Understanding a Home Equity Line of Credit (HELOC)
Building equity in your home—in other words, ownership of part or all of it as an asset—can give you access to cash in the form a Home Equity Line of Credit (HELOC). You can use the equity you’ve built up over time (by paying off part or all of your mortgage) as collateral to secure a line of credit, similar to a credit card.
Because HELOCS are secured against the value of your home equity, lenders may offer rates lower than other types of loans. Like a credit card, a HELOC is a revolving source of funds that you can access as you need—and as you pay it off, that access is renewed.
Let’s dig into more details so you can decide if a HELOC is the right financial answer for you.
When to use a HELOC
A HELOC can be used to make needed repairs and upgrades to your home when insurance won’t cover all or any of the costs (if damage was done by weather, for example) and you don’t have enough in savings to cover the entire cost right now. While HELOC funds may also be used to pay for other expenses, borrowing against your home’s equity comes with risks. A smarter move can be to wait on other, non-essential purchases until you have saved enough to pay cash. A sinking fund is a great way to save money for something like this.
If you recently purchased a home with plans to renovate it, know that a HELOC will only become available to you once you’ve earned enough equity in the home—usually after years of regular mortgage payments. If you’re still looking to buy a home and think that you’d need to do repairs immediately, be sure the purchase price is low enough that it makes that expense worth it.
You will end up paying more for home repairs over time if you have to borrow the money to complete them.
Understand the risks
Opening a HELOC is not without risk—if you default on the payments, you can lose your home, even if you made your original mortgage payments. A lender could put a second lien on your house, which gives them the right to your home, and the first mortgage lien, if you fail to make agreed-upon payments on your HELOC.
Because a HELOC uses your equity in the home as collateral, you are more likely to get better interest rates than on unsecured credit, like credit cards. And a HELOC will let you borrow money against your equity again and again (as you pay down your balance) over a set number of years (read on for more about this). However, this shouldn’t tempt you to over-borrow or use a HELOC in place of an emergency fund. In the end, you’ll be making monthly HELOC payments in addition to monthly mortgage payments.
How payments on a HELOC work
Your credit union will probably have some of the best HELOC interest rates around town—or even online. This can help make shopping around for the best rate easy. But there’s more you’ll need to find out: how much you’ll be approved for, how and when you’ll have access to funds, and how big your payments will be over the life of the open credit line.
Each lender will have guidelines dictating how much they can lend (and at what rate) based on the value of your property, your creditworthiness, and possibly your employment history. They will calculate something called a combined loan-to-value (CLTV) ratio to determine how much to lend you.
Let’s say you’re working with a lender who offers a maximum CLTV ratio of 80%, and your home is worth $300,000. If you still owe $150,000 on your mortgage, you may qualify to borrow an additional $90,000 in the form of a HELOC ($300,000 x 0.80 = $240,000; $240,000 - $150,000 = $90,000).
You may be offered access to these funds through an online transfer, a check, or a credit card connected to your account at the lender’s banking institution. HELOCs tend to have few or no closing costs (unlike home equity loans), but they often have variable interest rates.
Generally, you will have a minimum monthly payment that is a percentage of what you currently owe on the line of credit. As your balance increases, your minimum monthly payments do, too. Payments can also increase if the interest rate increases.
The phases of HELOCs
Most HELOCs have two phases. First is the draw period, during which you can access your available credit as you want. Many HELOC contracts only require interest-only payments during the draw period, though you may have (and should ask for) the option to pay extra and apply it toward the principal (borrowed amount).
Then, the loan (the total money you’ve borrowed, which doesn’t have to be the full line of credit amount) starts the repayment phase. You can no longer access additional funds, and you make regular principal-plus-interest payments until the balance is paid off. Most lenders have a 20-year repayment period. Some lenders have different types of repayment options for the repayment period.
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