Understanding Home Equity Line Of Credit: A Comprehensive Overview

Filed in Loan by on November 18, 2020 0 Comments

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

A home equity line of credit, also known as HELOC, is a line of credit secured by your home that gives you a revolving credit line to use for large expenses or to consolidate higher interest rate debt on other loans such as credit cards. A HELOC often has a lower interest rate than some other common types of loans, and the interest may be tax deductible. Please consult your tax advisor regarding interest deductibility, as tax rules may have changed.

Understanding Home Equity Line Of Credit (HELOC)

If you understand how credit cards work, you already have a basic understanding of how HELOCs work. When using a credit card, the bank sets a credit limit based on your household income, assets, and credit score. In each billing cycle, you can spend as much or less as you like, provided that you don’t exceed this limit. When you pay the bill, the available credit is increased by the amount of your payment.

A HELOC works the same way. With a HELOC, you borrow against the available equity in your home and the home is used as collateral for the line of credit. As you pay off your outstanding balance, the amount of available credit is replenished, just like a credit card. This means you can borrow again if you need to, and you can borrow as little or as much as you need throughout your draw period (usually 10 years) up to the credit limit you established at closing. At the end of the draw period, the repayment period (usually 20 years) begins.

Although the basic concept of HELOC resembles that of a credit card, there are a number of important differences between the two. Borrowers should carefully study these specifics before applying for HELOC.

Underwriting Standards

HELOCs are subject to underwriting standards from lenders, which means that you will need to document your income and employment status as you would if you were refinancing your home mortgage.

When you apply for a credit card, you are asked to provide information about your income and employment, but you do not typically have to document it. Note that not all borrowers will qualify for a HELOC, and that qualifying for a credit card may be easier in general.

Collateral

As a HELOC is secured by your home’s value; if you don’t repay it, you could end up in foreclosure. A credit card, on the other hand, is a form of unsecured credit so you are significantly less likely to lose your home if you cannot repay what you borrow. With credit card default, even if your creditors sued you and you had to declare bankruptcy you might be able to keep your home.

Interest Rates

HELOCs, like most credit cards, have variable interest rates that change over time with rates in the economy. With a credit card, your interest rate is based on a benchmark interest rate, such as the prime rate or the London InterBank Offered Rate (LIBOR), plus a margin or mark-up that is based on your credit score, repayment history, and how much the lender needs to charge to potentially earn a profit.

HELOC interest rates are priced similarly. However, HELOCs often have significantly lower interest rates than credit cards due to the collateral giving the lender a cushion if you default. That being said, when interest rates increase, people who thought they were borrowing money cheaply could find themselves stuck with HELOCs whose interest rates are comparable to credit card rates.

There is also the possibility of getting a HELOC with a fixed-rate option. In this case, the loan will often have a variable interest rate during the initial draw period, and then converts to a fixed interest rate for the repayment period.

Variable interest rate: When you have a variable interest rate on your home equity line of credit, the rate can change from month to month. The variable rate is calculated from both an index and a margin. An index is a financial indicator used by banks to set rates on many consumer loan products. Most banks, including Bank of America, use the U.S. Prime Rate as published in The Wall Street Journal as the index for HELOCs. The index, and consequently the HELOC interest rate, can move up or down.

The other component of a variable interest rate is a margin, which is added to the index. The margin is constant throughout the life of the line of credit. As you withdraw money from your HELOC, you’ll receive monthly bills with minimum payments that include principal and interest. Payments may change based on your balance and interest rate fluctuations, and may also change if you make additional principal payments. Making additional principal payments when you can will help you save on the interest you’re charged and help you reduce your overall debt more quickly.

Fixed interest rate: Some lenders, including Bank of America, offer an option that allows you to convert a portion of the outstanding variable-rate balance on your HELOC to a fixed rate. Payments you make on a balance at a fixed interest rate are predictable and stable and can protect you from rising interest rates.

Interest Deductibility

Unlike credit card interest, HELOC interest can sometimes be tax-deductible, but only if the loan is “used to buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS).

