A potential borrower shows up at your desk (or virtual desk), asking about options. They bought their place in 2010 for $300,000, refinanced it in 2020 at 3% when it was valued at $450,000, and now believe it to be worth $680,000. They owe $350,000 on it while paying their 3%like clockwork. They have been talking about the $330,000 in equity versus their $80,000 of 29% credit card debt, their $25,000 8% car loan, their $12,000 medical debt from that procedure a few years ago, and their daughter’s $80,000 student loan debt. What to do…
The answer that you give the borrower may be different depending on whether you are a bank, a credit union, an independent mortgage bank (IMB), or a mortgage broker. It will also be dependent on the borrower’s tax situation, credit, long-term plans, financial knowledge, etc. A loan officer meeting with a borrower in person (versus the borrower seeking help on the internet) will ask, and calculate, whether it makes sense to refinance the entire first mortgage, or do a second, which includes home equity lines of credit (HELOCs) and home equity loans (HELOANs). HELOANs and HELOCs are two common types of second mortgages. A HELOAN is a fixed-rate second, funded as a lump sum, while HELOCs are credit lines for the borrower to draw upon as needed. Historically, home equity loans were offered almost entirely by banks, but IMBs are now beginning to offer home equity options as well. Of course, when rates drop there is more interest in borrowing, and more activity in offering a new first mortgage to combine existing first and second mortgages or get cash out to consolidate debt. And, according to Federal Reserve economic data, there is $36 trillion in home equity available, which is huge considering our first mortgage volume last year was less than $2 trillion in originations.
For an IMB or a broker, the loan officer will often refer the borrower to their own credit union or bank for a second mortgage. Many credit unions and banks put these loans into their portfolios. That said, often the bank or credit union won’t, or can’t, do the second mortgage. In which case, the borrower will return to their loan officer for next steps. Some IMBs allow brokering out if the price for that option clearly beats the price of a similar product offered by the mortgage bank. Other IMBs won’t allow the LO to broker them out, so either the LO can’t help the borrower, or they use the IMB’s product.
At this point it is in the best interest of the loan officer to counsel the borrower and provide valuable information gained from experience.
An experienced loan officer will explain that both home equity loans and home equity lines of credit are loans that allow the client to convert some of their home’s equity into cash. These loans have similar benefits. Both HELOCs and HELOANs have relatively low interest rates because they use the home as collateral. They’re also second mortgages that don’t affect the interest rate on the first mortgage. With millions of borrowers having rates below 4%, this matters.
A HELOC is similar to a credit card. The borrower usually has 10 years to draw from the line of credit, during which time they only have to pay interest on the amount borrowed. After that, they can’t borrow anymore, and they will have to pay both principal and interest. Once the draw period is up, borrowers must make substantially bigger payments to pay back the balance owed on the credit line they used during the draw period. HELOCs often begin with a lower interest rate than home equity loans, and that rate is variable (typically based on the prime rate).
For HELOCs, the amount of credit available to the borrower is dependent on the equity in their home, their credit score, and their debt-to-income (DTI) ratio. Because HELOCs are secured by an asset, they tend to have higher credit limits and much better interest rates than credit cards or personal loans. Most well-qualified borrowers are able to take out up to 80% of the equity they have in their home.
Some HELOCs tend to have very low or no origination fees and are relatively simple to process, which makes them a more attractive option than a refinance or cash-out refinance for many borrowers. Others require the borrower to pay an annual fee for the account or an origination fee to cover the cost of setting up the HELOC, a home appraisal, a title search, and an attorney. Depending on the lender, the upfront costs may not be worthwhile if the client doesn’t need to borrow a significant amount of money.
Lenders and investors are expanding the credit box when they go into HELOCs, or “piggyback” seconds, on cash-out refinances over 80 LTV caps that use the equity in the home for collateral. The loans are often outside of Agency guidelines, which means that the new debt can eliminate loan-level price adjustments (LLPAs), loan size limits, and private mortgage insurance. A borrower can use a HELOC to pay off consumer debt, with better terms and therefore a lower overall cost. Borrowers can use HELOC funds for a variety of purposes, including home improvement projects, education, and high-interest credit card debt consolidation.
HELOANs are second mortgages that typically have fixed interest rates, meaning the payment is the same each month. A home equity loan payment would be in addition to your client’s usual mortgage payment. The borrower receives the loan at one time as a lump sum. A home equity loan can be a good source of funds for a home improvement project with a defined cost and one-time expenses such as debt consolidation.
HELOANs and HELOCs have key differences that make each loan suited to different borrowers. Advantages of a HELOAN include receiving a sum of money at once, an interest rate that is fixed, and the monthly payments won’t change for a set period. Disadvantages of HELOANS include the borrower immediately starts making payments on both principal and interest, and the borrower must know exactly how much they’ll need. Borrowing more money will require taking out another loan.
HELOCs have advantages that can be explained by a good LO. HELOCs are flexible and can be used for anything that requires cash, including medical bills, college tuition and other expenses. The borrower pays interest compounded only on the amount drawn, not the total equity available in the credit line. Borrowers can continue to draw from the line as needed, which means they don’t need to know exactly how much they’ll need upfront. But rising interest rates can increase the payment, and the minimum monthly payments will increase during the repayment period once the principal is factored into the cost. If home prices were to decline, borrowers hoping to refinance their HELOC to pay off the original don’t have the equity to do so, as seen during the financial crisis when home values plummeted. Many borrowers who used this method found their homes in foreclosure.
Interest paid on HELOCs and HELOANs is only tax deductible for the amount used on a HELOC to “buy, build, or substantially improve” a home. Additionally, with the standard deduction increasing to $14,600 for single filers and $29,200 for married couples filing jointly in 2024, most HELOC interest paid will not be high enough for most filers to justify itemizing deductions unless they are doing so already for other reasons. Lender requirements for a HELOC vary, but generally, borrowers will need more than 20% equity in their home, a 600 or better credit score, at least two years of verifiable income history, and a DTI ratio of 43% or less.
Whether an IMB, credit union, bank, or broker, there are alternatives to a HELOC, besides a HELOAN, that allow a client to access their home’s equity. A cash-out refinance is one option, although given the low rates that millions are enjoying on their home loan, this option is not as popular as it once was. A cash-out refinance allows the client to refinance their current mortgage loan with a higher loan amount, pocketing the difference. A cash-out refinance may be a better choice than a HELOC if your client only wants one loan on their property and one mortgage payment to make each month. And cash-out refinances typically have more attractive rates.
Loan officers, regardless of place of employment, know that these options, when used conscientiously, can be an excellent tool for borrowers to consolidate high-interest debt at a lower rate, make substantial improvements to their home, invest in real estate, and so on. However, they come with significant risks, and borrowers should be made aware of those issues before signing up for a product that erodes their ability to build wealth through the equity in their home, regardless of origination channel.
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