If you’re a homeowner and have a large expense coming up, you may have heard of a home equity line of credit—also referred to as a HELOC—as a potential solution. A HELOC can be a great way to get a loan, and often has a lower interest rate than you’d pay otherwise. But what is a home equity line of credit, and how does it work? Below, we’ll go over all of the basics that you need to know about home equity line of credits, including what they are, how they function, and what you need to do to apply.
What is a Home Equity Line of Credit?
A home equity line of credit is a loan that you take out using the equity you own in your home as collateral. The more equity that you have in your home, the more that you can borrow.
Most homeowners who use a home equity line of credit do so only for very large expenses, such as home renovations, new cars, and university tuition fees. Many also consolidate existing loans into a HELOC in order to take advantage of lower interest rates.
Perhaps the easiest way to understand a home equity line of credit is to equate it to a credit card. You borrow from the equity in your home, withdrawing funds as you need to, as opposed to taking one lump sum payment. These funds can be accessed whenever you need them (for example, if you have unanticipated travel expenses or medical bills that you need to cover), though they can not exceed the amount of equity you currently own.
HELOC vs. Conventional Loan
There are a couple of differentiating factors between a home equity line of credit and a conventional loan.
For starters, a HELOC generally has variable interest rates, which means the interest rate can “float” (i.e. change) over the course of the loan period. With a conventional loan, you almost always lock in at an interest rate that doesn’t fluctuate during the loan’s term. It’s worth noting however that some lenders will offer fixed interest rates on a HELOC, so if you’re interested in that you can certainly inquire.
Another difference is that a home equity line of credit often has lower interest rates. Because you already have the equity available, a HELOC is considered a less risky investment for lenders, which in turn allows them to offer lower interest rates than you might get with a conventional loan.
The third major difference between a home equity line of credit and a conventional loan is the payout. As mentioned above, a HELOC functions similar to a credit card, with a set limit that you can borrow up to. This is different from a conventional loan, where you borrow a pre-determined amount all in one lump sum. So if you have $100,000 in equity on your home, you can borrow up to that amount. That means you can borrow $4,000 for a vacation, $20,000 for a new car, $30,000 for home improvements, and so on, with the cap being the amount of your home you actually own.
Note that with a HELOC, you only pay interest on the amount that you borrow—not the potential amount that you could borrow. So if you take $20,000 of your $100,000 in equity for a new car, you’ll only pay interest on that $20,000.
HELOC Repayment
There are two major time constraints on a home equity line of credit: the draw period and the repayment period. Together, most HELOC repayment periods last about 30 years—10 years for the draw period and 20 years for the repayment period.
The draw period is when your HELOC is active, meaning that you can borrow against your equity any time during this period, which generally lasts 10 years. During the draw period, you only have to pay interest on the loan and are not required to contribute to principal.
The repayment period starts after the draw period has ended and is usually about 20 years. At this point, you would have to take out another HELOC if you wanted to borrow from your equity. You’ll also have to start making both interest and principal payments toward the loan. Remember that most home equity lines of credit have variable interest rates, so the interest rate you were given when you originally withdrew the loan may not be the interest rate you have when you begin the repayment period.
How to Apply for a Home Equity Line of Credit
You can apply for a home equity line of credit much like you would apply for a second mortgage. In order to determine whether your qualify for a HELOC and what your borrowing limit and initial interest rate will be, a lender will look at a number of factors, including:
- How much equity you currently have in your home
- Your income
- Your debt-to-income ratio
- Your credit score
A lender will also want to know your employment status and history, as well as have an appraisal conducted on your home. Generally, you’ll know whether you’ve been accepted for the loan after the lender has verified your income and completed the appraisal.
What if You Sell Your Home?
A common question that homeowners have in regards to HELOCs is “what happens if I sell?” The answer is that you’ll have to pay off your home equity line of credit when you sell your home, even if you’re still in the draw or repayment period.
Most of the time, you should have no trouble paying back your HELOC, since you’ll be selling your home for more than you owe (in turn leaving you with money left over to pay the loan back).
However, complications do arise if you’re underwater on the sale. If that’s the case, you will still have to repay your home equity line of credit, but you’ll have to find another way to secure the funds. You can do so through savings, or you may have to initiate a short sale with your lender.
Is a Home Equity Line of Credit a Good Idea for You?
A HELOC is considered to be one of the best ways for homeowners to secure a loan for large purchases. To figure out if it’s the right move for you, take a few factors into account:
- How much equity you currently own in your home
- How long you intend to stay in your home
- What type of expense you’re looking to secure the loan for
A home equity line of credit is usually used for large purchases, as opposed to day-to-day spending. Think of it like a rainy day fund that you can tap into when savings just won’t cut it. Keep in mind though that you’re better off establishing a fair amount of equity before taking out a HELOC, since you don’t want to cap your borrowing limit too low.
Note that you will have closing costs associated with your home equity line of credit that you’ll need to budget for. These include your application and processing fees (usually $100+, though many lenders refund this amount if your application is denied), an appraisal fee (about $150 to $250), an origination fee (about 1% of the amount you’re borrowing), and attorney’s fees (since you won’t want to go about the process alone).
As with all loans, never take out more than you can afford. Any line of credit can be a slippery slope if you don’t have the means to pay it off over time, and a home equity line of credit is no different. Evaluate all your options and be sure to look over your loan amortization schedule to ensure you can handle payments with your current income.
