What is a HELOC Loan?
While planning your debt consolidation, or covering some emergency expenses, you might have stumbled on something called a HELOC loan. But what financial benefits does it provide?
HELOC stands for “Home Equity Line Of Credit” and like a mortgage, the amount is based on your home equity. Both HELOC and home equity loans are types of second mortgages you can take on your home.
Mortgages generally have lower interest rates than other loans, and the most common uses for a HELOC are home repairs, renovations, emergencies, and instant financial flexibility, depending on the situation. Compared to variable-rate credit cards, they can have up to 3 times lower APR.
How Does a HELOC Work?
A HELOC is a type of second mortgage, so the amount you can draw depends on the equity you possess. Each bank decides on the loan amount depending on your property value, equity, and your credit score as a combined loan-to-value ratio or CLTV.
Therefore the size of the second mortgage is directly proportional to how much of the first mortgage has been paid off.
The way a HELOC works is comparable to the way a credit card does. It’s not a lump sum you have to pay off with interest; rather, you can use only part of your loan, and you’ll be paying interest only on the amount you actually spent.
HELOC funds can be accessed in several ways, depending on the lender. The most common avenues are via check, online transfer, or a credit card connected to the account.
The draw period for a HELOC is usually 10 years, but not always. During that time, the minimum monthly payments are interest-only. You do have the option to cover the principal, and if you completely pay off your balance while still in the drawing period, the bank will offer to close the line of credit.
After the draw comes the repayment. While it lasts, you cannot get any more HELOC funds, and your monthly payments will comprise both principal and interest. Thankfully, the standard repayment length is 20 years.
Getting approval for a HELOC will depend on your bank and several other factors:
- Sufficient home equity
- A credit score in the mid 600s
- Reliable payment history
- Low debt-to-income ratio
To be eligible for a HELOC, you need equity as collateral. The amount of equity that you have is a direct result of the current market value of your home and your remaining mortgage debt. Most banks will give you a loan based on 80%-90% of the value of your home.
HELOC with a Bad Credit vs. a Good Credit Score
As always, homeowners with a higher credit score enjoy better interest rates: The difference between someone with a 620 and 750 credit score could be more than 5% in monthly interest rates. If a loan is large enough, this could amount to thousands of dollars per year.
Reliable Payment History
While your payment reliability is reflected in your credit score, most lenders usually check this parameter separately. The reasoning is simple: A regular debt repayment history means that person is more likely to pay off a second mortgage.
The assessment is so strict because, in case of a foreclosure, the HELOC lender is the second party to receive funds. In other words, they’re in a riskier position than the original mortgage lender.
The Importance of Debt-to-Income (DTI) Ratio
Keeping your debt-to-income ratio low is crucial when applying. It directly informs the lender on the amount of income you have available to cover your monthly payments.
You can calculate your DTI by dividing all monthly debt payments by your gross monthly income. If your DTI is below 43%, you’re eligible for a Qualified Mortgage - a loan with fewer risky features.
HELOC Interest Rates
Variable interest rates are par for the course with a HELOC, and they’re a direct sum of the index rate and the margin. The index rate is a market-dependent baseline used by banks to set rates on loans, including HELOCs. The margin depends on your credit score.
A high credit score means a lower margin, and, by extension, a lower interest rate. Some banks offer fixed rates for several years, switching to a variable one after that period expires.
Variable interest rates could potentially expose you to paying higher interest on the money you spent. Using your HELOC funds while interest rates are lower and being frugal while the index is high would be a wise financial move.
Calculating Your HELOC Value - Explained
Knowing what factors influence HELOC value makes calculating its financial impact easy.
With a home valued at $200,000 and a mortgage of $90,000, home equity totals at 110,000. For example, if a bank limits the borrowing amount to 80% of the property value, and there are no other liens tied to it, the formula for your HELOC is as follows:
80% of the home’s market value: $200,000 x 0.8 = $160,000
Potential line of credit: $160,000 - $90,000 = $70,000
While HELOC loans have obvious benefits, they do come with additional expenses for HELOC borrowers before the line of credit is set up. These differ by bank and state, but include:
- Application fees
- Home appraisal fees
- Annual fees
- Attorney and documentation prep fees
- Recording fee
- Inactivity fee
- Upfront charges
Make sure to check with your lender beforehand what extra charges your HELOC setup will bring. The best course of action is to get quotes from multiple banks and find the one that suits you the most in terms of both principal, payment terms, and fees.
