Looking for a home equity line of credit (HELOC)? Your home will become one of your largest assets. The journey to home ownership may be difficult but the rewards are greater. Once you’ve been in your home for a length of time, you may want to upgrade your home, build an addition or simply repair those shingles on the roof. Paying for it can be costly out of pocket, but since you’ve lived in your home for several years you’ve built equity. Equity is simply the difference between your homes value and what you still own on the mortgage. Luckily, you have the ability to tap into that equity through a Home Equity Line of Credit, or HELOC for short.
What is a HELOC? (Home Equity Line of Credit)
A HELOC is exactly as it sounds. It’s a line of credit against the equity you’ve built in your home. This gives you an opportunity to access the equity you’ve amassed and put it towards improving your home or taking that dream vacation. Often referred to as a second mortgage, you can apply for this loan product through many traditional banks, credit unions and even online lenders. Similar to the mortgage process, they will need various pieces of information and data points for the approval process. Also, they may request your home be valued to ensure nothing has drastically changed.
Here’s How a HELOC Works
A HELOC can be thought of as a credit card, minus the card. Many home equity lines come with a check book you can use to make a draw on your line of credit. Also, many lenders have a minimum you can withdraw at a time, such as $500. From there, you can spend your money how you see fit. Be sure not to get carried away because like any loan, it’ll eventually have to be repaid. HELOC’s are typically sold in a 10/10 fashion, meaning you can draw on your line for 10 years and then spend the next 10 years in repayment. Also depending on the institution, you may be required to make interest payments during the 10-year draw period.
HELOC Interest Rates
Interest rates for HELOC’s are low due to the Federal Reserve lowering interest rates. This benefits the consumer because you can now borrow against your homes equity and a lesser rate than previously offered. Interest rates can be pegged to the Treasury yield or LIBOR, but almost always the rate is pegged to another source.
With rates being as low as they are, you may have little impact on a variable rate line of credit. However, keep in mind that when rates begin to rise or if they rise, you will begin paying more in interest expense. Be sure to look at all your interest rate options and if possible, solidify a locked in interest rate during the repayment period.
How Do Lenders Calculate Lines of Credit?
The calculation varies depending on internal procedures and compliance practices, but the idea is simple. Your lender will calculate your potential line of credit by taking the value of your home, subtracting out the mortgage still owed, and subtracting a percentage from the remaining equity you have. For example, if you have a $100,000 home with a $70,000 mortgage remaining, you have $30,000 equity in your home. Now, a lender isn’t going to lend you the full $30,000 because that’s risky and would bring your loan to value to 100%. Instead, they will likely lend you somewhere around the 80% – 85% LTV, giving you access to $20,000. Reason being if you were to stop paying on your loans and the bank had to foreclose and sell your home, they would have a 10% buffer room out of the gate.
How Can I Use a Home Equity Line of Credit?
Once you are approved for a home equity line of credit you can use the funds for anything you want. You simply make a draw against your line and use the cash for your own needs. Many people will use the money to make upgrades to their home, which in turn raises the property value and boosting your equity in the home. Other people will typically use lines of credit to fund large purchases such as a wedding or university costs. Keep in mind though you don’t want to draw from your credit line on a whim because you only have at most, 20 years to pay back your note, which is less than a traditional 30-year mortgage.
Advantages of a HELOC
One of the biggest advantages in a HELOC is you can tap into the equity in your home. If it weren’t for a second mortgage you’d be left with illiquid cash, forcing you to sell your home in order to access the value you’ve amassed. This product allows you to use your equity for a reasonable interest rate for purchases you may need to make. The other advantage is that you can potentially boost the value of your home by making the appropriate updates and repairs. At the end of the day, you not only borrowed to fix your home, but you also improved your equity position, a win-win.
Disadvantages of a Home Equity Line of Credit
One of the disadvantages is if you are a spender, it will leave the door open to amassing a mountain of debt. Some home equity lines can be hundreds of thousands of dollars and paying that back over a 10-year period can prove costly. Another disadvantage is that it will cost you to access the equity you’ve built in your home. Yes, you’ve paid all that money in, the bank is the one taking on the risk of lending you money and that doesn’t come free. While interest rates tend to be competitive, depending on your situation it can be a costly way to access money.
HELOC vs. Home Equity Loans
Now, you may be wondering what’s different between a HELOC and a home equity loan. The main different is a home equity loan is an installment loan, meaning you receive a lump sum or money at signing and have a fixed set of payments over a set period. The interest rate can be variable or fixed, but the amortization schedule will remain constant. Whereas with a line of credit, you are simply promised access to a certain sum of money, but you are never required to draw upon it, giving you the option but not the need to make a draw. Each has their benefits and it’s up to you to find the one that fits your situation best. Home equity lines of credit are a wonderful way to access that hard-earned equity in your home without selling the whole thing. Be sure to understand what you’ll be doing with the money because if used incorrectly, it can end up costing you more in the end.