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What is a Home Equity Line of Credit (HELOC) Loan

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A home equity line of credit allows you to borrow against the value of your home and withdraw cash as needed.

What is a home equity line of credit?

A home equity line of credit (HELOC) is a second mortgage that provides access to cash based on the value of the home. Similar to a credit card, you can withdraw from a home equity line of credit and repay all or a portion of it each month.

Borrowing money against the equity in your home can be done through a home equity line of credit (HELOC). Equity is calculated by subtracting the amount still owed on the principal mortgage from the value of the home.
You can also receive a HELOC if you own your home outright, in which case the HELOC serves as the primary mortgage rather than a secondary one. This is another scenario in which you can obtain a HELOC.
Borrowing money against the equity in your home is likely to provide you the best interest rate of any loan option you investigate when you are in the market for one.

Key Takeaways
Typically, you get 10 years to withdraw cash from a home equity line of credit while paying only interest, followed by 20 years to repay the principal and interest.

In contrast to most loans, your credit line’s interest rate is likely to fluctuate dependent on market conditions over its term.

In order to qualify for a home equity line of credit, lenders often require a credit score of at least 620, a debt-to-income ratio of less than 40%, and a minimum equity position of 15%.

The majority of HELOC lenders will allow you to borrow up to 85% of the value of your home (less any outstanding debt), however some have higher or lower restrictions.

Since you risk losing your home if you are unable to repay your loan, a home equity line of credit is best kept for expenses that will help grow wealth (such as home improvements and renovations) and for individuals who wish to strengthen their emergency finances.

A HELOC is unsuitable for financing trips or depreciating assets such as cars, and it would not be the ideal choice for someone who wants to sell their home soon.

How a HELOC works

A home equity line of credit (HELOC) functions similarly to a credit card in that it enables you to borrow against your available credit on an as-needed basis; however, instead of your available credit, it is against your home equity.

The interest rates on most HELOCs can be changed at any time. This indicates that the interest rate on your home equity line of credit (HELOC) will change in accordance with any changes in the benchmark interest rate. On the other hand, due to the fact that a HELOC is secured against the value of your home, the interest rate is often far more comparable to that of a mortgage than it is to the rate of a credit card.

To set your rate, the lender will start with an index rate, then apply a markup depending on your credit profile. Generally, the higher your credit score, the lower the markup. Before agreeing to the terms of the HELOC, you should make it a point to inquire about the amount of the margin, often known as the markup.

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How to get a home equity line of credit

The steps involved in obtaining a HELOC are quite similar to those involved in purchasing a home or getting a mortgage refinance. You will be required to establish that you are creditworthy in addition to providing some of the same paperwork. The following is a list of the steps that you will follow:

Utilize a home equity line of credit calculator to ascertain whether or not you have adequate equity.

Shop around for HELOC lenders once you have an idea of how much you are able to borrow.

Before you submit your application, make sure you have all of the required papers in order to ensure a smooth procedure.

Apply for the home equity line of credit when you have gathered all of the necessary paperwork and chosen a lending institution.

You’ll receive disclosure materials. Carefully read them, and make sure to ask the lender any questions you have. Check to see if the HELOC will satisfy your requirements. For instance, will you have to take out a loan for a few thousand dollars right away (what is commonly referred to as an initial draw)? Do you need to start a new bank account in order to get the best rate on the home equity line of credit?

Even though it is not as time-consuming as it was when you were getting your mortgage, the underwriting procedure might still take several weeks.

The final phase of the process is the closure of the loan, which entails signing the necessary documentation and releasing the line of credit.

How you pay back a HELOC

The draw period comes first, followed by the repayment period when you have a HELOC.

Draw period: If you want to borrow money from the credit line, you can do so during the draw period by writing a check, making a transfer, or using a credit card that is linked to the account. During the draw period, the monthly minimum payments typically exclusively go toward the interest on the loan; however, you are free to make payments toward the debt if you so want. (It is important to be aware that if you choose to pay simply the interest during the draw period, your monthly payments during the payback period will be significantly higher.) There is no set time limit on the draw period, but often it lasts for ten years.

Payback period: You will no longer be able to borrow money against the credit line while the repayment period is in effect. Instead, you are responsible for repaying the loan through a series of monthly payments that include both the principal and the interest. When compared to the payments made during the draw period, the monthly installments that include principal might have a significant impact on the total amount owed. There isn’t a set length for the repayment period, but it’s often around 20 years.

