A Home Equity Line of Credit is commonly referred to as a HELOC. It’s a line of credit that’s secured by your home, which has many benefits.
What’s a Home Equity Line of Credit?
A Home Equity Line of Credit, or HELOC, is a line of credit that’s secured by your home. It can be used for several purposes, such as home improvement, debt consolidation, purchasing another home, or saved for emergencies.
What makes it attractive is that the interest rate is generally lower than other types of loans, and you can get a larger amount based on the equity you have in your home.
The reason that interest rates are lower is because it’s secured by your home, which means that lenders view it as less risky.
It’s important to understand the difference between a HELOC and a Home Equity Loan because they’re two separate types of loans.
The main difference is that the Home Equity Loan is an installment loan, meaning you get a lump sum of cash that you’ll repay within a specific term and interest rate that was agreed upon.
Another potential benefit of a HELOC is that the interest paid may be tax deductible. However, you’ll want to consult with your tax advisor to see if you’re eligible.
Variable and fixed-rate options
Often, you’ll have two options, a variable rate or a fixed rate. With most lenders, the HELOC will have a variable rate, and once you have a specific amount outstanding, you can fix the rate for the amount you’ve drawn.
When you have a variable rate, it can change depending on the U.S. Prime Rate, which is published by the Wall Street Journal.
Your variable rate is determined by the U.S. Prime Rate plus a margin. The margin can be positive or negative, meaning it’s a number that can be added to or subtracted from the Prime Rate.
After you draw from the HELOC, you can leave it as a variable rate. Some lenders will only require an interest-only payment as the minimum, while others will charge principal and interest.
Check with your lender to see how the payments work. However, it’s always a good idea to pay principal and interest to ensure you don’t get stuck in debt.
The downside to leaving your outstanding amount as a variable rate is that it can fluctuate. If rates go down, that’s great. However, if it goes up, you’ll have to pay more in interest.
That’s why lenders will offer the fixed-rate option. You may be able to convert your outstanding amount from a variable rate to a fixed rate.
There may be a minimum outstanding amount required to convert the rate. However, it’ll be a good choice for you if the rates are increasing, and you’d be more comfortable with the same payment amount every month.
When you fix the rate, you’ll select a term offered by your lender. Then, you’ll be able to make payments that cover principal and interest without worrying about fluctuations in the U.S. Prime Rate.
How to use a HELOC
The Home Equity Line of Credit is a revolving loan, think of it as a credit card without a card.
When you need it, you can write a check, transfer the funds to a checking account, or pay for things directly from the HELOC, if the lender allows that type of transaction.
As with other line of credit’s, you can’t exceed your credit limit. Otherwise, you may be subject to fees or penalties.
When you make it payment, that amount will become available again. You’ll only pay for what you use, instead of paying for the entire credit limit.
Generally, you’ll have a draw period and a repayment period. The draw period can be 10 years, while the repayment period can be 15 or 20 years.
This means that for 10 years, you can draw from the HELOC, pay it back, and continue using it. If you still carry a balance after the 10-year draw period, you may have up 15 or 20 years to pay it back.
The terms and interest rates will depend on the lender, so it’s important to check with them before you make a decision.
How to qualify for a HELOC
The first step to getting a Home Equity Line of Credit is to apply. When you put in an application, the lender will pull your credit score, verify income, and calculate your debt-to-income ratio.
Regarding the amount you can borrow, loan-to-value is an important concept to understand.
The loan-to-value guidelines will vary based on the lender. However, common percentages range from 70% to 85%.
It’s calculated by finding the value of your home, multiplying it by the maximum loan-to-value, and subtracting your mortgage balance if you have one.
For example, if your home’s value is $750,000, you owe $350,000, and the maximum loan-to-value is 75% to get the best rate, then use the following equation to find out what your maximum line of credit can be:
750,000 (Home value) x 0.75 (LTV) = 562,500 – 350,000 (Mortgage balance) = 212,500 (Maximum credit line)
In this example, you can potentially borrow up to $212,500. Remember, lenders may have maximum credit limits, so you might not be able to borrow the full amount of equity that you have.
Another common way of calculating the equity is taking the value of your home, subtracting the mortgage, and taking a percentage of that number.
The way it’s calculated depends on the lender, so it’s good to understand both methods.
Before you apply for a HELOC, check with your lender to see if there are any fees associated with it. They may have application fees, annual or cancellation fees, early closure fees, etc.
Note: If the HELOC is going to be secured by your primary residence, you’re protected by the 3-day right of rescission. After you sign the closing documents, you have until midnight of the third business day to cancel (Source: Consumer Financial Protection Bureau.
Frequently asked questions
Do I need an appraisal for a HELOC?
It depends on the financial institution because some may use automated valuation models, and others may require an appraisal. It’s good to check with your lender because they may be able to cover the cost of an appraisal.
Are there closing costs on a Home Equity Line of Credit?
Closing costs will depend on the lender. There are lenders who waive or don’t charge closing costs, while others may charge between 2% to 5%.
How does a HELOC show up on my credit report?
A Home Equity Line of Credit will show up as a revolving credit because it’s a line of credit.
Will the HELOC be a lien on my house?
Yes, the HELOC will be a lien on your home. If your home is paid off, it’ll become the first lien. If you have a mortgage, it’ll be the second lien. Some lenders won’t become the third lien, so it’s important to disclose all of the information up-front.
A HELOC is a line of credit borrowed against the equity in your home. It can be a better alternative to a credit card, or personal loan, as rates tend to be lower. They’re commonly used for home improvement projects, debt consolidation, tuition, or as funds for an emergency.
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About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.