Defaulting on Home Equity Loans and HELOCs

Home equity loans and home equity lines of credit (HELOCs) are affordable ways to tap the equity in your home to use for home improvements, pay for education, and pay off credit cards or other higher-interest types of debt. Secured by your property, they typically have lower interest rates than unsecured loans. But what happens if you can’t make your payments?

The interest paid on these loans was tax-deductible at one point. However, with the Tax Cuts and Jobs Act (TCJA), the interest is only deductible if they “are used to buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS).

Key Takeaways

• Home equity loans and home equity lines of credit are two key types of debt used to tap the equity in your home.
• Defaulting on either can result in foreclosure, but what the lender will do largely depends on the amount of equity you have in your home.
• The more equity, the more likely your lender will choose to foreclose.
• If you’re underwater on your home, the lender can sue you personally for the money you owe.
• Many lenders work with you if can’t make payments, so it’s important to contact them as soon as possible.

Home Equity Loans vs. HELOCs

There are two types of debt instruments used to turn the equity in your home into available cash. The first is a home equity loan (sometimes known as a second mortgage), which is a set amount of money financed for a set period (usually five to 15 years) at a fixed interest rate and with a fixed payment.

The second is a HELOC, which has a variable interest rate and functions more like a credit card with an expiration date—often up to 10 years after the line of credit is taken out. You can run into trouble with either type of debt if you have serious financial problems, lose your job, or experience an unexpected illness.

A further complication of a HELOC is the contrast between the initial phase (called the draw period, which is when you have access to the line of credit and may have to pay only interest on the money you borrow) and the second phase (when the line of credit expires and you must begin repaying both principal and interest on your remaining balance).

Warning

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

Lenders Won’t Automatically Foreclose

Defaulting on a home equity loan or HELOC could result in default and foreclosure. What the home equity lender does depends on the value of your home and how much you owe upon default. If you have enough equity in your home, your lender will likely initiate foreclosure procedures, because it has a decent chance of recovering some of its money after the first mortgage is paid off. The more equity, the more likely your lender will choose to foreclose.

If you are underwater and your home is worth less than the amount you owe, your home equity lender may be less likely to foreclose. That’s because the first mortgage has priority, meaning that it’s likely that the home equity loan or HELOC holder will not receive any money after a foreclosure.

Instead, the lender may choose to sue you personally for the money you owe. While a lawsuit may seem less scary than foreclosure proceedings, it can still hurt your credit, and lenders can garnish wages, try to repossess other property, or levy your bank accounts to get what is owed.

Don’t Wait to Act

Most mortgage lenders and banks don’t want you to default on your home equity loan or HELOC, so they will often work with you if you are struggling to make payments. Should that happen, it’s important to contact your lender as soon as possible. The last thing you should do is try to duck the problem. Lenders may not be so willing to work with you if you have ignored their calls and letters offering help.

When it comes to what the lender can do, there are a few options. Some lenders offer to modify your loan or line of credit. This can include modifying the terms, such as interest rate, monthly payments, or loan length—or some combination of the three. For example, Bank of America offers HELOC modifications for borrowers that:

• Have had the loan for at least nine months
• Have not received any kind of home equity assistance in the last 12 months or twice in the last five years
• Are undergoing financial hardship
• Have made at least six full payments during the life of your loan
• All borrowers on your loan agree to participate

Other private lenders—such as Sallie Mae, which offers student loans—work with a borrower who is struggling to meet payments by offering multiple deferments and forbearance options. For borrowers who don’t qualify, banks may offer payment extensions or repayment plans to catch up on delinquent payments.

Limited Government Help

Federal government help is available for homeowners who have trouble keeping up with their payments. But it is fairly limited.

• The federal government established the Homeowner Assistance Fund under the American Rescue Plan Act in response to the COVID-19 pandemic. The program assigned $9.96 billion in funding for homeowners “facing financial hardship associated with COVID-19.” Qualified homeowners could use funds to cover mortgage payments, homeowners’ insurance, utilities, and other related expenses.
• HUD offers distressed homeowners counseling services at no cost. HUD-approved agencies can help guide you through the options you have to help prevent legal action, including foreclosure. You can find more information from HUD’s circular here.

Is a Home Equity Loan the Same As a HELOC?

While both options give access to a home’s equity through borrowing, the two products differ in important ways. A home equity loan is essentially a second mortgage that comes with fixed interest for the term of the loan. HELOCs are instead a form of revolving credit lines that comes with adjustable interest and variable minimum payment amounts.

Can I Lose My Home If I Don’t Pay My HELOC?

If you fail to repay your HELOC, your lender may foreclose on your home and you could end up losing it to the bank. In addition, you will have a negative hit to your credit score, making future borrowing more costly or difficult.

Do I Need to Pay for a HELOC If I Don’t Use It?

Most lenders will charge some sort of origination fees to open a HELOC, although these are often far less than with a mortgage. During the draw phase, you may access and pay back any money allowed under the line of credit. During the repayment phase, you must repay any outstanding balances without being able to draw additional funds.

The Bottom Line

Home equity loans and HELOCs allow you to tap into the equity in your home. If you find yourself in trouble, you have options, including lender workouts and limited government help. The key in all options is to get help right away instead of hoping the problem will disappear on its own.

Read the original article on Investopedia.