Home buying is a wealth-building strategy, as well as a way to own a living space. As a homeowner pays off the mortgage over the years, the home becomes a store of value. That equity can be useful for making renovations or pursuing new business investments.
A home equity line of credit, abbreviated as HELOC, enables homeowners to reach and use the value they’ve accumulated in their homes. An owner might tap into their home equity to increase the value of the home still further. The interest on a HELOC can be a tax deduction, if the reason for taking out the loan is to improve the real estate’s value.
The owner pays a small annual fee, say $50, in exchange for this ability to borrow against the equity. The percentage of equity the lender might approve for the account could be as much as 85% of the home’s value — minus the current mortgage debt.
So, just like an original mortgage, a HELOC allows the homeowner borrow against the value of the real estate asset. Given that the HELOC collateral is the home, the homeowner will want to steer clear of any activity that could make it more of a stretch to repay the loan, raising the risk of losing the house to the lender.
Selling a House With a HELOC
Imagine you’ve had a HELOC with a 10-year line of credit for five years. You’ve used it wisely. You’ve bought a truck and started a landscaping business. Now, you’d like to sell your home, which today is worth $100,000 more than you paid for it. That profit will be eaten up immediately by your landscaping business, which needs a tractor and a regular assistant. Can you keep your equity line for five more years?
Here’s why the answer is no. Your HELOC was recorded as a second mortgage or deed of trust by the county recorder. Now, if you’re going to sell your home, the buyer will want a title clear of encumbrances. The lender won’t release its lien from your title before you resolve and close out your HELOC.
This makes sense when we consider the lender’s perspective. A HELOC is secured by a homeowner’s equity in the property. If that owner transfers the house, and becomes unwilling or unable to continue the monthly payments, the lender has nothing to foreclose, and thus no leverage to compel the borrower to find ways to repay the HELOC.
There are two takeaways here. First, whether a HELOC is your second or only mortgage, you could lose the home to foreclosure if you fail to pay it off. Second, before you sell your home, you’ll have to terminate the HELOC.
Pro tip: Before closing the account, you could owe a lump sum or balloon payment. Pandemic-related circumstances can turn HELOCs into hardships. Some lenders may agree to offer loan modification and forbearance for home equity lines.
Averting a Settlement Crisis
Imagine this scenario: You paid off the HELOC a long time ago, but never requested termination. Now, before settlement can conclude, you must get a release from the lender.
Just because you’ve paid off the account, doesn’t mean you’ve closed it. In contrast to your regular mortgage, HELOC accounts offer funds that can be drawn, paid back, and then redrawn. This is why the account stays open until the borrower formally asks for it to be terminated.
Owners sometimes do overlook this. Some owners never draw from the account at all. Where no monthly payment is due, there may be no monthly billing statement. But whether or not you use the funds made available through a HELOC, the loan is attached to your home. When you’re finished, have the lender release the lien and clear your title. Don’t wait until years later — by which time the HELOC might have been assigned to another company, and clearing the cloud will entail complicated communication and research.
Keep in mind, too, that where the lender does not require a title insurance policy, a HELOC can fall through the cracks, failing to get recorded or released. So do keep evidence of all payments and communication with the lender, and have that ready with your documentation when you go to sell your house.
Pro tip: Buying a new home? Consider the importance of owner’s insurance. HELOCS that go unrecorded or are yet to be recorded will be missed in title company’s searches, and can cloud your new home’s title. HELOCs can also be vehicles for seller fraud. Picture the seller who takes out a HELOC just before the sale — simply to access the funds, with no intention of making payments on the account. Fast forward several months after closing, when the HELOC lender sends a notice of foreclosure to the current owner — who knew had no idea what the former owner was up to…
Nuts and Bolts
As with mortgages in general, expect plenty of requirements and documents to be involved. The HELOC approval process involves title searches, truth-in-lending disclosures, and attorney opinions. Many steps involve upfront fees and costs. There’s the underwriter approval, the signed note, and the recorded lien. Your circumstances might also call for a power of attorney, which would also be recorded with the county.
And just as with a regular mortgage, the homeowner must produce proof of income and tax returns. The mortgage company will run a credit report and examine the owner’s mortgage payment history. The underwriter will likely insist on a full home appraisal to confirm the home’s value — and insurance to cover known hazards.
Read all the loan paperwork. Note that HELOCs have variable interest rates. To start off, the lender takes the standard rate, then marks it up based on the applicant’s credit rating. As standard rates change, the HELOC interest rate will vary. Check for the cap over the life of the loan. Be prepared to pay that much interest.
During the draw period, which frequently spans ten years, your monthly payments go to the interest. As with a regular mortgage, you can probably pay into the principal as desired. Ask the mortgage specialist about this, if you want the option.
You must stop borrowing during the repayment period, which may span 20 years, unless your lender allows renewal. At this point the monthly payments tend to be higher — encompassing both interest and principal.
Some HELOCs have opening fees and early payoff penalties, so look for those provisions, too.
The Reward: Flexibility
The decision to apply for a HELOC might be right for you. It can make good sense for those who need to have funds at the ready, but not necessarily for immediate use. Some homeowners use as much equity as they can reach. Others open the credit line with a zero balance, and pay no interest on it unless and until the right time comes to use it.
All things considered, the HELOC’s most important benefit is flexibility.
Federal Title & Escrow Company: Three Reasons HELOCs Create Title Headaches (July 13, 2012).
Clare Trapasso, Homeowners Are Rushing to Get HELOCs — Should You Do It, Too?, Realtor.com (June 14, 2018).
Holden Lewis and Kate Wood, HELOC: Understanding Home Equity Lines of Credit, NerdWallet (June 5, 2020).
Photo credit: Michael Longmire via Unsplash.