What to Know About Home Equity Loans in Texas

Throughout the television comedy “Arrested Development”, George Bluth, Sr. famously told his son Michael, “There’s always money in the banana stand.” Michael took it as a reference to income from a family business but later realized that there was literally cash hidden in the walls of the banana stand.

Likewise, Texas homeowners may have money in their house, just in a different way. The value of the owner’s interest in a home—less the outstanding balance of loans secured by the home (such as the mortgage loan)—is called home equity.

For many years, this value was inaccessible for Texans. For most of Texas’ history, home equity lending was prohibited. Borrowed from Spanish and Mexican law concepts, homestead protections became a permanent part of Texas law in 1840, and homesteads have been considered sacrosanct ever since. The homestead was, and is, protected from forced sale for the payment of debts, with a few exceptions, such as taxes and purchase money loans. These protections are enshrined in the Texas Constitution. Borrowing against the equity in a homestead was a no-no.

Texas became the last state to permit home equity loans when the legislature passed—and voters approved—a constitutional amendment allowing home equity loans, effective Jan. 1, 1998. Additional changes have taken place since then.

Texas laws are very specific and are designed to prevent homeowners from borrowing too much against their homes, maintain the stability of the lending market, and avoid predatory lending practices. Having a basic understanding of Texas law regarding these types of loans and the definition of the terms used is vital when advising clients. Homeowners should exercise caution when borrowing against home equity. However, using equity in a home can be a valuable financial tool.

Types of Loans

The Texas Constitution, Article XVI, Section 50, provides for protection of the homestead from forced sale. As amended, it contains the provisions for home equity lending. Loans covered by this section generally fall into three categories: cash-out refinancing, home equity loans, and home equity lines of credit (HELOC).

Cash-Out Refinancing

Cash-out refinancing involves taking out a home loan that is larger than the existing one. The existing loan is paid off, and the new loan replaces it. The owner is left with a single monthly payment. The difference between the loans comes to the owner in cash. The additional debt reduces the owner’s equity in the home. These loans can be helpful if the owner wants to renovate the home, consolidate high interest debt, obtain a lower interest rate, or as a source of liquid cash for other needs (such as college tuition). Drawbacks may include fees, closing costs, higher payments, and a longer mortgage term.

Home Equity Loans

A home equity loan is a separate loan, or a second mortgage. It does not replace the existing loan. The borrower has two payments instead of one. These loans can be helpful for the same reasons as cash-out refinancing and have similar drawbacks. Since the lender is in second lien position, home equity loans may have higher interest rates than cash-out refinancing. However, if the owner already has a good rate on her first mortgage, she can keep it. Home equity loans may also be taken on homes owned free and clear.

Home Equity Lines of Credit

Another potential drawback for both cash-out refinancing and home equity loans is that the loan amount is fixed. If an owner borrows too much, the result is paying interest on unnecessary funds. Borrowing too little could require taking out an additional loan. This is a problem, because an owner may have only one home equity loan at a time.

One way to address that problem is with a home equity line of credit. A HELOC is a form of open-end account where the credit line is approved up to a certain amount. During the “draw period,” the borrower may take out money as needed, and may repay or reborrow money. Thus, the owner may borrow as needed, rather than taking a single lump sum. Payments during this period are often interest-only.

After the draw period, often ten years, the loan enters the “repayment period.” During this time, payments become fixed and include principal and interest. These loans often have lower closing costs and may be particularly suitable for short-term needs. However, HELOCs often have variable interest rates.

Texas Constitutional Requirements

Unlike most laws, many of the rules regarding home equity lending are spelled out in the constitution itself. Article XVI, Section 50(a)(6) of the Texas Constitution sets forth the requirements for these loans. The Finance Commission of Texas and the Texas Credit Union Commission are authorized to interpret the provisions. The interpretations, found in Title 7 of the Texas Administrative Code, Chapter 153, are subject to judicial review. However, the Texas Supreme Court held in Sims v. Carrington Mortg. Services, L.L.C., 440 S.W.3d 10 (Tex. 2014) that compliance with the interpretations is considered compliance with Section 50. Thus, a lender who complies with the interpretations is considered to have complied with Section 50, even if the interpretation is later held to be wrong by a court.

The loan must be secured by a voluntary lien on the homestead created under a written agreement with the consent of each owner and his/her spouse. The agreement may not contain any blanks left to be filled in relating to the substantive terms of the agreement.

80% Limit

The principal amount, when added to all the other outstanding principal balances of all other indebtedness secured against the home, may not exceed 80 percent of the fair market value of the homestead on the date the extension of credit is made. That is, the borrower must retain at least 20 percent equity in the home.

2% Limitation on Fees

The owner or owner’s spouse may not be required to pay fees that total more than 2 percent of the original principal amount of the home equity loan. This excludes fees for third-party appraisals, surveys, title insurance, and title examination reports, as well as any interest or bona fide discount points used to buy down the interest rate.

