Home equity loans used to be all the rage. Then they got a bad rap. Now they're back in style, but with some twists intended to make them safer for lenders and borrowers alike.
Equity loans are cyclical largely because they track the housing market. When prices rise, homeowners have more equity to borrow against. When they fall, the opposite is true.
For the 12-month period which ended February 2013, a composite of 20 major U.S. cities posted price increases of 9.3 percent, the highest annual growth rate since May 2006, according to the S&P Case-Shiller Home Price Indices. Consider that and it's clear why home equity loans "are making a comeback," says Neena Vlamis, president of A and N Mortgage Services in Chicago.
Still, these loans aren't the free money they were often perceived to be during the equity-rich housing boom of the early-2000s, says Kelly Kockos, senior vice president and home equity products manager at Wells Fargo in San Francisco.
"In certain pockets of the housing market, home prices are increasing, unemployment claims have dropped, more people are working," says Kockos. "Those are all good indicators that home equity will be brought back as a product choice for consumers who want to responsibly leverage their home."
If you're in the market for a home equity loan, here's what you'll need to know:
Types of home equity loans
There are two types of home equity loans: second mortgages and home equity lines of credit (HELOCs). The chief difference is that a second mortgage has a fixed repayment term while a HELOC is revolving debt, like a credit card.
Both types usually are second-position loans, which means the lender has a secondary claim on the collateral, i.e., your home, if you default on the loan. Some lenders also offer first-position HELOCs, which allow homeowners who don't have a first mortgage to borrow against their equity through a credit line.
Homebuyers can also get a two-loan package that used to be called a "piggyback," but today is known as a "simo," which is shorthand for simultaneously closing first and second loans. Kockos says simos appeal mainly to people who want to avoid a more expensive jumbo loan or use a HELOC to make home repairs.
Rates and terms
Home equity loans tend to carry higher interest rates than first mortgages, though rates are always a function of the lender, property location and the borrower's financial situation.
Home equity loan rates may be fixed or variable, and terms can range from open-ended to as long as 30 years. Some loans offer an interest-only payment option or allow you to convert all or part of your outstanding balance from a credit line into a fixed-term loan.
HELOCs commonly have floating rates based on the prime rate plus a margin, explains Vlamis. The margin depends in part on the loan-to-value ratio (LTV) which is the loan amount as a percentage of the property's value.
"The interest rate is affected by the LTV," Vlamis says. "The lower the loan-to-value, the lower the rate."
Borrowing 100 percent or more of your home's value is no longer an option because, as Kockos explains, "there is not a huge appetite in the (banking) industry to be lending to people who have very little money invested."
Instead, LTVs are typically limited to 75, 80 or perhaps 90 percent.
Some lenders today will allow a higher LTV if you obtain a HELOC then decide to refinance your first mortgage without taking out cash and you've made the payments on both loans, says Joe Parsons, senior loan officer at PFS Funding, a mortgage company in Dublin, Calif.
The LTV for two loans is known as a "combined" or CLTV.
"We have had zero problems or resistance with lenders agreeing to subordinate when we are sliding the new first mortgage underneath the equity line and the CLTV is greater than 100 percent," Parsons says.
Closing costs and fees vary considerably, so it's a good idea to shop around and compare.
Qualifying for a home equity loan
Home equity loans used to be approved without much fuss, but today, full documentation of your income, credit and collateral will be required. Vlamis says the process is virtually identical to applying for a first mortgage.
"The banks are not foolish any longer," she says.