Is an Equity Line of Credit Considered a Second Mortgage?
If you do not own your home free and clear, you may have a variety of types of loans secured on it. The first mortgage is usually the largest and has the longest term, frequently 30 years. You can also obtain a second mortgage if you have sufficient equity. A home equity line of credit, like a traditional home equity loan, is a type of second mortgage.
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HELOC Basics
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A home equity line of credit gives homeowners a way to access the equity in their homes on an as-needed basis. Rather than borrowing a large sum all at once, you open a line of credit for a certain amount, say $40,000. Then you use it to pay for home improvements, college expenses or other similar goals by writing checks as the bills come in. Usually a HELOC has a shorter term than a first mortgage, frequently 15 years or less. The bank collects interest only on the balance you have borrowed, and you often postpone payback to a later period.
Comparison with a Traditional Second Mortgage
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A traditional second mortgage, also called a home equity loan, allows you to borrow a fixed amount which you repay in set payments over a predetermined term, often 10 to 15 years, but up to 30. Unlike the HELOC, you get the money in one lump sum and start paying it back right away.
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Qualifying and Limits
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How much you can qualify to borrow with a HELOC depends on several factors. Calculate your equity by subtracting your first mortgage from the market value of your house. Different lenders will allow you to borrow different percentages of your equity, called the loan-to-value or LTV ratio. For example, if you have $50,000 in home equity, and your lender allows 90 percent LTV, you could borrow up to 90 percent of $50,000 or $45,000. The lender also will consider your credit history in qualifying you, and you will need to pay a higher interest rate to borrow at a high ratio. For example, you will pay as much as 5 points over prime for a loan at 100 percent of equity.
Advantages of a HELOC
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The home equity line of credit has several advantages.You can use it like a credit card to borrow money as you need it. Unlike a credit card, you can wait until the payback period to begin returning the money. The home equity line thus also gives you better flexibility than a traditional second mortgage. Like a regular second mortgage, you can deduct up to $1 million in interest from federal income tax if you use the money to improve your home. For other purposes, you can deduct up to $100,000 unless you use the borrowed money to invest in life insurance or tax-exempt bonds.
Disadvantages of HELOC
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Any second mortgage, including a home equity line of credit, puts a lien against your house. If you fail to pay on time, your lender could take your home. A second mortgage also makes selling your home or refinancing more difficult. Finally, if you do not exercise financial discipline, an HELOC makes it easy to fall deeper into debt.
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