Home equity line of credit (HELOC)

A home equity loan is simply a loan that is taken out with the equity of a borrower’s home used as collateral. This may or may not be a second mortgage, since a home equity loan can be taken out on a home that is owned free and clear.

A home equity loan may be for either a fixed dollar amount, or it may be structured as a line of credit. For the latter, this is known as a home equity line of credit, or HELOC. These typically carry an adjustable rate, and let you spend money up to the amount of equity that has been pledged, over a period of time, as needed, using a special-purpose debit card or by writing a check. The upfront costs are typically low, and you will usually not have to pay points for this type of loan.

It’s important to know that since you are able to draw money at any time, interest is calculated daily, instead of monthly, although usually the bottom line difference in interest is negligible. The biggest drawback of this type of loan instrument is that you re exposed to changing interest rates. A HELOC will always be structured as an adjustable rate mortgage, but unlike a standard ARM, a HELOC will reflect changes in the interest rate much faster. If you intend to take out a sizeable sum of money at one time, it may be better to see if your lender will allow you to convert the line of credit into a fixed-rate loan at the time you draw the funds.

Also, unlike a standard ARM, a HELOC does not have a rate cap outside of the legal maximum that is allowed in a given state. The home equity loan is based on prime rate plus a margin, but often, this margin is not disclosed unless you specifically ask the lender for that information.

Being told that your home equity loan is based on prime rate sounds good, but it can be misleading. What the lender means when they say that, is that they are going to lend you money based on the prime rate plus an undisclosed added percentage, which can be substantial. A home equity loan can bring you tremendous flexibility with minimal added costs, by giving you the power to leverage your home, but be sure to know the exact terms of the loan before you enroll.