willing to insure any amount over 90% CLTV, or comprehensive loan to value ratio, at least not as of this writing. Given how badly they were burned by piggyback loans, I would not expect this to change any time soon.

Caveat Emptor