High-Interest Debt Refinancing

If the interest rate on a HELOC is, for example, 5.5% and the interest payments are tax deductible, then the interest rate on your credit card debt may be 29.9% and the interest payments are not tax deductible, it’s easy to see how a HELOC can save you a ton of money and help you get out of debt faster by consolidating your debts and using the HELOC product to pay off your credit card balance. In effect, you will have swapped a high interest loan for a low interest loan.

How to Qualify For a Home Equity Line of Credit?

To qualify for a HELOC, you need to have available equity in your home, which means the amount you owe on your home must be less than the value of your home. You can usually borrow up to 85% of the value of your home minus the amount you owe. In addition, the lender usually looks at your credit score and history, employment history, monthly income, and monthly debts, just like when you first got your mortgage.

Lender requirements will vary, but here’s what you’ll generally need to get a HELOC:

  • A debt-to-income ratio that’s 40% or less.
  • A credit score of 620 or higher.
  • A home value that’s at least 15% more than you owe.

How to Get a Home Equity Line Of Credit?

  1. Determine whether you have sufficient equity, using a HELOC calculator.
  2. Once you have an idea of what you can borrow, shop HELOC lenders.
  3. Gather the necessary documentation before you apply so the process will go smoothly.
  4. Once you have pulled together your documentation and selected a lender, apply for the HELOC.
  5. You’ll receive disclosure documents. Read them carefully and ask the lender questions. Make sure the HELOC will fit your needs. For example, does it require you to borrow thousands of dollars upfront (often called an initial draw)? Do you have to open a separate bank account to get the best rate on the HELOC?
  6. The underwriting process can take hours to weeks, and may involve getting an appraisal to confirm the home’s value.
  7. The final step is the loan closing, when you sign paperwork and the line of credit becomes available.

How Much Can You Borrow with a HELOC?

Your maximum home equity line of credit will vary depending on the value of your home, what percentage of that value the lender will allow you to borrow, and how much you still owe on your mortgage. Typically, a HELOC’s credit limit is 75% to 85% of the value of your home, minus your mortgage balance.

For example, suppose you have a house that’s worth $400,000, and you have $275,000 left on your mortgage. Your bank offers you a HELOC based on 80% of the house’s value, or $320,000. Subtract the $275,000 you owe, and that gives you a maximum limit of $45,000 on your line of credit.

How Do You Pay Back a HELOC?

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

Draw period: During the draw period, you can borrow from the credit line by check, transfer or a credit card linked to the account. Monthly minimum payments often are interest-only during the draw period, but you can pay principal if you wish. The length of the draw period varies; it’s often 10 years.

Repayment period: During the repayment period, you can no longer borrow against the credit line. Instead, you pay it back in monthly installments that include principal and interest. With the addition of principal, the monthly payments can rise sharply compared with the draw period. The length of the repayment period varies; it’s often 20 years.

At the end of the loan term, you may receive a large lump sum or balloon payment that covers any principal not paid during the loan term. Before closing HELOC, consider negotiating an extension or refinancing option so that you are covered if you cannot afford a lump sum.

Benefits of a Home Equity Line of Credit

A HELOC has several advantages over other means of borrowing money. These include:

  1. Flexibility: A HELOC lets you choose exactly how much you borrow and when. You can take out money and pay it back freely throughout the draw period. And once the draw period ends, you usually have a long repayment period to pay off the loan.
  2. Low Interest: A HELOC is less risky for the lender than many other loans, because it has your home as collateral. For this reason, banks tend to offer lower interest rates on HELOCs than on other types of credit. This makes a HELOC a useful way to consolidate higher-interest debts, such as credit card debt. However, this is only helpful if you refrain from using the credit cards while you’re paying off the debt. If you turn around and run the balance right back up, you’ll just have new debt on top of old.
  3. Right to Pay Early: No matter what the minimum payment is on your HELOC, you can always choose to pay more. In fact, many consumers choose to treat their HELOC just like any other loan and pay it off in installments. For instance, say you take out $20,000 from your HELOC and use it to buy a boat. You could then break up that $20,000 into 60 payments, add interest, and pay it back over five years. That way, it’s just like having a regular boat loan, but at a better interest rate.
  4. Tax Deductions: Because a HELOC is a type of home loan, the interest on it is usually tax-deductible. That’s a perk that most forms of credit, such as credit cards and auto loans, don’t have.
  5. A Chance to Change Your Mind: When taking out a HELOC at your main home, you have the legal right to cancel it within three days and pay nothing. You can change your mind for any reason or no reason at all. All you have to do is notify the lender in writing and he must cancel the loan and return any fees you paid. So if you get a better deal from another lender or if you decide you don’t need the money you have a chance to turn down.

