HELOC
Encyclopedia
A home equity line of credit (often called HELOC and pronounced HEE-lock) is a loan
in which the lender agrees to lend a maximum amount within an agreed period (called a term
), where the collateral
is the borrower's equity
in his/her house. Because a home often is a consumer's most valuable asset, many homeowners use home equity credit lines only for major items, such as education, home improvements, or medical bills, and choose not to use them for day-to-day expenses. HELOC abuse is often cited as one cause of the subprime mortgage crisis
.
in that the borrower is not advanced the entire sum up front, but uses a line of credit
to borrow sums that total no more than the credit limit
, similar to a credit card
. HELOC funds can be borrowed during the "draw period" (typically 5 to 25 years). Repayment is of the amount drawn plus interest. A HELOC may have a minimum monthly payment requirement (often "interest only"); however, the debtor may make a repayment of any amount so long as it is greater than the minimum payment (but less than the total outstanding). The full principal amount is due at the end of the draw period, either as a lump-sum balloon payment
or according to a loan amortization schedule
.
Another important difference from a conventional loan is that the interest rate on a HELOC is variable. The interest rate is generally based on an index, such as the prime rate
. This means that the interest rate can change over time. Homeowners shopping for a HELOC must be aware that not all lenders calculate the margin
the same way. The margin is the difference between the prime rate and the interest rate the borrower will actually pay.
HELOC loans became very popular in the United States in the early 2000s, in part because interest paid was (and is) typically (depending on specific circumstances) deductible under federal and many state income tax laws. This effectively reduced the cost of borrowing funds and offered an attractive tax incentive over traditional methods of borrowing (such as credit card debt). Another reason for the popularity of HELOCs is their flexibility, both in terms of borrowing and repaying on a schedule determined by the borrower. Furthermore, HELOC loans' popularity growth may also stem from their having a better image than a "second mortgage
," a term which can more directly imply an undesirable level of debt. However, within the lending industry itself, a HELOC is categorized as a second mortgage.
Because the underlying collateral
of a home equity line of credit is the home
, failure to repay the loan or meet loan requirements may result in foreclosure
. As a result, lenders generally require that the borrower maintain a certain level of equity in the home as a condition of providing a home equity line.
Traditional mortgages in the United States are usually non recourse loans
, while mortgages in countries such as Canada are generally recourse loans. "Nonrecourse debt or a nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable." A HELOC may be a recourse loan for which the borrower is personally liable. This distinction becomes important in foreclosure since the borrower may remain personally liable for a recourse debt on a foreclosed property.
, Countrywide Financial
, Citigroup
, JP Morgan Chase, National City Mortgage, Washington Mutual
and Wells Fargo
began informing borrowers that their home equity lines of credit had been frozen, reduced, suspended, rescinded or restricted in some other manner. Falling housing prices have led to borrowers possessing reduced equity, which is perceived as an increased risk of foreclosure in the eyes of lenders. On January 27, 2010 a federal judge refused to dismiss a class action lawsuit against Chase for freezing HELOC loans. Courts have held that a bank may freeze a HELOC in instances where a home's value decreases substantially, which is deemed by courts as a 50% reduction in value.
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
in which the lender agrees to lend a maximum amount within an agreed period (called a term
Time
Time is a part of the measuring system used to sequence events, to compare the durations of events and the intervals between them, and to quantify rates of change such as the motions of objects....
), where the collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
is the borrower's equity
Home equity
Home equity is the market value of a homeowner's unencumbered interest in their real property—that is, the difference between the home's fair market value and the outstanding balance of all liens on the property. The property's equity increases as the debtor makes payments against the...
in his/her house. Because a home often is a consumer's most valuable asset, many homeowners use home equity credit lines only for major items, such as education, home improvements, or medical bills, and choose not to use them for day-to-day expenses. HELOC abuse is often cited as one cause of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
.
Differences from conventional loans
A HELOC differs from a conventional home equity loanHome equity loan
A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. These loans are useful to finance major expenses such as home repairs, medical bills or college education...
in that the borrower is not advanced the entire sum up front, but uses a line of credit
Line of credit
A line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...
to borrow sums that total no more than the credit limit
Credit limit
A credit limit is the maximum amount of credit that a financial institution or other lender will extend to a debtor for a particular line of credit...
