A common scenario we see in our office is a client who calls us worried that their lender is foreclosing on them for missed payments on a Home Equity Line of Credit (HELOC). Resolving a mortgage foreclosure is much simpler than resolving a credit line foreclosure.
What is a HELOC?
A HELOC is an increasingly popular way to finance a home purchase or home renovations. This product allows a lending bank to provide a homeowner access to a credit line up to a certain amount relative to the value of the home and the homeowner’s financial ability to sustain loan payments. Most HELOCs come with attractive interest rates and offer greater flexibility in repayment than traditional mortgages.
How is a HELOC different from a mortgage?
Traditional mortgages and HELOCs both use the value of a home as collateral for the loan. One main difference is that a traditional mortgage is considered to be a term loan and come with more restrictive options for repayment of funds back to the lender. A HELOC is considered to be a demand loan and offers greater flexibility in both access to funds and repayment of funds back to the bank.
There is at least one large drawback to HELOCs that most borrowers do not consider when signing up. Since a HELOC is a demand loan, the lender can unilaterally choose when to call for a return of their funds. There is no set time limit a homeowner has access to the funds for. The recall of up to possibly the full amount of the outstanding HELOC is entirely at the bank’s discretion. This is in contrast to a fixed term mortgage where the loan term is agreed to by the lender and the mortgagor at the beginning of the term. The lender cannot call the entire mortgage due until the end of the term.
How does a HELOC put my home at greater risk in a foreclosure?
If a homeowner misses a few payments on a mortgage they can simply pay back those missed payments (arrears) to bring the mortgage back into good standing, assuming there is still some term (time) left on the mortgage. However, if a homeowner misses a few payments on a HELOC, the lender can call the entire amount due and owing. The homeowner has fewer options to avoid foreclosure with a HELOC. Most lenders will only accept payment plans on arrears for 6 months to a maximum of 12 months. With a traditional term mortgage, the arrears might amount to only be a few thousand dollars which can be paid back over the course of up to a year. But with a HELOC the process is much more difficult. Very few homeowners have the financial capacity to pay a $100K HELOC back over 6 short months. Once the bank calls the HELOC due, the homeowner gets trapped into a foreclosure that becomes very difficult to escape from.
In short, a HELOC can be a fabulous and flexible solution to a homeowner’s financing needs. Just be aware that flexibility comes with some hidden pitfalls. A homeowner needs to be absolutely certain they will always be able to easily make the HELOC payments. If there is any uncertainty on future income, a term mortgage is a much safer means of financing.