What Is Home Equity Line of Credit?

A home equity line of credit, the same HELOC is a type of loan that uses your home equity as collateral. The amount of credit available to you depends on the equity of your home; Also on your credit score and debt-to-income ratio. Because assets secure HELOCs, they have higher credit limits and better interest rates than credit cards or personal loans. Although HELOCs typically have variable interest rates, there are several fixed-rate options.

Key takeaways

• A Home Equity Line of Credit (HELOC) uses your home’s equity as collateral.
• Your credit limit depends on home equity, credit score, and debt-to-income ratio.
• HELOCs have higher limits and better rates than unsecured loans but come with variable interest rates. Fixed-rate options are available.
• Using your home as collateral includes the risk of a second lien. If you fail to make payments, you risk losing your home.
• HELOCs can lead to debt overload due to their accessibility and the temptation to borrow excessively.
• HELOCs offer flexible access to funds with a variable rate and a draw period, typically 10 years, followed by a repayment period.
• Home equity loans provide a lump sum with a fixed interest rate and consistent monthly payments.

Home equity loans basics

Home equity loans and HELOCs borrow against your home’s equity, which is the value of your home minus your mortgage balance. These loans secure against your home’s equity, offering low interest rates similar to first mortgages. They cost less than unsecured loans like credit cards for the same amount.

But, using your home as collateral has risks. Lenders put a second lien on your home. If you don’t make payments, they have rights to it, just like your first mortgage. The more you borrow, the higher the risk you face.

Home Equity Line of Credit Explained

The terms of each HELOC are different, although they most often have a draw period of 10 years and a payback period of about 15 years. During the raffle, borrowers have the opportunity to use the credit line limit on HELOC, as well as pay the minimum interest.

As soon as the raffle period expires, borrowers will have to pay substantially larger payments; To repay a line of credit used during the lottery.

HELOCs have a high risk of debt overload. Especially because they are easy to get because of their raffle and repayment terms. In recent decades, when the value of a home has grown substantially, borrowers have found themselves in their own homes with ever-increasing capital and access to cheap credit through their HELOCs.

Many borrowers are accustomed to only low-interest payments on HELOC during the raffle period. Consequently, not ready to pay HELOC during the repayment period. So they take out another HELOC or home equity loan to repay the first one.

They can continue this cycle until the value of their home rises again. When home values fell during the financial crisis, many borrowers who used this method found their homes seized. There is no absolute limit to how much HELOC a borrower can get. The downside is that continuing to remove HELOCs can lead to many risks.

What is the difference between a HELOC and a home equity loan?

A HELOC offers you access to funds up to a set limit to draw from as needed, with a variable rate, making it flexible. A home equity loan gives you a lump sum upfront with a fixed interest rate, leading to consistent monthly payments. HELOCs have a draw period for borrowing, whereas home equity loans distribute the full loan amount immediately.

What are today’s average HELOC rates?

Today’s HELOC rates vary by lender. Your annual percentage rate (APR) mainly depends on your credit score, existing debt, and the loan amount you want. Lenders often base HELOC rates on the prime rate. This rate is what lenders offer to their most creditworthy borrowers.

Lenders add a margin to the prime rate based on your borrower profile. For instance, with a prime rate of 8.5%, adding a 1.5% margin means a 10% rate for you. Sometimes, lenders offer a negative margin as an introductory deal to attract new borrowers, switching to a positive margin later.

The current prime rate is 8.50%. Last month, it was the same. Over the past year, it has been as low as 7.50% and as high as 8.50%.

HELOCs usually have variable interest rates. This means your rate will change with the baseline interest rates. However, HELOCs are secured against your home’s value, offering lower interest rates than credit cards or personal loans, similar to mortgage rates.

To get the best HELOC rate, shop around with at least three lenders. Your bank or mortgage provider might offer discounts to current customers. Look out for introductory rates that end after a certain period.

Consider lenders that provide a fixed-rate option before opening a HELOC. This option lets you lock in your APR when you draw from your equity, protecting your loan from rising interest rates and simplifying long-term financial planning.

HELOC costs and requirements

A HELOC has two phases. The draw period allows you to borrow money up to your limit. You must pay interest, but you can choose whether to pay the principal. This phase usually lasts for 10 years.
During the repayment period, you cannot borrow more money. You must pay back the principal and interest. This can significantly increase your monthly payments compared to the draw period. The repayment period often extends to 20 years.What are the costs of a HELOC?

Taking out a HELOC involves various costs besides interest. Closing costs range from 2% to 5% of the loan amount. Some lenders may not charge these costs, but they might require you to keep the line open for a set period. Additionally, some lenders charge an annual fee, typically about $50.

To qualify for a HELOC, lenders usually require:

• A debt-to-income ratio of 40% or less.
  A credit score of 620 or higher.
  A home value at least 15% more than your debt.

