Growing up, I often heard the phrase, “I’m going to need a second mortgage to pay for that!” – often referring to large, surprise expenses, or just the ridiculous cost of traveling sports teams (or simply because my parents were raising six kids)! It was burned in my brain that this was something to be avoided. However, in recent years as I have advised clients in different phases of life and with wildly divergent needs, I have come to view “second mortgages” with a different lens. So much so, that I have one now, having taken one out earlier this year to fund substantial home improvements to accommodate a growing family. Second mortgages are not one homogeneous thing. In fact, they can take a variety of forms, including home equity loans and home equity lines of credit (HELOC, for short). Technically speaking, a second mortgage is any “lien taken out against a property that already has a home loan on it,” that home loan normally being your primary mortgage.
Our goal today is to focus on and demystify HELOCs, as I find many clients do not fully understand what they are, how they work, and when they should be used (and when they should be avoided). We’re going to briefly look at all three of these questions in hopes of giving you a more complete understanding of what could be a very valuable resource at your disposal, especially as rising interest rates dissuade you from wanting to move from your current home (and thus give up that 2.5% interest rate you locked in during the pandemic refi boom).
Before we continue, I will say that we are not lenders, nor are we able to keep up with the exact details of every HELOC offering provided by banks and credit unions these days. Our goal is to help you get familiar with the general concepts so that you can be an informed consumer as you engage with your favorite bank / lender to find the right product for you.
WHAT IS A HELOC?
As noted above, HELOC is short for home equity line of credit. It is a way to tap into the substantial equity that exists in your home in a convenient and cost-effective way. Perhaps the best way to understand them is to simply unpack the two key terms that make up this name:
Home equity – Your home equity is the difference between your home’s value and the current value of any loans used to acquire (or improve) it. For many, this represents the greatest chunk of their net worth, especially in rapidly appreciating housing markets like we have here in the Seattle Metro area.
Let’s start with a simple example that we’ll use throughout the remainder of this piece:
Purchase price = $600,000
Original loan value = $480,000
Original home equity (at purchase) = $120,000
Current home value = $950,000
Current loan value = $350,000
Current home equity = $600,000
In this case, through a combination of mortgage payments and home price appreciation, this homeowner has grown their home equity from $120,000 at purchase to $600,000 now.
Line of Credit – Unlike a traditional mortgage where you take a lump sum at one time (at the time of purchase), a HELOC is a standing amount that you can draw on as needed (“line of credit”). You can limit your withdrawals only to the amount needed at the time needed. More on this next, as we look at how these loans work.
HOW DOES IT WORK?
Let’s go back to our example where the homeowner has $600,000 of equity and a $350,000 mortgage balance on a home valued at $950,000. Doing the math, you see that this is currently a loan-to-value (LTV) of ~37%. Now, let’s assume the lender is willing to loan up to 80% LTV (the typical max, though some lenders will go higher in some circumstances), meaning that the total debt on this property can be $760,000. The HELOC lender will then take this $760k and reduce it by the $350k primary mortgage to arrive at a potential loan value of $410,000.
That’s right, you as the homeowner now have access to $410,000 of liquidity (cash) that would have otherwise been tied up in your home and only accessible if you sold the property (or taken a reverse mortgage, but that’s an entirely different ball of wax).
Easy enough, but how does the borrower gain access to these funds, and how/when do they need to be paid back? Here I am going to give an example from my own HELOC, acknowledging that, while this structure is fairly common, the exact structure offered to you can and will differ from one lender to the next. Let’s now look at three key concepts – the draw period, the payback period, and the interest rate.
Draw period – a HELOC will have a “draw period,” which is the length of time during which you can access funds from the available loan amount ($410,000 in this case). During this time, you can take as little as $0 and as much as $410,000 – or any amount in between. Here we will assume a 10-year draw period. During the draw period, you are only required to pay interest on the outstanding amount (no repayment of principal is required but can be made).
Payback period – once your draw period expires, it’s time to pay back the loan. At this point, you can no longer take additional amounts against this HELOC, and the outstanding amount gets amortized at a fixed or variable rate and principal and interest payments commence. In my case, this period is 15 years (making the total HELOC loan life 25 years). In other words, it’s just like taking a 15-yr mortgage. If the outstanding balance is $100,000 at that time and the interest rate is 5%, you will start making monthly payments of $791 for 15 years (will vary if rate is adjustable). Like with a traditional mortgage, you can choose to pay more if you want, thus reducing the loan length and saving on total interest paid.
