Home Equity Line of Credit (HELOC)

When homeowners need money to help cover expenses, a home equity line of credit, or HELOC, is one way to rustle up some extra funds. HELOC funds can be used to remodel your home, pay for college or even take vacations. It also can be handy for people who need an alternative resource to pay mounting debts. People turn to HELOCs because they are an easy way to get money they need. It is wise to understand the process of using a HELOC to avoid financial trouble.

What is a HELOC? 

A HELOC resembles a second mortgage but functions like a credit card. HELOC funds can be drawn when you need the money instead of taken in a lump sum, as is common with second mortgages, which also are called home equity loans. You could borrow on your HELOC to pay for a child’s wedding and later to buy a car. You can access HELOC funds when you want, but cannot exceed the amount set when you signed for the credit line.

Some people confuse HELOCs with mortgage loans, but they are different. A mortgage is used for one purpose: to fund the purchase of a home. You never see the money, since it’s conveyed to the seller, and for the most part you stick to a repayment schedule that typically stretches from 15 to 30 years. HELOCs, by contrast, are revolving credit lines that use your home as collateral against default. What you spend HELOC funds on needn’t have anything to do with real estate. The only role of your home in a HELOC is to serve as collateral to secure the money you borrow.

HELOCs have advantages for those who use them wisely. Since the credit line is secured by a dwelling, the interest charged on what you borrow is generally far lower than what you would pay on an unsecured credit card. The catch, of course, is that the home secures the HELOC. If you default, the lender can foreclose on your home.

How Do HELOCs work?

Applying for a home equity line of credit is a lot like getting a primary mortgage. Lenders will want to know how much equity you have in your home, what its appraised value is, how much money you earn, what your outstanding debts are and your credit score. The lender’s goal is to vet you as a credit risk and know what your collateral is worth.

Once the lender verifies your income and reviews an appraisal of your home, it will contact you with an offer. Say you have a home that appraises at $300, 000, you still owe $100,000 and don’t have any other liens on your property. You need to demonstrate your ability to repay a HELOC, so you’ll need to submit proof of employment and other income and have a solid credit history. After the lender evaluates all the information, it decides how large a credit line you can manage. They might, for example, offer you a $100,000 credit line for 10 years with a variable interest rate starting at 4%.

HELOCs come with different borrowing and repayment schedules, but the 30-year repayment period is quite common. Before you file an application, consider how long you want the credit line to remain active. Also consider whether the lender charges closing costs and fees for appraisals and filing official documents with the court. In some instances, lenders waive these fees, in others you pay them.

Home equity lines of credit come with various terms, and many allow you to use the line for years without repaying principal. In our example, you could borrow up to the maximum $100,000 during the 10-year draw period, making interest payments on the balance. After that, the credit line is frozen and you’ll have to pay interest and principal for another 20 years. You must make minimum monthly payments on your borrowed money, but you can accelerate repayment if you desire.

Once you’ve been approved, the lender might give you a HELOC account card or checks so you can use with your HELOC line conveniently.

Terms vary from loan to loan. It’s very important to understand how your HELOC works before you enter in the agreement. Some loans might require immediate payment of all money owed at the end of the draw period. Others may extend repayment over decades. To avoid repayment and keep a credit line open, borrowers often seek a new HELOC at the end of the draw period, refinancing their HELOC so they can continue borrowing while avoiding a big increase in the minimum monthly payment.

If you sell your home, you will be required to repay what you owe on the HELOC right away. This is usually easily done if the sale price exceeds what’s owed on the HELOC and any other mortgages. But it can mean trouble if the home is underwater, meaning it’s worth less than what is owed to the lenders. If that happens you’ll need to make up the difference from your other savings or negotiate a deal, called a short sale, with the lenders.

Like other types of mortgages, the interest on a home equity line of credit is tax deductible. Interest rates can be low, but they also are usually variable, meaning the adjust in relation to a chosen financial index. Interest on a loan might start at 4% annually, but might rise or fall in concert with changes in the index. And since you are paying interest on the balance due, the monthly payment will change in tandem with the interest rate. Some HELOCs offer interest rate locks, which freeze rates until they are unlocked and the borrowers’ discretion.

How Much Can You Borrow?

Lenders use formulas to decide how large a home equity lines of credit you qualify for. Each lender is different, so it is often a good idea to apply to several banks, credit unions and online before choosing the best offer.

During the years preceding the real estate market collapse of 2008, lenders were quite lax in their HELOC underwriting requirements, often allowing home owners to borrow as much as 100% of the equity in their homes. Changes in lending laws and a sense that overly permissive standards led to a collapse of the housing market led to stricter standards. Today, most borrowers are restricted to borrowing 80% of the equity in their homes. As mentioned, the borrowers’ income and credit history also play a role in determining the home equity credit line.