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Home equity loan and home equity line of credit basics - TIAA-CREF

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Borrowing<br />

Know How Now: Financial Education Series<br />

<strong>Home</strong> <strong>equity</strong> <strong>loan</strong> <strong>and</strong> <strong>home</strong><br />

<strong>equity</strong> <strong>line</strong> <strong>of</strong> <strong>credit</strong> <strong>basics</strong><br />

Article Highlights:<br />

• <strong>Home</strong> <strong>equity</strong> borrowing is increasing.<br />

• <strong>Home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> <strong>line</strong>s <strong>of</strong> <strong>credit</strong> can be valuable cash<br />

management tools.<br />

• Underst<strong>and</strong>ing the best use <strong>of</strong> each is important to maintain your<br />

financial security.<br />

<strong>Home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> <strong>home</strong> <strong>equity</strong> <strong>line</strong>s <strong>of</strong> <strong>credit</strong> (HELOCs), are lending tools that allow<br />

you to borrow against the <strong>equity</strong> in your <strong>home</strong>. Such <strong>loan</strong>s are <strong>of</strong>ten used to improve your<br />

<strong>home</strong>, pay for college, make large purchases, or meet certain expenses. In recent years,<br />

stricter lending st<strong>and</strong>ards meant fewer <strong>home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> HELOCs were approved.<br />

However, a March 2013 report from Equifax found that 2012 was the first time since the<br />

recession that <strong>home</strong> <strong>equity</strong> revolving <strong>line</strong>s increased, although the $65.5 billion in such<br />

<strong>loan</strong>s taken out in 2012 is roughly a third <strong>of</strong> the amount taken out in 2006. 1<br />

An uptick in <strong>home</strong> <strong>equity</strong>-based lending is good news for <strong>home</strong>owners. Secured by real<br />

estate, these <strong>loan</strong>s usually have lower interest rates than <strong>credit</strong> cards or personal <strong>loan</strong>s.<br />

That makes them a useful tool for covering large expenses, such as <strong>home</strong> improvements or<br />

college tuition. However, using them effectively as part <strong>of</strong> a broader financial plan requires<br />

underst<strong>and</strong>ing the answers to a few key questions.<br />

What is the difference between a <strong>home</strong> <strong>equity</strong> <strong>loan</strong> <strong>and</strong> a HELOC<br />

Both <strong>home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> HELOCs are <strong>loan</strong>s made based on the <strong>equity</strong> in your <strong>home</strong> —<br />

the value <strong>of</strong> your <strong>home</strong> less the amount financed. <strong>Home</strong> <strong>equity</strong> <strong>loan</strong>s are structured so the<br />

borrower receives a lump sum <strong>and</strong> payments are made over a predetermined period <strong>of</strong> time.<br />

HELOCs, on the other h<strong>and</strong>, allow the borrower to access a specific amount <strong>of</strong> <strong>credit</strong> on an<br />

as-needed basis, usually by writing checks issued for the <strong>line</strong> <strong>of</strong> <strong>credit</strong>. HELOCs have a<br />

limited time during which the borrower can take advances on the <strong>credit</strong> <strong>line</strong> called a “draw<br />

period.” There is a minimum amount due based on the outst<strong>and</strong>ing balance while the draw<br />

period is active. When that period is over, the remaining balance is typically converted into<br />

amortizing payments at a fixed or variable rate <strong>of</strong> interest for repayment over a period <strong>of</strong><br />

time similar to a <strong>home</strong> <strong>equity</strong> <strong>loan</strong>.<br />

When <strong>and</strong> how should these <strong>loan</strong>s be used<br />

Borrowing against the <strong>equity</strong> in your <strong>home</strong> can be a powerful tool, but it’s one that should<br />

be used strategically <strong>and</strong> carefully. Use <strong>home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> HELOCs to pay <strong>of</strong>f highinterest<br />

debt or tax obligations, improve your <strong>home</strong>, make tuition payments, or purchase<br />

big-ticket items like automobiles at a more favorable interest rate. It’s typically not a good<br />

idea to use them to meet everyday expenses or “splurges” like vacations.


<strong>Home</strong> <strong>equity</strong> <strong>loan</strong> <strong>and</strong> <strong>home</strong> <strong>equity</strong> <strong>line</strong> <strong>of</strong> <strong>credit</strong> <strong>basics</strong><br />

