HomeMortgagesWhat Is a HELOC (Home Equity Line of Credit)?

What Is a HELOC (Home Equity Line of Credit)?

Homeownership has many advantages, such as taking out a Home Equity Line of Credit or HELOC. As you pay for your home, you build equity, and lenders allow you to borrow money against the equity of your home. Your equity is calculated by taking your home’s value minus the amount you owe on the primary mortgage.

A home equity line of credit or HELOC is a second mortgage that gives you access to cash based on the value of your home. You can draw from a home equity line of credit and repay all or some of it monthly, somewhat like a credit card.

How does a HELOC work?

A HELOC is a secured loan that is backed by the equity in your home. A home equity line of credit is a revolving credit much like a credit card, it allows you to repeatedly borrow money up to the approved amount. You do not have to use the entire line of credit if it is not needed. You are then responsible for paying any of the credit that was used plus interest.

A HELOC has two phases: the draw period and the repayment period.

  • Draw period –  During this period you can access your available credit as you choose. You may be required to pay interest-only monthly payments, but you can pay principal if you wish. The length of the draw period varies, it’s often 10 years.
  • Repayment period – During this period, which typically lasts 10 to 20 years, borrowers can no longer borrow against the credit line and must pay back their lender for the principal and any interest owed.

Lenders are more likely to extend a loan when there is collateral to secure repayment of the loan. Because a HELOC uses a home as collateral, it typically offers lower interest rates than some other types of loans. But since you use your home as collateral, If you default on your HELOC, you can lose your home.

How much can you borrow with a HELOC?

Lenders’ guidelines vary, but qualified borrowers can usually access up to about 80% of their equity with a HELOC. If you estimate your home’s value at $200,000, and you have a mortgage loan for $100,000, you have $100,000 in equity. If your lender will lend you 80% of your equity, you can borrow up to $80,000 with a HELOC. 

If you decide to move forward by applying for a HELOC, the lender will determine how much you can borrow against your equity. The lender will hire an appraiser to assess your home’s value. You’ll pay for this appraisal when you close on your HELOC. The appraiser determines your home’s value by reviewing your home’s size, condition, features, and recent home sales in your market area. Depending on the condition of your home, they appraise the value higher or lower than other similar homes in your area.

Once your home is appraised, the lender will let you know exactly what you can borrow.

Qualification requirements for HELOCs

If you are considering a HELOC, then you will need to choose a lender and complete an application process that is like applying for a mortgage. 

Once you begin the application process, your lender will request information about your current income, assets, and debts. The lender also will check your credit. Once you have submitted the paperwork to the lender, they will approve or deny your application for the HELOC. The lender will then offer you an interest rate based on the information they reviewed, such as your credit score, income, and current debt. After determining how much you can borrow, it’s important to make sure you’re prepared to make the payments before moving forward.

Equity loan tax deductions

This mortgage tax break continues to confuse many homeowners when filing taxes. Adding to the confusion are the mortgage tax deduction changes in the Tax Cuts and Jobs Acts (TCJA) of 2017.

For many homeowners, there are a few cases where the interest on a HELOC can be deductible, but there are also many times HELOC interest will not be tax-deductible. For those with valuable real estate holdings, just a portion of your mortgage and home equity loan is tax-deductible. It depends on your specific situation and is mostly based on your mortgage balance and what the mortgage debt was used for.

The above link is an advisory the Internal Revenue Service (IRS) issued on HELOC tax-deductible interest for tax years 2018 to 2025. If you plan on taking this deduction, your loan must be used to “buy, build or substantially improve” the residence that secures the underlying loan.

Home equity loan vs HELOC

The equity in your home is a valuable asset that you can use to access additional funds with a home equity loan or a home equity line of credit, known as a HELOC. Both secured loan products use your home’s equity to secure the funding made available by the lender. 

Home Equity Loan

A home equity loan is a secured loan product that accesses your home’s equity. A lender will approve you for a specific amount based on your home’s value and equity. Home equity loans can have a fixed interest rate, meaning the payment is the same each month, which makes them easier to factor into your budget. Since they pay a home equity loan out in one lump sum, a home equity loan is an excellent source of money for major projects and one-time or emergency expenses.

