home equity

My refinance loan is a HELOC. Is that bad?

Don TaylorDear Dr. Don,
We recently refinanced our mortgage of $87,000 to get a lower monthly payment. We just found out the loan we have is not really a mortgage but a home equity line of credit. Are we at a disadvantage with this type of loan? It's a 15-year loan at 3.99 percent interest with a $500 penalty if we pay it off in the first three years. We always buy down the principal when possible. The line is secured by the property. Does this type of loan cost more in the long run? Can I still get another home equity line of credit or second mortgage, if necessary?

Thanks,
-- Robin Refi

Dear Robin,
Home equity lines of credit, or HELOCs, and home equity loans are secured by the property. To the extent allowed by the tax code, based on the size and use of the loan proceeds, the interest expense is tax deductible.

Home equity lines and loans used to be called second mortgages. That's because there was almost always a first mortgage that was first in line to be repaid in the event that the home went in to foreclosure. (That’s why it’s called a first mortgage.) When you use a HELOC to refinance your first mortgage, however, then the HELOC gets to sit first chair, and it has first dibs on the home's value in foreclosure.

There are two disadvantages to a HELOC. One is that the interest rate is variable and can change over time. That's a disadvantage if rates head higher. The other is that the HELOC lender may have recourse in a foreclosure if the proceeds from foreclosure don't cover the outstanding loan balance. Recourse laws vary by state. What's meant by recourse is that the lender can go after other assets than just the property in seeking repayment on the loan.

Another issue is that HELOCs, at least in the early years of the loan, are interest-only. You're not paying down principal unless you take the initiative to do so. You say you do that on a regular basis, so it shouldn't be a big issue with you.

If you have a HELOC sitting first chair, then you might be able to get a second home equity line or loan on the property. It won't be easy, and it could be a better deal to request an increase in the size of the original HELOC or to refinance the HELOC in a larger amount than to get a second loan. You'll be able to decide down the road if that situation comes up.

I think most of your confusion is with the way the loan appears in the bank's online banking system, not with anything related to tax code or state laws concerning recourse.

You decided on this path in refinancing your mortgage. Unless something I've said gives you pause, then stay the course, and move on with your lives.

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Dear Dr. Don, I have a variable-rate home equity line of credit, or HELOC, at 2.9 percent. I'd like to convert it to a fixed-rate mortgage. I have 20 years remaining to pay off the home equity line. Would it be beneficial... Read more

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