<strong>Home</strong> <strong>equity</strong> <strong>loan</strong>s are usually best for one-time purchases where you know the amount<br />

you’re going to need. For example, if you plan to add a room onto your <strong>home</strong>, you might opt<br />

for a <strong>home</strong> <strong>equity</strong> <strong>loan</strong> to finance it, allowing you to make fixed payments at a lower interest<br />

rate than other types <strong>of</strong> financing.<br />

HELOCs are generally preferred when the borrower needs periodic access to funds, such as<br />

making a tuition payment or making an unexpected <strong>home</strong> repair. It’s best to use this for<br />

specific reasons <strong>and</strong> pay down as much <strong>of</strong> the balance as soon as possible, just as you<br />

would on a <strong>credit</strong> card. Every time you borrow against the <strong>equity</strong> in your <strong>home</strong>, you’re<br />

extracting money from the return you’ll get on the <strong>home</strong> if you ultimately sell it. Also, by<br />

securing the <strong>loan</strong> with real estate, you are pledging <strong>and</strong> putting at risk your residence if the<br />

payments can’t be made.<br />

Will my <strong>home</strong> <strong>equity</strong> <strong>loan</strong> or HELOC interest be tax-deductible<br />

Another advantage <strong>of</strong> using <strong>home</strong> <strong>equity</strong> financing is that the interest may be tax-deductible,<br />

provided you meet certain criteria. Since there are various restrictions on deductibility<br />

based on tax filing status, ownership interest in the property, the amount financed, <strong>and</strong> how<br />

the funds were used it is recommended that you consult a tax advisor regarding the<br />

potential tax implications <strong>of</strong> this type <strong>of</strong> borrowing. IRS Publication 936 fully explains the<br />

particulars <strong>of</strong> <strong>home</strong> <strong>equity</strong> debt deductions.<br />

How do I qualify for a <strong>home</strong> <strong>equity</strong> <strong>loan</strong> or HELOC<br />

Qualifying for a <strong>home</strong> <strong>equity</strong> <strong>loan</strong> or HELOC is similar to qualifying for a conventional<br />

mortgage. You’ll be asked to fill out an application <strong>and</strong> provide pro<strong>of</strong> <strong>of</strong> income, assets <strong>and</strong><br />

expenses. Be sure you review your <strong>credit</strong> reports with all three major <strong>credit</strong> reporting<br />

agencies (Equifax, Experian, <strong>and</strong> Trans Union) before you apply to get a sense <strong>of</strong> your <strong>credit</strong><br />

scores <strong>and</strong> ensure that there are no errors that could cause you to be denied. Then, look at<br />

your overall debt ratio <strong>and</strong> pay down as much as you can. Tip: For a free copy <strong>of</strong> your <strong>credit</strong><br />

report from each <strong>of</strong> the three major <strong>credit</strong> reporting agencies visit AnnualCreditReport.com.<br />

The value <strong>of</strong> your <strong>home</strong> is another critical factor in determining whether your <strong>loan</strong> or <strong>line</strong> <strong>of</strong><br />

<strong>credit</strong> will be approved. In most cases, the amount <strong>of</strong> all <strong>loan</strong>s <strong>and</strong> <strong>credit</strong> <strong>line</strong>s on a<br />

property—including first <strong>and</strong> second mortgages, <strong>home</strong> <strong>equity</strong> <strong>loan</strong>s, <strong>and</strong> <strong>home</strong> <strong>equity</strong> <strong>line</strong>s<br />

<strong>of</strong> <strong>credit</strong>, <strong>and</strong> any other outst<strong>and</strong>ing liens—cannot exceed 80% <strong>of</strong> the current property’s<br />

market value. <strong>TIAA</strong> Direct has a useful <strong>Home</strong> Value Estimator that can give you an idea <strong>of</strong><br />

your <strong>home</strong>’s value. However, any lender will likely order a real estate appraisal to determine<br />

the current market value <strong>of</strong> your <strong>home</strong> before approving the <strong>loan</strong>. If you obtain a HELOC, it’s<br />

possible that your <strong>home</strong> <strong>equity</strong> <strong>line</strong> may change over time, depending on fluctuations in the<br />

value <strong>of</strong> your <strong>home</strong> <strong>and</strong> overall market conditions.<br />

You’ve worked hard to build <strong>equity</strong> in your <strong>home</strong>. <strong>Home</strong> <strong>equity</strong> <strong>loan</strong>s <strong>and</strong> HELOCs are tools<br />

that can make that <strong>equity</strong> work for you when you need to make big purchases or cover large<br />

expected or unexpected expenses. Work with a reputable <strong>loan</strong> advisor to choose the best<br />

option for your needs.<br />

1<br />

More Americans Paying Off Debt <strong>and</strong> Opening New Lines <strong>of</strong> Credit, Equifax.com, March 2013. http://blog.<br />

equifax.com/<strong>credit</strong>/more-americans-paying-<strong>of</strong>f-debt-<strong>and</strong>-opening-new-<strong>line</strong>s-<strong>of</strong>-<strong>credit</strong>/<br />

The material is for informational purposes only <strong>and</strong> should not be regarded as a recommendation or an <strong>of</strong>fer to<br />

buy or sell any product or service to which this information may relate. Certain products <strong>and</strong> services may not be<br />

available to all entities or persons.<br />

C10186 238120_317302<br />

A14014 (05/13)

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