Homeowners can tap into their assets to access equity which they can use to finance substantial purposes. A home equity line of credit (HELOC) allows homeowners to continuously borrow against the value of their homes to acquire cash.
A HELOC is an appealing aspect of homeownership, and those considering acquiring this loan should assess their situation to ensure they can afford the risk.
What is a HELOC?
A HELOC is a revolving line of credit that homeowners can access as they need. For those with a primary mortgage on their home, the HELOC becomes a second mortgage that borrowers pay back in time. Homeowners without a mortgage will take out the HELOC as their primary mortgage.
HELOC’s come with their own interst rate, and borrowers will pay back the interest just like they would on a mortgage or credit card payment. Interest rates for HELOCs are adjustable, meaning they can change with the market. HELOC interest rates typically remain close to mortgage rates.
Homeowners should use HELOCs to finance purchases that contribute to their wealth, like a home improvement project that adds value to their home. Those who need access to smaller amounts of funding should consider other financing options like a credit card.
Draw and Repayment Period
A HELOC consists of a draw and a repayment period. During the draw period, homeowners will continuously borrow against their home using a credit card for the account, transferring funds, or depositing a check. They will have to make a minimum interest-only payment each month but should also entertain the idea of paying back part of the principal to avoid a higher balloon payment down the line. Additionally, paying down the principal frees up more potential funds that homeowners can access again should they need them in the future. The draw period typically lasts for ten years.
During the repayment period, homeowners can no longer draw against their home and will only pay back the loan, paying back both interest and principal. If the homeowner sells their home or reaches the end of the repayment term, they will likely pay a lump sum to cover any outstanding balance. The repayment period typically lasts for twenty years.
HELOCs use your home for leverage, allowing you to secure significantly larger amounts of money than you’d otherwise have access to. However, it is important to note that this means the lender could place a lien on your property in the event you fail to make payments.
How Does a HELOC Work?
HELOCs consider the amount of equity that a homeowner has in their home and allows them to tap into the equity they’re building. When someone purchases a home, they immediately begin to build equity by contributing a down payment and then slowly paying off the principal balance on their mortgage payments. Homeowners can determine if they have enough equity by multiplying their home’s value by the percentage of value that a potential lender will let them borrow. They will then find the difference between that potential amount of equity and the remaining balance on their mortgage to determine the total borrowable amount.
Example of Potential HELOC
A homeowner with a home valued at $500,000 may have paid $200,000 of their principal. If their HELOC lender allows them to borrow up to 85% of the home’s value, they will multiply $500,000 by 0.85 to determine they can borrow a maximum amount of $425,000. That maximum, minus the $300,000 they still have to pay off on their mortgage, means they can acquire a HELOC for up to $125,000.
Homeowners should note that the amount they paid for their home may not always correspond to the home’s value when they apply for their HELOC. The lender may order an appraisal to establish a true market value.
How to Get a HELOC
Those who wish to acquire a HELOC can consult with various lenders to find one that offers the most percentage of value along with a competitive interest rate. Potential buyers can work with banks, credit unions, and possibly their primary mortgage lender to acquire a HELOC. The lender will consider the borrower’s current standing and provide them with an application.
To secure a HELOC, borrowers must start by filling out an application. Typically, HELOCs banks, credit unions, and other financial institutions work with homeowners. Applying for and receiving approval for a HELOC can take several weeks, so potential borrowers should prepare to wait before they can begin accessing their funds.
HELOC Requirements
HELOC lenders will consider several qualifications when evaluating a borrower. However, the approval process can be less strict than a credit card application as the homeowner already has property they can use as collateral. Homeowners will need to meet the following criteria to qualify for a HELOC:
- A credit score of at least 620,
- A debt-to-income ratio below 40%,
- A certain amount of equity in the home,
- Reliable payment history and income.
The Process of Paying Back a HELOC
Similar to a credit card, HELOCs have a revolving credit line that allows borrowers to continuously draw from funds up until they reach their established limit. Borrowers can then make monthly minimum payments or pay down the outstanding balance in full to free up potential borrowing power in the future.
Borrowers should note that if they sell their home with an outstanding HELOC balance, they must pay the remaining balance in full. Additionally, failure to make payments on monthly payments can result in a lien or risk foreclosure.
Benefits of Getting a HELOC
A HELOC is the easiest way to access a home’s equity and can provide borrowers with several benefits.
Finance Expensive Projects
Homeowners who plan to complete home improvements and renovations can take advantage of this opportunity as the money they put into their homes will pay off when it comes time to sell. Therefore, if they still have an outstanding balance on their HELOC, the additional profit their home improvements earn them can help satisfy the remaining balance. HELOCs typically allow borrowers the chance to access more funds than they would be able to afford with a credit card or personal loan.
Lower Interest Rates
HELOC interest rates vary from credit card interest rates, making this option more appealing to borrowers. While a credit card can have an interest rate near 12%, a HELOC interest rate remains similar to mortgage rates, placing them currently near 6%. Since homeowners typically use HELOCs to access large amounts of financing at once, lower interest rates help keep monthly repayment costs down.
Tax-Deductible
Some homeowners may use their HELOC to improve their homes, making the interest on their second mortgage tax-deductible. Therefore, borrowers can continue to save money by claiming the interest during tax season.
Drawbacks of Getting a HELOC
Of course, as with any sort of borrowing, HELOCs also have a few drawbacks.
Potential Foreclosure
The largest drawback of a HELOC is the potential risk of foreclosure. If a borrower stops making payments, they could lose their home. Therefore, borrowers should ensure that they have a stable income and can reliably make payments before acquiring this type of loan.
Additional Costs
HELOCs can also have application and closing fees that make acquiring a loan unaffordable. Each lender could also have their own terms and conditions that set a minimum withdrawal amount and strictly define a draw period, limiting a borrower’s flexibility and financing options.
Variable Interest Rates
The market’s potential changes could drastically affect the amount that a borrower has to pay on their monthly payment. In 2022, interest rates more than doubled, which increased the interest rate for HELOC borrowers. Potential borrowers should cautiously consider the implications of an unstable housing market and understand that they will need to continue making payments to avoid foreclosure.
HELOC versus Home Equity Loan
A HELOC is a revolving line of credit that homeowners can access when needed. Home equity loans, on the other hand, simply offer borrowers a lump sum of money that they must repay on a predetermined payment schedule.
Who Should Apply for a HELOC?
Many homeowners might consider applying for a HELOC as they undeniably present clear benefits when compared to other financing options. HELOCs can present an ideal option for homeowners who have substantial equity in their homes and who wish to make upgrades or improvements to their property.