How a HELOC Affects Your Credit Score?

While a HELOC acts much like a credit card, giving you ongoing access to the equity in your home, there is a big difference when it comes to your credit score: some bureaus treat HELOCs to a certain extent like installment loans rather than revolving lines of credit.

This means that borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. As with any line of credit, a new HELOC on your report will likely temporarily lower your credit score. However, if you borrow responsibly paying on time and not using your full credit line, your HELOC can help you improve your credit score over time.

How to Find the Right Lender for your Home Equity Line Of Credit?

If you decide that a HELOC is the right type of loan for you, look there for an offer that suits your needs. Check your main bank first as some banks offer discounts on HELOC to their regular customers. Receive a detailed price quote that includes information on interest rates, caps and fees. Then check with other lenders to compare their offers. There are a few things to keep in mind when shopping:

  1. Understand The Rate Index: Shopping for interest rates on a HELOC can be confusing. Since the interest rate is usually variable, you can’t look at one number and compare it across lenders. You have to ask each bank exactly what index its interest rate is based on. Once you know the index, do a little research to find out how much that index tends to change over time and how high it has been in the past. That will give you a clearer idea how much interest you’re likely to pay over the life of your loan.
  2. Compare Caps: It’s also important to know what the cap on your interest rate is. That will tell you how high the monthly payment on your loan can possibly go if interest rates rise. Check both the lifetime cap on the loan and the periodic cap, if there is one. Make sure that you know, and can afford, the maximum possible payment.
  3. Compare Fees: Along with comparing the APRs between different banks, you will also need to get details about closing costs and other fees. These charges are not reflected in the APR for a HELOC. Make sure you can afford the upfront costs on any HELOC you’re considering, as well as the monthly payments.
  4. Understand How Payments Work: Find out whether the monthly payments on your HELOC will include both principal and interest, or interest only. Interest-only payments sound like a good deal, but when the plan ends, you’ll have to pay off the entire principal in a huge balloon payment. Even if your payments include both principal and interest, check to see if the portion that goes toward the principal will be enough to pay off the full balance by the time the loan expires. If it’s not, you’ll still end up with a balloon payment. In some cases, it’s possible to extend your loan or refinance the balloon payment if you have to. Find out about these options ahead of time.
  5. Look Out For Penalties: Ask lenders what the penalties are for making loan payments late. Also, find out under what conditions the lender would consider your loan to be in default. If that ever happens, the lender can demand immediate payment in full – and if you can’t make that payment, it can take your home.
  6. Read the Fine Print: Ask each lender whether the HELOC has any special rules, such as a minimum withdrawal amount or restrictions on renting out your home. Find out whether the HELOC requires you to carry a balance at all times throughout the life of the loan. If it does, you can probably do better somewhere else.
  7. Get to Know Your Rights: Under the federal Truth in Lending Act, lenders must disclose all important details about a HELOC, including the APR, fees, and payment terms. The lender is not allowed to charge you any fees until it has given you this information. Moreover, if it changes any of these terms before you sign the contract, you have the right to walk away, and the lender must refund any fees you have already paid. And even after you’ve signed it, you still have the right to change your mind and cancel within three days.

Which Is Better For You: Home Equity Loan or Line of Credit?

It depends on your financial situation and needs. A HELOC acts like a revolving credit line, allowing you to tap the value of your home to the required amount as needed. A home equity loan is similar to a conventional loan with a lump sum withdrawal that is repaid in installments.

HELOCs typically have variable interest rates, while home equity loans are typically issued with a fixed interest rate. This can save you from a future payment shock if interest rates rise. Work with your lender to decide which option is best for your financing needs.

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