October 2, 2022

Home Equity Line of Credit (HELOC) is a Better Option than a Mortgage Refinance

Savings – A Lost American Virtue

In an uncertain world it is important that everyone has at least six months’ worth of savings available.  It might not be possible to save this much for the average person.  The best option to establish a readily available and reasonably priced source of funds is to take out a home equity line of credit (HELOC).

Here are some of the basic things to know about a HELOC.

A home equity line of credit (HELOC) can provide emergency funds at a fraction of the cost of a credit card advance or personal loan and there are no monthly fees.

A HELOC is a mortgage on your home which means that you are using the collateral in your home as security for the loan.  If the borrower already has a first mortgage, then the HELOC would be a second mortgage lien.

The application process with a bank is very easy and usually there are no upfront costs. The borrower may be responsible for paying the fees associated with setting up the HELOC if the line of credit is cancelled within five years. Keep in mind that the bank must incur costs for underwriting, credit report fees, processing, title search, appraisal and closing costs. A HELOC is a much lower cost option for obtaining cash than doing a fee laden cash out refinance of a first mortgage.

The application process is similar but less stringent than applying for a first mortgage. The borrower’s income is verified, and the credit score must meet the bank’s standards. Most banks will lend up to 80% or more of the home’s value minus any first mortgage balance.  At the time of application, the borrower puts in a request for a specified loan amount.

Once the HELOC is approved, the borrower is given a check book to access the approved credit line.  There is no requirement to borrow any funds.  The money is quickly available when needed which can be a lifeline in the case of job loss or unexpected expenses.

The interest rate of a HELOC is variable and is typically based on the prime rate or other short-term index plus a specified margin.  The rate and payment on any advances will therefore change monthly. Interest rates on personal loans and credit cards can easily be more than triple the rate on a HELOC.

The monthly payment on a HELOC is interest only which keeps the payment low. Borrowers have the option of paying more than the minimum payment due and can pay off the loan in full at any time.  The interest on a HELOC is tax deductible which lowers the cost of the loan.

The biggest risk of a HELOC is that if a default occurs, the bank may initiate a foreclosure proceeding.  If you are comfortable with the concept of using your home equity as collateral, a HELOC is the lowest cost and most flexible option for borrowing money.

Second Mortgage Investors Facing 100% Losses

Extinguished

Risky Lending

Second mortgage liens have always been considered risky lending.  Investors in second mortgages are about to find out that the risk was higher than anticipated.

WASHINGTON, April 6 (Reuters) – The U.S. Treasury will soon finalize details on a plan to extinguish and modify second-lien mortgages as part of its overall housing program, a senior Treasury official said on Monday.

The second liens — home equity loans that were often written in tandem with a primary mortgage during the housing boom years — have been an obstacle to refinancing and modifying loans to make them more affordable.

The official, speaking to reporters on condition of anonymity, said assistance would be provided and also guidelines that “comprise a clear path for the reduction of second lien debt.”

He said these range from extinguishing them to keeping them in place as a part of mortgage modifications done under a $75 billion program the Obama administration is implementing to make failing mortgages affordable to home owners.

Under the “old rules” obtaining a second mortgage was not easy.  There were tough restrictions on loan to value levels and the borrower needed sterling credit.   Investors are now discovering why the old rules made sense as they face total losses on second mortgages approved during the lending boom.

Mortgages Secured By Negative Equity

During the peak years of the housing boom it was common for second mortgage lenders to allow borrowing up to 100% of a home’s value.   As housing prices cratered over the past three years, the collateral backing these high risk second mortgages was vaporized leaving lenders  with an essentially unsecured note.

It has become somewhat of an open industry secret that second mortgage investors  do not even bother trying to foreclose or collect since recovery would be minimal.   The second mortgage lien remains on title, however, preventing homeowners from selling or refinancing unless they can come to a settlement with the second mortgage lender.

It now appears that most of the underwater second mortgage investors will be forced to recognize a 100% loss of investment based on legislative decree.

Many Losers, Some Winners

The end result of the second mortgage easy lending fiasco is a total loss for many second mortgage investors.  Most of the companies that specialized in second mortgage lending are no longer in business.  Many future applicants looking for a second mortgage loan will be out of luck as lenders abandon second mortgage lending.

Every disaster, however, seems to have some winners. Those homeowners who borrowed to the max and used second mortgage money for cars, furniture or exotic vacations and such are no doubt smiling at the prospect of having their debt extinguished.