, similar to a credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
. HELOC funds can be borrowed during the "draw period" (typically 5 to 25 years). Repayment is of the amount drawn plus interest. A HELOC may have a minimum monthly payment requirement (often "interest only"); however, the debtor may make a repayment of any amount so long as it is greater than the minimum payment (but less than the total outstanding). The full principal amount is due at the end of the draw period, either as a lump-sum balloon payment
Balloon payment
When a debt is repaid in payments of varying amounts there are some colourful jargon terms used to describe the different loan structures. The term balloon payment arises because if you hold back most of a debt and pay it only towards the end of the agreement, both those last payments and the total...
or according to a loan amortization schedule
Amortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
.
Another important difference from a conventional loan is that the interest rate on a HELOC is variable. The interest rate is generally based on an index, such as the prime rate
Prime rate
Prime rate or prime lending rate is a term applied in many countries to a reference interest rate used by banks. The term originally indicated the rate of interest at which banks lent to favored customers, i.e., those with high credibility, though this is no longer always the case...
. This means that the interest rate can change over time. Homeowners shopping for a HELOC must be aware that not all lenders calculate the margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
the same way. The margin is the difference between the prime rate and the interest rate the borrower will actually pay.
HELOC loans became very popular in the United States in the early 2000s, in part because interest paid was (and is) typically (depending on specific circumstances) deductible under federal and many state income tax laws. This effectively reduced the cost of borrowing funds and offered an attractive tax incentive over traditional methods of borrowing (such as credit card debt). Another reason for the popularity of HELOCs is their flexibility, both in terms of borrowing and repaying on a schedule determined by the borrower. Furthermore, HELOC loans' popularity growth may also stem from their having a better image than a "second mortgage
Second mortgage
A second mortgage typically refers to a secured loan that is subordinate to another loan against the same property.In real estate, a property can have multiple loans or liens against it. The loan which is registered with county or city registry first is called the first mortgage or first position...
," a term which can more directly imply an undesirable level of debt. However, within the lending industry itself, a HELOC is categorized as a second mortgage.
Because the underlying collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
of a home equity line of credit is the home
Home
A home is a place of residence or refuge. When it refers to a building, it is usually a place in which an individual or a family can rest and store personal property. Most modern-day households contain sanitary facilities and a means of preparing food. Animals have their own homes as well, either...
, failure to repay the loan or meet loan requirements may result in foreclosure
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
. As a result, lenders generally require that the borrower maintain a certain level of equity in the home as a condition of providing a home equity line.
Traditional mortgages in the United States are usually non recourse loans
Nonrecourse debt
Non-recourse debt or a non-recourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the...
, while mortgages in countries such as Canada are generally recourse loans. "Nonrecourse debt or a nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable." A HELOC may be a recourse loan for which the borrower is personally liable. This distinction becomes important in foreclosure since the borrower may remain personally liable for a recourse debt on a foreclosed property.
HELOC freeze
In 2008 major home equity lenders including Bank of AmericaBank of America
Bank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...
, Countrywide Financial
Countrywide Financial
Bank of America Home Loans is the mortgage unit of Bank of America. Bank of America Home Loans is composed of:*Mortgage Banking, which originates purchases, securitizes, and services mortgages. In 2008, Bank of America purchased the failing Countrywide Financial for $4.1 billion...
, Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
, JP Morgan Chase, National City Mortgage, Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
and Wells Fargo
Wells Fargo
Wells Fargo & Company is an American multinational diversified financial services company with operations around the world. Wells Fargo is the fourth largest bank in the U.S. by assets and the largest bank by market capitalization. Wells Fargo is the second largest bank in deposits, home...
began informing borrowers that their home equity lines of credit had been frozen, reduced, suspended, rescinded or restricted in some other manner. Falling housing prices have led to borrowers possessing reduced equity, which is perceived as an increased risk of foreclosure in the eyes of lenders. On January 27, 2010 a federal judge refused to dismiss a class action lawsuit against Chase for freezing HELOC loans. Courts have held that a bank may freeze a HELOC in instances where a home's value decreases substantially, which is deemed by courts as a 50% reduction in value.
External links
- Federal Reserve site offering information on HELOC loans
- "Should you tap home equity?" - CNNMoney.comCNNMoney.comCNNMoney.com is the world's largest business website. The site is the online home of Fortune and Money, and serves as CNN.com's exclusive business site. The site, edited by Chris Peacock, together with the three titles, is part of the Fortune|Money Group, and attracts more than 10.8 million unique...
, November 6, 2006 - Home Equity Loans
- Financial ABC: Home Equity Line of Credit
- "What you should know about Home Equity Lines of Credit (HELOC)"