HELOC

A HELOC allows you to borrow against the equity in your home. This is a secured loan product that allows you to access a line of credit that has a set limit based on the value and equity in your home.  

HELOCs often begin with a lower interest rate than home equity loans but the rate is adjustable, or variable, which means it rises or falls according to the movements of a benchmark. That means your monthly payment can rise or fall.

 Home Equity LoanHELOC
DisbursementLump-sum amountRevolving credit line for a preapproved amount; contract may require a minimum draw at closing
RepaymentFixed monthly paymentsTypically interest-only payments during the draw period, followed by full monthly payments
Interest RatesUsually fixedGenerally adjustable, though banks may cap your rates or offer a fixed rate for a specific period of time
PointsLenders may charge upfront “points” that lower your interest rateDoes not use points
Closing CostsSimilar to a first mortgage; typically 2–5% of the loan amountIf applicable, closing costs tend to be smaller than those of one-time loans
ProsMonthly payments won’t change and are for a set periodPay interest compounded only by the amount you draw, not the total equity available in your credit line
ProsA fixed interest rateOffer the flexibility of interest-only payments during the draw period
ConsUsing all your home’s equity at once can cause issues if home values decline in your areaRising interest rates can increase your payment
ConsLack of flexibilityYou may overspend by overusing the line of credit and having larger payments when you enter the repayment period

How to pay back home equity line of credit

After the draw period of a HELOC is over, you enter your repayment period. The loan converts to a repayment schedule, during which both principal and interest will be due every month. Because you’re only charged for your outstanding balance at the end of your draw period, your monthly repayment amount will largely depend on how much you borrowed. Repayment periods vary based on the terms of your agreement but typically last 10 to 20 years. 

Alternatives to a HELOC

Cash-Out Refinance

An alternative to a home equity loan or HELOC is a cash-out refinance loan. When you do a cash-out refinance, you refinance your primary mortgage for more than you currently owe and receive the difference in a lump sum.

A cash-out refinance may be a good option if you are eligible for rates that are lower than you are currently paying on your mortgage. This way, you would lower the rate on your mortgage, and the new rate would likely be lower than what you would receive on a home equity loan or HELOC.

Credit Cards

Credit cards offer a line of credit that is like a HELOC. While this makes borrowing for any purpose easy, it is also incredibly expensive. Credit card interest rates are substantially higher than that of any HELOC or home equity loan.

Credit cards can be a good option if you need money quickly, such as an emergency repair to home or auto that cannot wait. There is no extensive application process and if you already have an account, the credit is already available for use. If you use a credit card for emergency funding, you should pay off the balance as quickly as possible because the interest can add up quickly.

Personal Loans

A personal loan is an unsecured loan you can use for any purpose. The interest rates are higher than the rates on home equity loans, but they are typically still a cheaper borrowing option than most credit cards.

Interest rates on personal loans are typically two to three times higher than home equity interest rates

FAQ

How long does it take to get a HELOC?

If you decide to apply for a HELOC and decide on a lender, the application process can take anywhere from 30 to 45 days. This is the time needed for the loan underwriters to complete the application process. They use this time to confirm you meet lending requirements for the new debt.

How many years is a HELOC loan?

A HELOC has a draw period of up to 10 years. You can draw funds from the line of credit. Your monthly payment will only be the interest on the HELOC. After the draw period of a HELOC is over, you enter what’s known as the repayment period. The loan converts to a repayment schedule, during which both principal and interest will be due every month. Repayment periods vary based on the terms of your agreement but typically last 10 to 20 years. During this time, you cannot make additional draws.

Can I sell my house if I have a HELOC?

A HELOC loan or any other type of mortgage loan should not keep you from selling your home. As the closing is processed, they pay any claims against your property with the buyer’s purchase money. 

If your loan balance is higher than your sales price, which can happen in distressed sales, you will need to discuss this with your lender prior to signing a sales contract. Some lenders will agree to a “short sale” in which the lender accepts a payoff amount less than the loan balance as paid in full. Otherwise, you must pay the difference from your own funds.

Conclusion

HELOC’s are an option when you want to access the equity in your home for additional funds. These funds can be used as needed for home repairs, paying off high-interest credit card debt, or any large expenses that come up during the draw period on your HELOC.

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