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What the Heck is a HELOC? Here’s Exactly What You Need to Know
The first time Laura Agadoni used a home equity line of credit — aka a HELOC — was to finish the basement in her suburban Atlanta home.
Whenever she had to pay contractors, she used the $20,000 line of credit.
“By doing so, we added value to our home using the equity in our home,” she said.
Most recently, she used a HELOC to help buy an investment property. She’s using the rental income to pay off the debt.
“I like the flexibility of having a big line of credit available to me in case I need to or want to use it,” she said.
So, what the heck is a HELOC anyway? It’s a good question and one that a lot of homeowners — even those who already have HELOCs — are asking.
A recent survey conducted by TD Bank found that many borrowers didn’t fully understand the details of their HELOC or misunderstood the terms of their line of credit.
Get informed and read on to learn more about HELOCs.
What is a HELOC?
A home equity line of credit (HELOC) is just that — a line of credit. Think of a HELOC like you would a credit card: You use it to make purchases, and then pay for those purchases later.
Unlike a credit card, which is unsecured debt, a home equity line of credit is secured because it’s backed by an asset with value: your house. When you make your mortgage payment each month, and as the market value of your home goes up, you’re building equity. A HELOC allows you to borrow against that equity.
Once you’ve been approved for a HELOC, you can borrow as much or as little as you need. This is what sets a HELOC apart from a home equity loan, in which the bank lends you a lump sum. With a HELOC, you don’t borrow it until you need it.
How Do Lenders Calculate Your Line of Credit?
Typically, lenders use your loan-to-value ratio to determine the size of your HELOC, according to Casey Fleming, a mortgage advisor for C2 Financial Corp. and the author of the book “The Loan Guide: How to Get the Best Possible Mortgage.”
Many banks will only offer a HELOC that keeps your total loan-to-value ratio at or below 80%. Some, such as the Pennsylvania State Employees Credit Union, will go as high as 90%.
Loan-to-value is easy to calculate when you just have a mortgage. Simply divide your current loan balance by the current value of your home. A loan balance of $100,000 for a home that’s appraised for $200,000 means you have a loan-to-value ratio of 50%.
If you want a HELOC, you’ll have to factor that amount into your loan balance. If you wanted to take out a $25,000 home equity line of credit, you’d have a total loan balance of $125,000 on a home valued at $200,000. Your new loan-to-value would be 62.5%.
In this scenario, if the lender will let you borrow up to 80% loan-to-value, you could be eligible for a $60,000 line of credit.
Lenders may also factor in your debt-to-income ratio, meaning how much debt you have compared to how much money you bring in, Fleming said. They may also look at your credit score.
A note: You’ll likely pay some of the same fees you paid for your first mortgage. According to the Federal Trade Commision, you could be on the hook for a new appraisal, title search, application fee and other charges.
Some lenders, such as Chase, will charge you an annual fee (Chase’s is $50). You could also see a prepayment penalty or an early closure fee if you close the line of credit within a certain number of months. Sound Credit Union in Washington, for example, charges a $345 fee is you close your HELOC within 24 months.
Of course, these fees can add up fast, so be sure to get a sense what your HELOC will really cost you before taking the plunge. And don’t forget to shop around to see who can offer you the best rates and the lowest fees.
How Does a HELOC Work?
Once you’ve been approved, you can start using your line of credit as you need it. This period is called the draw period and typically lasts between five and 10 years. During the draw period, many lenders allow borrowers to make interest-only payments.
Once the draw period ends, you cannot borrow more money and enter the repayment phase. You may be required to make a large, lump-sum payment on the outstanding balance (known as a balloon payment) or begin making monthly payments toward principal and interest, depending on the HELOC’s original terms.
Some borrowers are unprepared for the repayment period and may be surprised when their monthly payment goes up because they’re also paying principal, not just interest.
Of course, maybe you want to keep your line of credit and extend the draw period. Many lenders will do this, so long as your home still has enough equity and your financial health hasn’t tanked. Typically, a lender will “pay off” your old line of credit by simply extending you a new one, says Fleming.
What About Interest?
Most HELOCs have variable interest rates, which means they go up and down based on a financial index, typically the prime rate. Some banks will add a few percentage points, called a margin, to the prime rate. The current prime rate is 3.75%.
Many HELOCs also have interest rate minimums and maximums. Fleming said it’s typical for a rate cap to be set at 18%, though he noted that the prime rate hasn’t been in the double digits since the 1990s.
HELOCs typically offer lower interest rates than other forms of credit, said Jeffrey Hensel, a hard money lender at North Coast Financial Inc. The national average for credit card rates is roughly 15%, according to CreditCards.com.
“Another pro of HELOCs is that the borrower is only charged interest on the amount of funds currently taken out of the credit line,” Hensel added. “When the borrower deposits the borrowed funds back into the credit line, the interest stops accruing on that amount.”
How Can You Use a HELOC?
You could use a home equity line of credit to pay for anything, but that doesn’t mean you should. One of the most common uses for HELOCs is to finance home renovation projects or pay for major home repairs. A HELOC can also serve as a backup to your emergency cash fund.
They are sometimes used to pay down debt with higher interest rates, though not all experts agree on whether this is a good idea.
“I see this as a tool for people with a good or excellent (financial) track record,” said
Philip Lee, a Massachusetts-based wealth manager for Financially In Tune. “I caution against borrowing money if there is a fundamental issue with credit or spending. If people have spending problems, the use of a HELOC may simply make the situation worse off.”
It’s also probably not a good idea to buy a car, finance a vacation, or pay for other short-term items with a HELOC, advises Ryan Frailich, a financial coach and planner for Deliberate Finances.
Unlike a home renovation project, which will add value to your home, these items begin depreciating immediately or have no value. You could be paying for a new car long after you stop driving it, for example. And, if you don’t have the cash now, what’s to say you’ll have the cash to pay down your HELOC debt once the repayment period starts in 10 years?
“If you’re borrowing against your home for consumer goods, you’re negating that big benefit (of home ownership) of forced savings,” Frailich said.
Home Equity Loan vs. Home Equity Line of Credit?
As we discussed above, in addition to a home equity line of credit, you can also get a second mortgage in the form of a home equity loan. With a loan, you’re looking at a lump sum, a fixed interest rate and monthly payments that won’t change over the years.
Home equity loans are used for similar reasons, typically home renovation projects, paying off debt with a higher interest rate, etc. If you know exactly how much you need to borrow, and you have the money to make regular monthly payments of both principal and interest (on top of your first mortgage), you might go with a loan instead of a line of credit.
There are no surprises with a home equity loan, which allows you to plan out your monthly expenses well into the future. With a HELOC, many homeowners get used to 10 years of interest-only payments and then feel a squeeze when they have to start paying principal and interest after the draw period ends.
“You want predictable payments, and a schedule of repayment and have the cash flow to support it,” Lee said.
A home equity loan is also good if you don’t want (or can’t handle) the temptation of available credit — once you get your lump sum, that’s it.
Always keep in mind that both HELOCs and home equity loan can be risky, because if you can’t make your payments, you could lose your home. In fact, experts are predicting a wave of foreclosures in the coming years because so many people used HELOCs during the most recent recession. A RealtyTrac analysis found that more than 1.8 million homes with HELOCs opened between 2005 and 2008 are now seriously underwater.
So make sure you thoroughly consider all your options or consult with a financial expert before using a HELOC to pay for things.
Your Turn: Would you consider using a HELOC?
Sarah Kuta is an education reporter in Boulder, Colorado, with a penchant for weekend thrifting, furniture refurbishment and good deals. Find her on Twitter: @sarahkuta.