In the modern world, most of those who buy homes seek ways through which they can get hold of the equity in their houses to satisfy some needs. Such needs include renovation of the home, debt consolidation, education, and emergencies. One of the ways people use to access the equity in their homes is something known as a Home Equity Line of Credit-or for short, HELOC. If you’re a homeowner looking for a flexible and low-cost borrowing option, a HELOC may be the right solution for you. But what exactly is a HELOC, and how does it work? In this post, we’ll explore the ins and outs of HELOCs, including how they function, their advantages, disadvantages, and the key factors to consider before taking one out.
What is a HELOC?
A home equity line of credit-sometimes just called a HELOC-is a line of revolving credit that one borrows against the equity in his or her house. Equity is the difference between the market value of your house and the amount you owe on your mortgage. If your house is worth $300,000 and you owe $150,000 on your mortgage, then you have $150,000 in equity. You can borrow up to 85% of any equity, although how much you actually can will fall to lender requirements and your overall financial profile. HELOCs are like credit cards in the sense that it involves revolving credit. You can borrow precisely what you need up to a predetermined limit, and you pay interest only on the money that you have actually borrowed. While in the case of a regular home equity loan you get a lump sum upfront, with a HELOC, you will get a line of credit over time. A HELOC is the flexible option to borrow when one needs ongoing or uncertain expenses.
How does a HELOC work?
To use a HELOC effectively, you have to understand how this works. The following describes with precision its key features and explains exactly how it actually works.
- The Application Process
For the most part, the application process for a HELOC follows that for most other loans with a number of critical differences. You’ll want to seek out a lender that originates HELOCs bank, credit union, or online lender. The lender will then review your financial profile-your income, credit score, and amount of equity in your home to preapprove you for a certain credit limit.
Note that general qualification criteria for a HELOC include but are not limited to:
Credit Score: The better your credit score is, the better off you’ll be with getting approved; it may even give you a better interest rate.
Equity in the Home: Lenders usually let you borrow up to 85 percent of your home’s appraised value, minus any outstanding mortgage balance.
- Income and Debt-to-Income Ratio: Lenders will consider the income of the borrowers and how much debt is already outstanding to decide on whether one is in a position to repay the line of credit.
If approved, you will be granted a credit limit, which simply means the maximum amount that one can draw from the HELC. The amount would depend upon various factors that include but do not limit to equity in your house and your financial status.
- Draw Period
A HELOC typically operates within two periods: the draw period and the repayment period. The draw period is that length of time in which you are entitled to withdraw money against your line of credit. This, of course, depends on the peculiarities of your condition and usually takes 5 to 10 years. You may borrow in this period, pay back, and later-if you need it-you can borrow again.
The draw period is typically where your monthly repayments are lower, often set at just enough to cover the interest on your outstanding balance. Although some lenders will allow principal pay down in that time, more often than not, the minimum payment required during that period is interest-only, which makes those early payments far more digestible.
- The Repayment Period
Concluding the draw period is simultaneously when the repayable status of the loan expires. That is typically going to be anywhere from 10 to 20 years, and involves a period of time in which you can no longer borrow; you are going to have to pay back not just the interest in this repayment period, but you are also going to have to pay the principal back. Because you are repaying the balance that you borrowed-not just the interest-your monthly payment amount likely will be higher in this stage.
The interest rates charged for a HELOC are usually variable-that is, they change over time. Of course, that would imply that monthly payments would be different too. Rates are usually tagged to an index such as the Prime Rate plus a margin. This means that if the Prime Rate goes up, your rate of interest and, by extension, your monthly payments go up.
- Interest Rates And Fees
The interest rates on HELOCs are usually lower compared to credit cards and even personal loans.
They are higher than those for traditional home loans, nonetheless. Another significant advantage of a HELOC deals with its variable interest rate. Much like with credit cards, this is great when the rates go down, yet it also means that your interest rate can surge over time, and thus-by extension-make borrowing more expensive. Besides the interest, other fees that you are likely to pay when dealing with a HELOC concern:
Annual Fees: Some lenders charge annually to maintain the account.
Transaction Fees: Some withdrawals have associated fees, such as wire transfers.
Closing Costs: Just like the costs of taking out the loan against your home to begin with, HELOCs can have closing costs – these are often much lower than a traditional mortgage.
- Repaying a HELOC
How you repay your HELOC has to do with whether you are in the draw period or you have gone back into the repayment period.
If you had only been making interest payments up to this point during the draw period, then that principal balance remains intact. Once you go into the repayment period-when you actually start paying principal and interest-your monthly payment may go up substantially. This is going to stretch your finances a whole lot more, especially in the event that you have borrowed a great deal of money and your interest rate has gone up. Most borrowers try to pay off the principal ahead of time before the repayment period starts or refinance their HELOC whenever the interest rate becomes unsustainable.
HELOC Benefits
There are some irresistible benefits a homeowner should consider in reaping benefits from his or her house equity using a HELOC. Flexibility: You can borrow just what you need, when you need it-right up to your credit limit. This makes it also ideal for ongoing expenses, such as financing home renovations or paying tuition fees.
The interest rates are usually much lower, especially when compared to the rates charged on other forms of borrowings like credit cards and personal loans.
Interest-Only Payments: During a draw period, most often, HELOCs offer interest-only type of payments that can keep the monthly payments very low. Tax Deductibility: The interest paid on a HELOC might be tax-deductible if the funds are to be used for home improvement purposes. This is best consulted with a tax advisor.
Disadvantages of a HELOC
While this will serve a very important financial purpose, the following are some of the risks and disadvantages associated with it:
* Variable Interest Rates: Interest rates happen to be largely variable in nature; they could therefore fluctuate-a fact that might raise your payments over time.
* Risk of Foreclosure: Since the HELOC is tied to your home, an inability to repay the loan may mean the foreclosure of the house.
Risk of Overspending: The HELOC is a line of credit, and that type of money available is a temptation far too enticing to many borrowers who may borrow more than the amount they actually can afford to repay.
Conclusion
The HELOC is a flexible and possibly inexpensive means by which homeowners tap into equity in their houses.
Whether it be for home improvement, debt consolidation, or whatever, a HELOC gives one a revolving line of credit at lower interest rates compared to most unsecured loans.
There should be a trade-off in the financial situation and quantum of risks involved with this and greater interest rates or foreclosure, in case the payments are not made on time. It is always good to talk with a financial advisor or a mortgage professional before determining whether a HELOC is right for you, so that you understand the options a little better and find the best financial product that will suit your needs. For more about HELOCs, check these trusted resources: CFPB, or check this HELOC guide from Bankrate.