Interest rate – During the draw period, the interest rate can be either fixed or variable. When variable (more common), it is usually “prime +”, meaning a set % is added to the prime rate, which floats. The combination of these two elements determines your interest rate, which is applied monthly. Once the loan amortizes at the start of the payback period, this rate is also either fixed or variable, depending on the terms of your loan. Typically speaking, rates on HELOCs are going to be higher than a traditional mortgage. This is for a variety of reasons, primary being that a HELOC is subordinate to a primary mortgage, meaning the primary mortgage gets paid first in the case of financial distress. The higher interest rate compensates the HELOC lender for this added level of risk (amongst other things). It should also be noted that your credit score is highly likely to impact the interest rate offered to you by your HELOC lender.
WHEN SHOULD YOU USE A HELOC?
First and foremost, this is debt – and debt should only be utilized if you are responsible with it! A HELOC makes it “too easy” to access large amounts of cash, which can put irresponsible borrowers in a very difficult position.
Now, let’s assume you are a responsible borrower. Here are some circumstances where a HELOC might make sense:
- To finance a major home renovation or repair.
- To provide bridge financing when trying to move prior to selling your current home (note that a special type of HELOC may be required if the sole purpose is to make a down payment on a new home).
- To consolidate debt from other sources at a lower rate and with more favorable terms.
- To provide liquidity in turbulent financial markets, helping you to avoid becoming a “forced seller” or subjected to sequence of return risk (we owe you a separate paper on that topic!).
FREQUENTLY ASKED QUESTIONS
- Do I have to keep the HELOC for the full duration of its potential life?
No! A lot can happen in the 25 years or so that you may hold this line of credit. Let’s say you took it out at a rate of “prime + 4.0%” and the rate on your primary mortgage is 3.5%. Suddenly interest rates on primary mortgages drop to 3.0%. In that case, you can (and probably) should consider refinancing your primary mortgage and wrapping in your HELOC balance, thus fixing all of your house-related debt at a lower (fixed) rate of 3.0%. You can also choose to pay off the HELOC in full at any time. If you do so during the draw period, it’s often good to keep the HELOC open just in case future needs arise (as you don’t want to have to go through underwriting all over again).
- Is the interest paid tax-deductible?
Sometimes! The old answer was “yes” (with very limited exceptions), but recent updates (2018) to the tax code changed that. Now to write-off this interest as an itemized deduction, three criteria must be met:
- The interest must apply to a loan taken to “buy, build, or substantially improve” your home.
- You have to spend the money on the property in which the equity is the source of the loan (i.e., if the loan is drawn against your primary residence, the expenditures must be on your primary residence…no using those funds to improve your vacation home if you also want a tax deduction)
- You are limited to writing off the interest on a total of $750,000 of home debt (inclusive of your primary mortgage). In some cases, this can be increased. Consult with your tax professional for further details, especially if your primary mortgage pre-dates 2018 and your HELOC was initiated after this date.
Make sure to note this is an itemized deduction – so you will get no benefit from it if you instead take the standard deduction when filing your taxes. Also, note that interest from a personal loan used for the same purpose is not eligible for a deduction.
- Does it cost anything to take out a HELOC?
It costs you some time, but otherwise, HELOCs are generally free of charge to initiate. The lender typically pays all closing costs, with perhaps some minor exceptions (an exception may be if you are taking one for the sole purpose of making your next down payment). Some fees may be applied if you do not utilize the line of credit for a specified period of time, but these fees are generally minimal and easy to avoid.
- Do I have to take the full amount the lender is willing to loan?
In our example above, the borrower was able to access $410,000. Let’s say they plan to only need $150,000 to complete their remodel. Should they only open a HELOC with a $150,000 limit, or should they say yes to the entire amount (or something in between)? If you are a responsible borrower, take the whole thing! As we now know, you don’t have to use it all – but you would have access to it should an extraordinary need arise. On top of this, it does not cost you a penny more (or less) to take $410,000 vs. $150,000, nor should it impact your interest rate (though you’ll be paying a lot more in interest if you borrow the full $410k!). As noted earlier, check the exact terms from your lender before taking this advice, as these terms can and will vary.
- Where can I get a HELOC?
Many banks and credit unions offer them, but not all. For example, Chase (the nation’s largest bank) did not offer them at last check. You do not have to have an existing banking relationship with your lender in order to obtain a HELOC from them. Thus, you should shop around to find the offering best suited to your needs. Also, your HELOC lender certainly does not need to be the same lender through whom you obtained your first mortgage.
LET'S WRAP IT UP
We hope we have given you a digestible introduction to the land of second mortgages, particularly HELOCs. As we have noted, responsible borrowers may find these to be a valuable tool in their financial plan as they seek to complete a major renovation, consolidate debt, or simply access liquidity for any number of purposes. If you find yourself needing access to liquidity for any reason, please reach out to us and we’ll help you think through all of your options so that you can make an informed decision that looks not only at the here and now, but also at the impact on your long-term financial plan.