Buying a home is normally one of the largest investments most people make. It may also be the largest asset many people have. As years of mortgage payments go by, more and more of your money gets tied up in your home. You might start looking at your home and wishing you could have some of that cashflow back.
Maybe your home’s 1970s Formica kitchen desperately needs to be put out of its misery to make way for a top-of-the-line chef’s kitchen.
Maybe it’s time to finally turn that boring bookshelf into a secret door. On the other hand, you might be considering using your home equity—that’s the market value of your home minus your outstanding mortgage balance—to cover things like your existing student loan debt or to pay for your kids’ education.
Lenders have come up with a few creative ways to help you tap into your available home equity, one of which is a home equity line of credit, or HELOC (pronounced “he-lock”). A HELOC can help you finance large expenses like major renovations or higher education for you or your children.
However, like all financing options, it comes with some risks as well. To make things a little simpler, here are some basics on how the majority of home equity lines of credit work.
What Are Home Equity Lines of Credit?
A HELOC is a type of loan that uses the value of your house as collateral. However, unlike a lump-sum home equity loan, a HELOC is a revolving line of credit that works a bit like a credit card: You can borrow money as needed up to the lenders approved credit limit, pay back all or part of the balance, and then borrow up to the limit again throughout the line of credit “draw period.”
The interest rates offered for HELOCs are usually variable and are frequently tied to the prime rate which is a benchmark index that closely follows the economy, which means even if your rate starts out low, it could go up depending on the movement of the rate index the loan is tied to.
HELOCs can be used for most anything, but are most commonly used to cover the costs of big home expenses, like a major renovation or addition. If you are thinking of making home renovations and would like to get an idea on the possible rate of return for a particular project, check out our helpful ROI estimator tool.
Millennials are also more likely than older borrowers to use HELOCs to invest in a new business, make an expensive purchase, take time away from work to care for a dependent, or take a vacation.
It is important to note that utilizing home equity to invest in a new business is considered a risky proposition. If the business fails and you are unable to make the payments, you could be risking your home.
HELOCs have been declining in popularity since 2013, as interest rates for fixed rate loans have declined and combined with increased property values, a fixed rate cash out refinance has become the more popular loan choice. But HELOCs could again become an increasingly attractive option if home equity continues to increase in the U.S. to a near-record high while interest rates dip.
How Is a HELOC Calculated?
Taking out a HELOC typically allows you to access a certain percentage of the appraised market value of your home, minus the amount you still owe on your mortgage loan. The line of credit amount you are approved to access can vary from lender to lender depending upon a variety of factors, such as property value, the financial profile of the borrower, even the type of first mortgage you have on the home.
For example, if your home is appraised at $500,000 and you owe $300,000 on your mortgage, your available home equity would be $200,000. Depending on the factors noted above, a lender might allow you to take out up to 85% of that combined equity ($170,000 maximum equity line in this example). You could then draw on that amount as you need it.
You would receive the ability to access the funds in the form of a credit card or a checkbook. In this example, the liens on your home would then be a first mortgage with its own existing terms at $300,000 and a separate second mortgage (HELOC) with its own terms at $170,000, for a combined loan to value (CLTV) of 85%.
With a HELOC loan, you have a set draw period in which you can draw on the line and pay it back (like a credit card.) The “draw period” can vary but normally lasts 10 years, depending on the loan program you choose.
Many HELOCs allow you to make interest-only payments during the draw period. After the draw period ends (let’s say 10 years for this example) in which you can utilize the revolving line of credit, the line shuts down after 10 years to allow for loan payback.
Full principal and interest payments will be billed for the next 20 years so the loan can be paid off in 30 years total (10 year draw, 20 year payback). During the subsequent repayment period, you’ll generally make monthly payments until the loan is paid in full.
It is recommended that you read the initial disclosures for each HELOC program you are interested in to understand the repayment terms before applying. Choose the program that best fits your needs and one where you can best manage repayment.
What Are the Pros of Taking Out a HELOC?
Potentially Low Initial Interest Rates
Since the lender uses your home as collateral, a HELOC may cost you less in interest compared to other unsecured lines of credit. If your HELOC interest rate is variable, it may be tied to and rise and fall alongside the prime rate. Most HELOCs are tied to the prime rate as a base rate and then a lenders margin is added on top of the prime rate, which makes up the full interest rate charged.
For instance, in October 2019, the prime rate was lowered to 4.754%. As an example, using the October 2019 prime rate of 4.75% plus a lenders margin of, say, 2.25%, (normally rounded to the nearest 1/8th) equals 7.00% variable interest rate charged.
Because prime can rise with the Fed funds rate and change on a monthly basis, lenders normally place annual and lifetime caps on their HELOC loans to keep the payments in line for the borrower. These loans carry yearly and lifetime interest rate caps to help control changes due to index fluctuations.