The process of getting HELOC

To get a home equity line of credit, follow these steps:

1. First, calculate your existing equity by subtracting what you owe on your mortgage from your home’s current value. Decide on the amount you need to borrow.
2. Collect necessary documents like W-2s, recent pay stubs, mortgage statements, and personal ID to ensure a smooth application process.
3. Shop around and apply with multiple lenders to find the best HELOC offer.
4. Carefully read the disclosure documents. Ask the lender any questions to ensure the HELOC meets your needs. Check if it requires a large initial draw or opening a new bank account for the best rate.
5. Prepare for the underwriting process. It may not be as thorough as your mortgage application, but it can still take weeks.
6. Wait for the loan closing. This is when you sign the documents, and the credit line becomes available.

Remember, the closing price isn’t your home’s current value. The lender might appraise your home during underwriting. If your area’s home prices have risen, your equity might be higher due to an increased property value compared to your remaining mortgage.

Special considerations

You might get a tax deduction for HELOC interest if you spend the loan on home improvements. The IRS has yearly deduction limits, which depend on your tax filing status, and you need to itemize deductions to benefit.

Some agencies may view large HELOCs as installment loans, not revolving credit, so fully using your HELOC limit might not hurt your credit as much as maxing out a credit card. Getting a HELOC can lower your credit score at first, but responsible use, like making payments on time and not using all the available credit, can improve your score over time.

What are the advantages and the disadvantages of a HELOC?

Advantages: HELOCs offer flexibility in borrowing and repaying with a variable rate. They are good for ongoing expenses, like home improvements. Disadvantages include the risk of borrowing more than needed and the potential for interest rates to rise, increasing monthly payments.

Conclusion

For example, a borrower in 2010 had a mortgage balance of $100,000, $200,000 on a home. This will allow them to raise HELOC to $85,000. In this example, they get this maximum amount. In 2012, they had a mortgage + HELOC.

Considering some mortgage payments, the debt is now $150,000; However, their house now costs $300,000, which allows them to borrow another HELOC up to $112,500. This brings their balance to $262,500.

Eight years later, a combination of two HELOCs; Also, their mortgage gives a balance of $250,000 while the house is now at $600,000. This means they can take another HELOC up to $297,500.

The homeowner now has the first HELOC repayment period. Accordingly, the second HELOC repayment period will begin in two years.

The main risk for this borrower will be using the third HELOC; Not to cover the first two, but to make minimum payments on all three. In 2022 their second HELOC will move into the repayment period. Suppose the value of their home has not increased at all.

In that case, if they can not open another HELOC to help cover the increased payments, they will become accustomed to a substantially inflated lifestyle; Accordingly, more than $500,000 will be owed to a home that owes $100,000 just 12 years in advance.

Home equity lines of credit FAQ

Are home equity lines of credit a good idea?

HELOCs can be a good idea for financing large expenses, such as home improvements, or consolidating high-interest credit card debt due to lower interest rates and potential tax advantages. However, they can be risky if the property value decreases or if you cannot manage the variable monthly payments.

What is the monthly payment on a $150,000 home equity loan?

The monthly payment depends on the interest rate and term of the loan. For example, at a fixed interest rate of 6% on a 20-year term, the monthly payment would be approximately $1,074, excluding any fees. For accurate calculations, use a loan calculator with the specific loan amount, interest rate, and term.

Can you pay off a HELOC early?

Yes, you can pay off a HELOC early without penalty in most cases. Doing so can save you money on interest. However, check your loan agreement for any prepayment clauses.

Is it hard to get an equity line of credit?

Getting a HELOC requires good credit, sufficient equity in your home, and a stable income. Lenders also look at your debt-to-income ratio. It can be challenging if you don’t meet these criteria.

How long does it take to get a HELOC?

It typically takes 2 to 6 weeks to get approved for a HELOC, depending on the lender’s process, your financial situation, and how quickly you submit the required documentation.

Is a HELOC cheaper than a loan?

A HELOC may have lower upfront costs and a lower initial interest rate than a personal loan, making it cheaper in the short term. However, the variable rate of a HELOC can increase over time, potentially making it more expensive in the long run.

How do I pay back my HELOC?

You pay back a HELOC in two phases: the draw period, where you may only have to pay interest on the amount you draw, and the repayment period, where you make monthly payments on the principal and interest. The terms vary by lender.

Can you lose a HELOC?

Yes, if you fail to make payments, the lender can freeze or close your HELOC and eventually foreclose on your home, as it serves as collateral for the line of credit.

Which bank is best for a home equity loan?

The best bank for a home equity loan depends on your needs, including interest rates, loan terms, fees, and customer service. It’s wise to compare offers from multiple lenders, including local banks, credit unions, and online lenders, to find the best deal for you.