Some lenders might even be open to negotiating these terms.
HELOC vs. Home Equity Loan
HELOCs and home equity loans differ by several key points, and each has its advantages.
HELOCs have a variable interest rate or a fixed starting rate that becomes variable. Home equity loans are always fixed-rate. The HELOC APR is slightly lower compared to home equity loans, also. But the main difference between the two is the loan type.
A home equity loan is a lump sum to be paid back with 10 to 30 years of fixed payments. A HELOC is more flexible: During the draw period you are only expected to cover the interest, and then start paying off the principal too when the repayment period starts.
HELOC for Home Improvements
The most common reason for taking out a second mortgage is to finance home improvements.
After all, renovations and remodeling projects increase home value, and using equity to create a more enjoyable living environment is one of the best ways to take advantage of a second mortgage.
Depending on the scale of home renovation you are planning on, either a HELOC or a home equity loan could be appropriate.
Keep in mind that using HELOC for home improvements might make your interest tax-deductible. According to the IRS, for this to happen, the funds must be used to buy, build, or substantially improve the taxpayer’s residence.
Other HELOC Common Use Cases
Home equity line of credit rates can quite favorable if you need to cover any of the following:
- Debt consolidation. Credit cards have less favorable interest rates than HELOC mortgages, so it might be smart to use a HELOC to cover higher-interest credit card debt
- Medical bills
- Education costs covered with a HELOC can be a better option than taking on a student loan, especially for borrowers with good credit scores
- Large purchases, but make sure you have a dependable strategy to pay off the debt during the draw or repayment period
HELOC - Pros and Cons
There are two sides to everything, including opening a HELOC account:
- Low interest rates with home equity as collateral. Compared to credit cards and personal loans, HELOC rates can be significantly lower
- Waived fees for higher credit scores, usually closing or application fees
- No fees for drawing funds
- Flexible repayment during both the draw and repayment periods
- Make sure that there are no fees for closing the account early
- Tax-deductible interest for a HELOC used for home improvement of qualified residence loans
- Adjustable spending and interest according to your needs
- Depending on your HELOC terms, your lender might set minimum draws
- Just paying off interest during the draw period leaves you with a larger balance to cover during the repayment
- Variable interest rates mean that any upward adjustment in index or margin increases your interest
- Using HELOC funds for anything that’s not an important investment
- Hidden fees tend to add up
- Home value can drop due to deterioration and reduce your equity: This is the main reason not to loan against more than 80% of your house value, which leaves you with 20% to compensate for any decrease in value when reselling the house or refinancing to cover the loan
The answer to “What is a HELOC loan?” depends on planned expenses, knowing it can help you properly use your equity for your second mortgage.
A HELOC is issued for a draw period of up to 10 years, during which the borrower is required to pay interest on the withdrawn sum. If you pay off your debt during the draw period, you may close the account or keep it open for future expenses.
The repayment period usually lasts up to 20 years, and the borrower is required to make both interest and principal payments to settle the debt.
HELOCs have great benefits for borrowers looking to cover the cost of home improvements, consolidate debt, cover medical bills, education costs, or cover a large payment with a low-interest loan.
Carefully planning your financial expenses is crucial to avoid foreclosure and losing your home. Therefore, using HELOC to improve your home and raise your equity is the best application of the loan funds.
Both have their advantages and drawbacks, so answering what is a home equity line of credit and what home equity loans are will help you choose between them.
A home equity loan is a lump sum with a predetermined payment plan and a fixed interest rate. HELOC loans have a variable interest rate and a flexible payment plan, more suitable for borrowers who want to pay off their debt at their own pace.
A HELOC can be used for any number of different payments. It's most useful for consolidating debt, home improvements, and renovation, college tuition, or medical expenses.
HELOCs are revolving credit lines, so lenders will most likely run a hard inquiry of your credit score to determine your eligibility, which could drop your total by a few points.
Being overdue on your HELOC payments or missing them completely will have the greatest impact on your credit score. Also, though it may seem counterintuitive, using your home and thus risking damage to it is another danger to your repayment, as your home is the collateral for a HELOC.
A HELOC or a home equity line of credit is a second mortgage that allows you to open a line of credit with house equity as collateral.
During the draw period, the borrower is required to pay off interest only, although they can choose to cover the principal payments, as well. During the repayment period, both interest and principal amounts need to be paid off.
Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.
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