Read the loan terms carefully and ask questions about how the rate and payments can change over time. Keep in mind that for equity loans against a primary residence, under the Truth In Lending Act, borrowers have three days after signing to change their mind if they sign the loan papers and then find when they get home that the loan terms are not the best fit for them. A borrower has until midnight of the third business day to contact the lender in writing to cancel the loan.
Take Out Money as You Need It
Instead of receiving a lump sum loan, HELOCS give you the option to draw on the money over time as needed. That way, you don’t borrow more than you actually use, and you don’t have to go back to the bank to apply for more loans if you end up requiring additional funds. Draw period may be for the first 10 years of a 30 year loan.
Only Pay Interest on the Amount You’ve Withdrawn
With a HELOC, you draw on the line of credit as needed, which also means under most terms, you only pay interest on the amount you’ve taken out during the draw period.
This is good for projects that you are not sure how much money will be needed or if you need to pay at different intervals. Also, with a line of credit, you can pay the line off and let it sit open at a zero balance during the draw period in case you need to draw on it again later for other needs.
Could Be Tax Deductible
Depending upon the borrower’s circumstances and even with the tax changes, interest could still qualify for tax deductibility . Check with your tax professional.
What Are the Cons of HELOCs?
Variable Interest Rates
Even though your initial interest rate may be low, if it is variable and tied to the prime rate, it will likely go up and down with the Fed funds rate. This means that over time, your monthly payment may fluctuate and become less (or more!) affordable.
Although these variable HELOCs come with annual and lifetime rate caps, the lifetime rate caps on some of these programs can run as high as 21% according to Bankrate.com.
Taking out a HELOC is placing a second mortgage lien on your home: There is plenty of paperwork involved, and you’ll likely have to deal with some upfront fees, such as an appraisal and other costs similar to closing on a house in the first place.
Some HELOCs offer low or zero fees. Sometimes loans with zero or low fees may have an early closure fee on the HELOC. Check your loan terms for details. Shop around and be sure to compare the fees charged along with items like any early closure fees on the line and the amount of the lenders margin that is charged.
<3>Your Home Is Used as Collateral
This means that if you aren’t able to make payments and go into loan default, your lender could foreclose on your home. And if the HELOC is in second lien position, they could work with the first lien holder on your property to recover the borrowed funds.
Adjustable mortgages such as HELOCs can be riskier than other loans because fluctuating interest rates can change your expected repayment amount. It’s generally not advisable to take out a HELOC to pay off other unsecured debts, since you risk losing your home if you can’t make payments.
You Might Not Get as Much Money as Expected
If your home loses a lot of value, your lender has the option to freeze the line of credit tied to the home’s value, even if you haven’t maxed out the original credit limit. So depending upon market conditions, there’s a chance you won’t actually be able to access as much money as you anticipated during the draw period.
It Could Affect Your Ability to Take On Other Debt
Just like other liabilities, adding on to your debt with a HELOC could affect your ability to take out other loans in the future. That’s because lenders consider your existing debt load before agreeing to offer you more.
Lenders will qualify borrowers based on the full line of credit draw even if the line is at a zero balance. This may be something to consider if you expect to take on another mortgage, a car loan, or other debts in the near future.
What Are Some Alternatives to HELOCs?
If you’re looking to finance a big-but-not-that-big project for personal reasons and you have a good estimate as to how much money you may need, a personal installment loan that is not secured against your property might be a better fit. With possibly fewer to zero upfront costs and minimal paperwork in comparison to a mortgage loan, personal loans could be a quick way to access the funds you need.
Personal loans might also be a better alternative to a HELOC if you bought your home recently and don’t have much equity built up in it yet. Instead of attempting to tap the little equity you have built up, you could continue to let it grow and instead opt for an unsecured personal loan.
Another option to a HELOC is a cash-out refinance. With a cash out refinance, you replace your existing mortgage with a larger mortgage with new loan terms and take the difference back in cash-out.
In the current lending environment, this is generally considered a good option if you have an idea of how much money you will need and have sufficient equity in your home, because fixed rates for mortgages have been on the lower side in recent years. Generally, cash-out refinance guidelines may require more equity in the home vs. a HELOC and could have higher fees associated with it.
Another option is a home equity loan. This loan is similar to a HELOC in that it is a second lien, as your home is used as collateral. The major difference is that a home equity loan funds a lump sum loan amount rather than a line of credit to draw from as needed. Home equity loans also come with a fixed interest rate option.
Moving Forward With Care
If you’re considering taking out a HELOC or another loan that uses your home as collateral, it might be worth going the extra mile to understand all the terms and risks involved before signing the paperwork.
You may want to evaluate alternatives for accessing the money you need, including personal loans, refinancing, and delaying your goal so you can save up for it.
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