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A balloon payment is a one-time, significant payment that is due at the end of a loan to repay any unpaid principal that accrued throughout the loan’s term. This payment is also known as a final balloon payment. Consider negotiating a term extension or a refinance option before you close on a home equity line of credit. This will ensure that you are protected in the event that you are unable to afford the initial lump sum payment.

Is getting a HELOC a good idea?

Whether a home equity line of credit is a good idea really comes down to your goals and financial situation. A HELOC is often used for home repairs and renovations, which can increase your home’s value. Another bonus: The interest on your HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home, according to the IRS.

Some use home equity lines of credit to pay for education, but you may get better rates using federal student loans. Financial advisors generally don’t recommend using a HELOC to pay for vacations and cars because those expenditures don’t build wealth, and may put you at risk of losing the home if you default on the loan.

» MORE: 5 good reasons to tap your home equity

Disadvantages of a home equity line of credit

The main drawback of a HELOC is that it increases the risk of foreclosure if you can’t pay the loan. Regardless of your goal, avoid a HELOC if:

Your income is unstable. If it’s possible that your income will change for the worse, a HELOC may be a bad idea. If you can’t keep up with your monthly payments, your lender could force you out of your home.

You can’t afford the upfront costs. A HELOC may require an application fee, title search, home appraisal, real estate attorney fees and points. These charges can set you back hundreds of dollars.

You aren’t looking to borrow much money. A HELOC’s upfront costs may not be worth it if you need only a small line of credit. In that case, you may be better off with a low-interest credit card, perhaps with an introductory interest-free period.

You can’t afford an interest rate increase. HELOCs have adjustable rates. The loan paperwork will disclose the lifetime cap, which is the highest possible rate. Could you afford a monthly payment with that much interest? If not, think twice about getting the loan.

You’re using it for basic needs. If you need extra money for day-to-day purchases and you’re having trouble just making ends meet, a HELOC isn’t worth the risk. It’s safer to get your finances in shape before taking on additional debts.

Variable rates leave you vulnerable to rising interest rates. Be sure to take this into account. Look at the size of the periodic cap (that’s how much the interest rate can change at any one time) and the lifetime cap (the highest interest rate you could be charged over the life of the loan) to get an idea of how high your payments could get.

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On the plus side, as with a credit card, you pay interest only on the amount of money you use, not the total credit line available to borrow.

» MORE: How to safely tap home equity in a financial emergency

Getting the best HELOC rate

This one’s on you: The more you research, the bigger your reward. As you look for the best HELOC rates, get quotes from various lenders. Check your primary bank or mortgage provider; it might offer discounts to existing customers. Get a quote and compare its rates with at least two other lenders. As you shop around, take note of introductory offers like initial rates that will expire at the end of a given term.

» MORE: 9 tips for getting the best HELOC rate

How a HELOC affects your credit score

Although a HELOC acts a lot like a credit card, giving you ongoing access to your home’s equity, there’s one big difference when it comes to your credit score: Some bureaus treat HELOCs of a certain size like installment loans rather than revolving lines of credit.

This means borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. Like any line of credit, a new HELOC on your report will likely reduce your credit score temporarily. However, if you borrow responsibly — making timely payments and not utilizing the full credit line — your HELOC could help you improve your credit score over time.

What to do if you can’t keep up with your HELOC payments

Since most HELOCs have an adjustable rate, it’s possible that your payments could exceed what you’d originally planned. If you can’t pay back what you’ve withdrawn, the lender could foreclose on your home; therefore, it’s important to act fast if you foresee a problem. Reach out to the lender to understand your options, and consider refinancing to lower your rate or change your payment terms.

Before you open a HELOC, you might look for lenders that offer a fixed-rate option. This lets you lock in your APR when you draw from your equity, which protects your loan from rising interest rates and can make long-term financial planning a little easier.

Is it better to get a home equity loan or line of credit?

That depends on your financial situation and needs. A HELOC behaves like a revolving line of credit, letting you tap your home’s value in the amount you need as you need it. A home equity loan works more like a conventional loan, with a lump-sum withdrawal that’s paid back in installments.

HELOCs typically have variable interest rates, while home equity loans are usually 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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