- If a buyer lacks the assets to cover the full cost of a home upfront, a mortgage provides him the cash to purchase the property in exchange for interest on the sum borrowed. Although variable-rate loans exist, most home mortgages use a fixed interest rate, and the monthly payment amount stays the same for the life of the loan. Once the borrower makes his final monthly payment, the total amount he will have paid is equal to the principal and all interest accrued on it.
However, mortgage schedules are designed so that each monthly payment pays down both the interest and the principal. Each dollar that goes toward paying down the principal is essentially an additional dollar worth of ownership bought back from the lender. The difference between the remaining unpaid principal on the mortgage and the market value of the property is equivalent to the borrower's "equity" in the home. Another way to think of equity is the approximate amount of money the homeowner would have left over if he sold his property at market value and paid down the outstanding balance of the mortgage. - The size of a primary mortgage is limited by the appraised value of the property. This way, if the borrower goes into default, the proceeds from the foreclosure sale will be able to cover the balance of the loan plus legal fees. A home equity loan is designed the same way: The loan amount is equal to some percentage of homeowner equity. If the home is sold, the amount left over after the primary mortgage holder is paid will, in theory, still be enough to cover the balance of the home equity loan.
In general, the combined value of the primary mortgage and home equity loan is not allowed to exceed 80 percent of the property's appraised value. For example, if a $400,000 house had a $200,000 mortgage, the largest home equity loan allowed would be roughly $120,000. - When a homeowner applies for a home equity line of credit, the lender appraises the value of his property, assesses his finances and determines the maximum amount that he is allowed to borrow. Once the HELOC is approved, its "draw period" begins. Ranging from 5 to 10 years, the draw period is the time during which the homeowner can borrow against the HELOC. He is responsible only for the amount he actually borrows. If a homeowner gets a HELOC for $40,000 but borrows only $7,500 during the draw period, the loan's principal will be $7,500. During the draw period, the borrower must make small monthly payments to cover the interest on the amount he has borrowed thus far.
Once the draw period ends, the 10- to 20-year "repayment period" begins. Even if he hasn't exceeded the maximum loan amount, he is not allowed to borrow any further money during repayment. These monthly payments are larger because they now include both principal and interest. In certain cases, the HELOC must be repaid in full -- principal plus interest -- at the end of the draw period. - A HELOC is an adjustable rate mortgage, meaning that the interest rate charged on the principal changes with the prime interest rate. Different HELOC lenders may offer incentives like initial fixed-rate periods in which the interest rate remains unchanged for several months to a few years. However, a HELOC will eventually revert to a basic ARM model.
While a standard ARM has a rate adjustment cap that limits the amount by which a rate can increase from year to year, a HELOC is tied completely to the prime interest rate. If the rate soars from 10 percent to 18 percent, a HELOC will follow suit. - Like a mortgage or home equity loan, a HELOC is a "secured" loan. This means the lender is entitled to place a lien for an amount equal to the balance of the loan -- principal plus interest -- against the property. If a foreclosed property with multiple liens is sold at public auction, the order in which each lien holder is paid depends on the type of loan it issued. For example, if a home with both a primary mortgage and a HELOC was foreclosed on and sold, the proceeds from the sale would first go toward paying off the outstanding balance of the primary mortgage. Any leftover proceeds would go toward paying off the balance of the HELOC.
If the proceeds from the sale do not cover the full balance of the HELOC, the HELOC lender can sue the borrower for a "deficiency." This allows the lender to pursue payment even after the borrower has been evicted from the property.
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