What is a home equity line of credit and how does it work?
What is a home equity line of credit and how does it work?

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A home equity line of credit (HELOC) can allow you to tap into the equity in your home to cover just about any expense. (iStock)

Home equity is defined as the difference between the value of your home and what you owe on your mortgage. Simply put, it’s the amount of your home that you actually own.

If you have equity in your home, you may want to tap into it to add value to your home, pay off debt, or achieve other goals. One way to do this is to use a home equity line of credit, or HELOC.

A cash-out refinance is another way to tap into the equity in your home. Credible, it’s easy to compare mortgage refinance rates from several lenders.

What is a home equity line of credit and how does it work?

A HELOC is a revolving line of credit that lets you borrow money against a portion of your home’s equity, usually up to 85%. It works much like a credit card – you’ll be able to withdraw as much or as little as you want up to a set credit limit. Eventually, you will repay the amount you borrowed plus interest. Note that HELOCs come with variable interest rates, which generally move with the prime rate and can fluctuate over time.

A HELOC has two important phases: the drawdown period and the redemption period. During the draw period, which can last from five to ten years, you will use special checks or a credit card to borrow money whenever you want and only make minimum payments.

Once the draw period ends, you will no longer be able to borrow against your credit limit. And you will have to repay the capital you borrowed plus interest. Depending on your agreement with the lender, you may have to pay off the balance immediately, or you may have a time period — usually 10 to 20 years.

It is important to note that some HELOCs have lump sum payments – larger lump sum payments due at the end of the repayment term to cover any remaining balance. If your HELOC agreement includes a lump sum payment, you may need to come up with thousands (or even tens of thousands) of dollars at a time.

Luckily, you have ways to get out of a HELOC lump sum payment. If you have enough cash, you can pay off your HELOC in cash before the lump sum payment is due. You can also refinance your HELOC or use a balance transfer credit card with a 0% introductory annual percentage rate, or APR.

Common uses of a HELOC

One of the advantages of a HELOC is its versatility. You can use it to cover just about any type of expense. Some of the most common uses of HELOCs include:

  • Home improvement projects — If you want to update your home, a HELOC is a great option. You can withdraw funds to remodel your kitchen, add an office, finish your basement or anything else. It’s a good idea to choose home improvement projects that increase the value of your home.
  • Debt Consolidation – Consolidation of your debts with a HELOC can make sense if you’re overwhelmed with high-interest credit card debt. With a HELOC, you can save hundreds or even thousands of dollars in interest. But keep in mind that a HELOC could put your home at risk if you are unable to repay the credit as agreed. Credit card debt is not secured by your home.
  • Medical fees – Unfortunately, insurance does not always cover all of your medical expenses. If you are facing healthcare costs and don’t have the money to cover them, a HELOC may be an option.

How to qualify for a HELOC

If you wish to purchase a HELOC, you will need to meet certain qualification requirements. Although each lender has their own criteria, most want to see a credit score of at least 680.

Lenders will also review your pay stubs and bank statements to understand your employment status and your debt-to-income ratio, or DTI, which compares how much of your total income is spent on debt. The lower your DTI, the better. Lenders generally prefer a DTI of 43% or less.

Additionally, lenders will look at your loan-to-value ratio, or LTV, to determine how much money you can borrow. Your LTV is your current mortgage balance divided by the current appraised value of your home. Most lenders require your LTV ratio to not exceed 85%.

Let’s say your the house is worth $300,000 and you owe $210,000 on your mortgage. In this situation, your loan-to-value ratio is 70%. If your lender offers HELOCs with a maximum LTV ratio of 85%, you’re in good shape.

Keep in mind that some HELOC lenders may have more lenient requirements. If you come across a lender that accepts borrowers with lower credit scores, for example, take a close look at their rates and fees because they can be high.

When a HELOC makes sense

A HELOC can be a good option if you want to finance a home improvement project that will improve the value of your home. In this situation, you may be able to claim the mortgage interest deduction on your federal tax returns, provided you meet all of the requirements to claim the deduction. It is a good idea to consult a tax advisor if this is your goal.

You may also consider a HELOC if you plan to purchase a vacation home or other real estate. It can help you cover down payment costs and closing costs.

Of course, HELOCs come at a price, so make sure you can afford the various closing costs before opening one. These costs will depend on the lender but may include application fees, appraisal fees and registration fees.

When to think twice about getting a HELOC

Although a HELOC is a good choice for some people, it is not right for everyone. If you only need a small amount of money, a HELOC is not worth it. Since the fees can exceed the amount you want to borrow, you might be better off with a 0% intro APR credit card, if you’re able to qualify for one.

Also, if you’re worried about spending more money than you need, a HELOC can lead you into a cycle of debt. You should also avoid this financing product if you are unsure of your future income and if you are unsure of being able to repay what you borrow.

Also, don’t use a HELOC — or any other form of credit, for that matter — to meet basic expenses like food and utilities. Instead, focus on how to increase your income and pay off your debt to improve your financial situation.

HELOC vs home equity loan or cash refinance

Home equity lines of credit aren’t the only way to tap into the equity in your home. You can also subscribe to a home equity loan or cash refinance.

With a home equity loan, the lender makes a lump sum payment, which you repay in monthly installments. A cash refinance replaces your original mortgage with a new loan for more than you owe on your home. You receive the difference in cash, which you can use for almost any expense.

Here is a comparison of three ways to leverage the equity in your home:

Advantages and disadvantages of a home equity line of credit

Each financial product has notable advantages and disadvantages. A HELOC is no exception. By comparing the pros and cons of this option, you can make an informed decision for your unique situation.

Benefits

The inconvenients

  • Must have good credit — Usually you need a high credit rating to obtain approval for a HELOC. If you don’t have the best credit, this may not be an immediate option for you.
  • Closing costs – HELOCs are not free. You will have to pay closing costs similar to those of a first mortgage.
  • Ongoing charges — In addition to closing costs, some lenders charge annual fees to keep your HELOC open, often referred to as annual fees or membership fees. You may also have to pay a fee if you don’t use your HELOC or if you terminate it early.
  • Unpredictable interest rates — Since most HELOCs have variable interest rates, your monthly payments may go up or down as you pay off your loan. Fluctuating payments can be stressful, especially if your budget is tight.
  • Foreclosure potential — A HELOC uses your home as collateral. If you don’t, the lender can foreclose on your home.

Where to get a home equity product

You can find HELOCs, home equity loans, and cash refinances at banks, credit unions, and online lenders. While some lenders offer all three home equity products to borrowers, others focus on only one or two.

To find the ideal option for your situation, it is important to do your research, shop around and compare the products available to you. Explore the requirements, pricing, terms, and fees of each choice to make the best decision.

If you decide that a cash-out refinance is a better fit for your financial goals, you can compare mortgage refinance rates from multiple lenders in minutes with Credible.

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