No Penalty for Paying Early

The loan must not have prepayment penalties.

Lien on Homestead Only

The loan may not be secured by any additional real or personal property other than the homestead, and may not be secured by wages. Section 50 loans may not be taken out on a secondary residence or a rental or investment property.

Limits on Acceleration

The lender may not accelerate the debt because of a decrease in the market value of the homestead, or because the owner defaults on other indebtedness not secured by a prior valid encumbrance against the homestead.

One at a Time

At the time of the loan, it must be the only debt secured by the homestead other than: (1) the purchase money; (2) the taxes; (3) an owelty of partition (a payment made to equalize a division of property by partition or divorce, which may be secured by a lien established by court order or written agreement); (4) a refinance of a lien against the homestead, including a federal tax lien resulting from the tax debt of both spouses, if the homestead is a family homestead, or from the tax debt of the owner; or (5) certain mechanics’ and materialmans’ liens. Only one such loan may be made in a 12-month period, even if the previous loan is repaid.

Equal Payments

The loan must be scheduled to be repaid in substantially equal payments of at least the amount of the accrued interest. The payments must be due at least once a month and not more often than every 14 days and must begin no later than two months from the date of the loan.

Required Disclosures

At least 12 days prior to closing, the lender must provide the borrower with a separate written notice that is set forth in Section 50.

At least one business day before closing, the owner must receive a copy of the loan application and a final itemized disclosure of the actual fees, points, interest, costs, and charges that will be charged at closing. This may be provided on the date of closing, or may be modified on the date of closing, only if a bona fide emergency or another good cause exists and the lender obtains the written consent of the owner.

Must Be Closed at the Office

The loan must be closed at the office of the lender, an attorney, or a title company.

Interest Rates

The lender may contract for and receive any fixed or variable rate of interest authorized by statute.

Authorized Lenders

Not just anyone can offer a home equity loan. Banks, savings and loan associations, savings banks, or credit unions doing business under Texas or U.S. law are authorized lenders, as are federally chartered lending entities or persons approved by the U.S. government to make federally insured loans. Mortgage bankers, mortgage companies, and other licensees regulated by the state of Texas are also authorized.

Use of Proceeds

The lender may require that the borrower use loan proceeds to pay debts secured by the homestead, and/or debts to another lender. The lender may not require the borrower to pay another debt to the same lender unless that debt is secured by the homestead. Stringer v. Cendant Mortg. Corp., 23 S.W.3d 353 (Tex. 2000). This provision also prohibits a borrower’s “voluntary” agreement to pay a non-homestead debt to the same lender, if the loan would not have been made without such an agreement. Box v. First State Bank, 340 B.R. 782 (S.D. Tex. 2006).

Rescission Period

The borrower may rescind the loan within three days after the loan is made, without any penalty or charge.

No Recourse; Judicial Foreclosure

The loan must be without recourse for personal liability against the owner and the owner’s spouse. Unless the loan was obtained by fraud, the lender’s only recourse is to foreclose on the home. Unlike most Texas foreclosures, the lien may be foreclosed upon only by a court order. For these loans, a special procedure is set forth in Rules 735 and 736 of the Texas Rules of Civil Procedure.

Forfeiture for Failure to Comply

If the loan does not comply with constitutional requirements, and the lender fails to cure within 60 days of being given notice by the borrower, the lender forfeits all principal and interest on the loan. Methods for curing some defects are provided in the constitution. These include refunding any overcharges, and a catch-all cure for “defects that are irremediable by other methods.” Wood v. HSBC Bank USA, N.A., 505 S.W.3d 542 (Tex. 2016).

Special Provisions For HELOCS

While the above rules apply to HELOCs, these types of loans are a little different. During the draw period, each single debit or advance must be at least $4,000. The owner may not use a credit card, debit card, or similar device, or pre-printed check unsolicited by the borrower, to obtain an advance. Each payment made by the borrower during the draw period must equal or exceed the amount of accrued interest. Usually, draw period payments are interest-only.

During the repayment period, all payments must be substantially equal. If you want to prepay part or all of the principal, you can, but during the repayment period, the required payments must be equal (on a normal amortization schedule). There cannot be a balloon payment.

Any fees associated with a HELOC must be charged and collected at the beginning, and there are no fees in connection with any debit or advance.

Taxes

For tax years 2018 through 2025, interest paid on these types of loans may be tax deductible if the funds are used for home improvements. Before 2018 and after 2025, the interest may be deductible regardless of how the funds are used. These deductions are subject to limitations. Anyone considering these deductions should consult with a tax professional.

Nothing in Tierra Grande should be considered legal or tax advice. For advice or representation on a specific situation, consult an attorney or tax professional.

Rusty Adams, J.D. ([email protected]) is a member of the State Bar of Texas and a research attorney for the Texas Real Estate Research Center.