What is a home equity line of credit? If you’ve been looking for a way to get a little money out of your home without selling it, you’ve probably come across this option, known as a HELOC for short. Now that you're no doubt wondering what a home equity line of credit is going to do for me, let me clarify.
What is a home equity line of credit?
Like a "second mortgage", a HELOC allows you to borrow money using the equity in your home as collateral. What differentiates a HELOC is that it’s like a credit card: You can borrow on an as-needed basis, up to the loan’s limit, over the term of the loan (usually 5 to 20 years). In fact, your lender will issue you a small plastic card that looks just like a credit card, allowing you easy access to your money.
This is a great option for those who want to borrow money but don’t know exactly how much they’ll need, or for people who don’t need to borrow a lump sum all at once and will be paying for something over time, i.e. medical bills, college tuition, or major improvements to their home.
For example, let’s say you have finally decided to put that pool in and an outdoor kitchen so you can cook for all your new friends! You have done your homework and estimate the project should cost no more than $100,000. You could set up a Home Equity Line of Credit for $100,000, and pay for the materials, labor, and other requirements over time, as the projects move along.
Your HELOC should be used for home renovations or for big, unforeseen expenses that you don’t have the cash reserves to cover. Your HELOC should not be used for everyday living expenses, extravagant family vacations or lots of gifts under the Christmas tree.
How much can you borrow with a HELOC?
The amount you can borrow depends on how much equity you have in your home. A lender will usually allow you to borrow approximately 75%-85% of the home’s appraised value, less the balance on your first mortgage.
To break it down, let’s say you have a home that’s been appraised at $1,000,000, and you still owe $400,000 on it. Your friendly neighborhood bank would take 75% of your home’s value (in this case $750,000), then subtract the $400,000 you still owe on it, leaving $350,000. The bank would then set up a HELOC with a limit of $350,000, which you could borrow in chunks over time.
But home equity isn't the only factor lenders look at. According to the Federal Reserve’s Consumer Finance Division, “in determining your actual credit limit, the lender will also consider your ability to repay the loan (principal and interest) by looking at your income, debts, and other financial obligations, as well as your credit history.”
How to pay off a HELOC
Another convenient aspect of the HELOC is that payments can be relatively flexible. Of course, different lenders have different requirements, but some will allow you to make interest-only payments until the term of the loan is up, when you’re then required to pay the entire debt. Others require that you pay a percentage of the principal as you go.
There are, however, some details that almost all HELOCs have in common. They are:
You pay interest only on what you borrow. So, if your limit is $25,000, but you’ve only borrowed $5,000 of that, you’ll pay interest on $5,000.
Interest rates on a HELOC are variable, which means they go up and down depending on certain economic factors. Some lenders offer a low “introduction” rate, which lasts for a matter of months, and will then adjust—and continue to readjust during the entire loan term.
Your credit “revolves,” which means that once you’ve paid off a certain amount, you can borrow that much more again. Say for example, you’ve received a $30,000 home equity line of credit so you can do some improvements that will add value to your home. You borrow $10,000 to fix the roof, and you pay that back within a year. At that point, you’ll still have a $30,000 line of credit, and you can go ahead and redo that bathroom.
Average interest rates for home equity credit lines are generally lower than for other types of home loans, because the lender’s risk is lower. After all, your home is their collateral, and you already have a proven track record of paying your bills on time, right?
Risks of a HELOC
HELOCs may sound sweet, but all that free-flowing cash doesn't come without risks. Beware and be vigilant of the maturity date of your credit line. Don’t let the due date catch you off guard with a high balance and no other means for repayment. You may be able to get a new credit line, but in most cases, you will have to reapply, and the lender will reevaluate your financial profile before approving the loan.
If you don’t pay off your HELOC under the terms you’ve agreed to, the lender can foreclose on your home. It doesn’t matter how much you’ve paid on your first mortgage; a HELOC (which is considered a second mortgage) can be lethal. So, as with every type of home loan out there, it’s best to be cautious and do your homework.