What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is an advantageous way to get your hands on some extra money. It’s, in fact, a second mortgage on your home. It’s like a big virtual credit card. You withdraw cash as you need it, and pay it back in full or in installments.
This option is only available to you if you have a reasonable amount of equity in your property. Ideally, you also have a stable income, so that making repayments is not going to be a financial burden.
The downside is that because your property is used as collateral for the loan, if repayments aren’t made, you could be subject to foreclosure.
How a HELOC Works
If you’re weighing up the pros and cons of equity financing, you certainly want to know the ins and outs of how it works. Educating yourself about the process will only empower you to make better and smarter financial decisions.
A home equity line of credit utilizes equity accumulated through a mortgage on a home or property. What exactly is considered equity? In this case, equity is the difference between the amount you owe and the total value of the home or property. Keep in mind that equity is a bit of a flexible term because while you may think your home is worth a certain price, you can never be sure until you put it on the market and see what it sells for or have it appraised separately.
If you already have an existing first mortgage when taking a home equity line of credit, then it remains as is, just with an added second lien, which is based on equity. You’ll also likely be familiar with the underwriting and approval process given it’s so similar to taking a mortgage.
To qualify, excellent credit will help but isn’t entirely necessary given you’re utilizing your home equity as collateral. However, just like any other form of borrowing, the more creditworthy the applicant, the better the interest rate.
Generally, you can borrow between 75-90% of this equity amount to finance big projects and invest or handle expenses like home repairs, resolve debt, and more.
The amount you have available to borrow is linked to how much you own of your house. For example, if your home is worth $600,000, and you have $200,000 left on your mortgage, that means you have equity of $400,000.
Typically a lender will give you up to 85% of this value - $400,000 x 0.85 = $340,000. You now have this much to use for home improvements or other purchases.
Most HELOCs come with a variable rate of interest and the annual percentage rate changes as the market fluctuates.
Home Equity Loan or Line of Credit?
The main difference between a home equity loan and a line of credit is that the first option gives you one fixed amount that you take in full, and you start to pay that back immediately. The line of credit, however, sits in the bank and lets you withdraw only what you need. This means you have less to repay in the beginning.
Home equity loans are generally provided as fixed-rate types. Home equity lines of credit are usually based on a variable rate. The risk with the latter is that you’re affected by any changes in the market, causing your repayments to increase
Reasons to Get a HELOC
The main reason people take out a HELOC is so they can make improvements on their property. Some lenders will recommend not using it to pay for travel or cars, as these aren’t wealth-generating. However, this kind of loan for education is approved by some financial institutions.
A bonus is that interest on a HELOC may be tax-deductible if it’s being used for wealth building purposes.
Reasons to Avoid a HELOC
Remember, a HELOC is tied to your property. If you can’t make the repayments, you risk losing your house. This loan is best suited for people with stable incomes and a high amount of equity in their homes. If your debt to income ratio is quite low, you’re best to avoid this kind of loan.
HELOCs also come with upfront fees. Most likely, you’ll need to get an appraisal done on your property, title searches, and attorney’s charges will also build up.
If you only need a tiny amount of credit, consider a credit card in place of a HELOC. The upfront costs may not make it worth it in the long run.
How Do You Pay Back a HELOC?
There are two stages of a HELOC, drawdown, and repayment. During the drawdown period, just withdraw funds as needed, and the minimum payback is only the interest. Naturally, you can pay back more if you choose.
Once the drawdown period closes, this can be up to 10 years, then the HELOC is locked, and you begin repaying it. The payments at this time change to both interest and principal. These amounts are considerably higher than interest-only payments, so factor this into the equation when preparing for this phase. This period is generally around 20 years.
Getting the Best HELOC Rate
Now this one is on you. Time to do your research. But before getting started, check that you have a good credit score. Start with your own bank or mortgage provider; the benefits here are existing customer discounts.
Shop around for quotes from at least two other lenders and look out for introductory offers.
How a HELOC Affects Your Credit Score
Like any type of loan, a HELOC will temporarily affect your credit history. Think of it as the same as if you’d maxed out a credit card with a high limit. However, this is only short term. As long as you make the minimum payments, it won’t be long before your credit score gets a boost.
Steps for Getting a HELOC
As a HELOC is similar to a mortgage or a home improvement loan, the process is very much the same. Once you’ve figured out that you have enough equity in your home, shop around for the best rate and get your documents together.
Then apply as usual. Approval can take anywhere from hours to weeks, and most likely, an appraisal will need to be made.
For anyone who plans to repair or renovate their property, a home equity line of credit is a popular choice. It’s ideal for those who own a high percentage of their home as this reduces the amount needed to be borrowed and the risk of foreclosure if repayments are tight.
Loads of financial institutions are willing to offer this kind of loan, so with shopping around, it’s possible to get the right one for your needs.