Home Equity Line Of Credit (HELOC): How It Works
A plain-English guide to how HELOCs work, the draw and repayment periods, and what it takes to qualify.
Are you considering taking out a home equity line of credit (HELOC) and need help figuring out where to start? You're not alone.
This type of loan can be confusing and intimidating, but understanding the basics will help make the process easier.
In this blog post, we'll break down everything you need to know about HELOCs, including qualification requirements, how they work, and the pros and cons of this type of loan.
Armed with this knowledge, you can make an informed decision about whether or not a HELOC is right for you.
What Is a Home Equity Line Of Credit (HELOC)?
A home equity line of credit, or HELOC, is a type of secured loan that allows homeowners to borrow money using the equity in their home as collateral. It's a useful way for homeowners to access funds for:
- Large home expenses, such as renovations, repairs, or new purchases
- Consolidating debt
- Covering other financial needs, such as college tuition
To determine equity, lenders will calculate the difference between the home's value and the amount of money owed on the mortgage.
For example, if a home is worth $200,000 and the homeowner still owes $100,000 on their mortgage, the equity in the home would be $100,000. Lenders typically will not let you borrow against the full amount of your equity, so the actual credit line offered is usually lower than this figure.
How Exactly Does a HELOC Work?
Unlike traditional loans, where lenders give borrowers a lump sum of money to cover the costs of what they need, a HELOC works more like a credit card, where the homeowner borrows money (up to a certain limit) and pays it back over time, with interest.
So if we go back to that example from above, the homeowner may have access to a credit line based on their available equity; however, they don't have to use the full amount, nor are those funds automatically distributed into their account.
Instead, this type of loan is broken down into two distinct periods: Draw and Repayment.
The Draw Period
The "draw period" is when homeowners borrow money from their HELOC. It usually lasts for a set number of years (commonly around ten, though this varies by lender), and during this time, they withdraw funds as needed, up to the maximum amount of the credit line.
Homeowners access the funds from their HELOC in several ways, such as:
- Writing checks
- Using a credit card
- Accessing the funds electronically
During the draw period, homeowners are typically only required to pay interest on the amount of money they borrow, and they can pay back the funds as quickly or as slowly as they want, as long as they remain within the credit limit.
The Repayment Period
The "repayment period" is when homeowners are required to repay the borrowed money. Depending on the lender, it begins after the draw period and can last several years.
During the repayment period, borrowers will be required to make regular payments that include both principal and interest. However, some HELOCs have the option to pay off the entire loan balance at once.
This can be a convenient way to pay off your HELOC quickly, but it may require you to pay a higher interest rate or additional fees. It's important to carefully consider your options and choose the right repayment option for your financial situation.
Interest Rates
HELOC interest rates are usually variable, so they change over time depending on the market. This is because they are commonly tied to a financial index, such as the prime rate published by the Federal Reserve.
As the prime rate changes, so does the interest rate on a HELOC, meaning the amount of interest homeowners pay on their HELOC can vary from month to month. So it's important to be prepared for potential rate changes.
Some HELOCs have a "cap" or "ceiling" on the interest rate, which means the rate cannot rise above a certain level.
While this provides some protection against large increases in the interest rate, it can also mean that homeowners may not be able to benefit from any decreases in the interest rate.
What Are the Disadvantages of a Home Equity Line of Credit?
While a HELOC is not right for everyone, it can be a useful financial tool for accessing funds and managing your finances. It's important to carefully consider the advantages and disadvantages of a HELOC before taking out a loan.
Advantages:
- Convenient Access to Funds: A HELOC provides access to a line of credit that you can tap into as needed, making it useful for unexpected expenses or financing larger purchases.
- Flexibility: With a HELOC, you can borrow as much or as little as you need, up to your credit limit.
- Minimize Interest: You only have to pay interest on the money you borrow versus a large lump sum. Additionally, if you consolidate your high-interest debt, you may save money on interest payments, depending on your rate and terms.
Disadvantages:
- Overborrowing: Because a HELOC allows you to borrow money as needed, up to the maximum amount of your credit line, it's easy to borrow more than you can afford to repay, leading to financial difficulties.
- Foreclosure: Since you're using your home as collateral, your lender can foreclose on your home and take possession of it if you don't make your payments. The Consumer Financial Protection Bureau notes this risk applies to any loan secured by your home.
- Variable Interest Rates: The amount of interest you pay on your HELOC can vary from month to month, and it may be higher than the interest rate on other types of loans, such as a personal loan or a fixed-rate mortgage.
HELOC vs. Equity Loans vs. Refinancing
While HELOC, equity loans, and refinancing are all forms of borrowing that can be used to tap into the equity that a homeowner has built up in their property, they each have different terms that make them distinct products.
This chart gives you a better idea of how they stack up side-by-side:
How Do You Qualify for a HELOC?
The specific qualification requirements for a HELOC will vary depending on the lender and the specific terms of the loan. However, some common qualification factors for a HELOC include:
- Ownership/Equity: While this might seem like a no-brainer, you must own your home and have sufficient equity before applying. The amount of equity required varies by lender.
- Proof of Income: Lenders want to see you've got a steady source of income, which you can prove through tax returns, paychecks, and bank statements.
- Credit Score: Lenders set their own minimum credit score requirements for a HELOC, and these can vary by lender and loan program. Check with your lender for current requirements.
- Debt-to-Income Ratio (DTI): Lenders evaluate your DTI as part of underwriting, and acceptable limits vary by lender and loan program.
If you're ready to apply for a HELOC, we recommend the following steps:
- Research and compare different lenders to find one that offers a HELOC with terms and rates that are favorable to you.
- Contact the lender via website, phone, or in person, and express your interest in applying for a HELOC.
- Provide the lender with the necessary information and documentation.
- The lender will review your application and, if approved, will provide you with a credit limit and terms for your HELOC.
- Once you have received your credit limit and terms, you can begin using your HELOC to borrow money, as needed, up to your credit limit.
It's important to carefully consider your financial situation before applying for a HELOC and ensure you understand the terms of your HELOC, including the interest rate and repayment terms, before agreeing to anything.
Uncover Your Best Mortgage Options with Modern Day Lending
As online lending continues to expand and alternative loan products become more available, navigating the mortgage market has become increasingly complex, leaving borrowers feeling overwhelmed.
Luckily, there's Modern Day Lending. We take all the guesswork out of searching for the right loan options for you and make it easy to quickly compare different loan options.
Whether you're looking for a traditional mortgage, a HELOC, or another asset-based loan, we can help you find the right loan product to suit your needs and budget.
Reach out to speak with one of our loan specialists to see what options are available to you.
