Often when homeowners need money for renovations or to pay off credit card debt, they tap into the equity in their home. One of the popular ways to do this is through what’s known as a home equity line of credit, or HELOC.
Unlike a home equity loan, a HELOC allows you to borrow and repay as much money as you need over a certain period of time, which makes it a great option if you have ongoing projects like home renovations.
How a home equity line of credit works
As the name indicates, a HELOC is a line of credit, one that’s based on the available equity in your home. A HELOC functions much like a credit card. The borrower is given a credit limit and can borrow money as needed up to that limit. As the money borrowed is repaid, the funds are replenished. However, a HELOC’s funds are only available for a specific length of time.
“A home equity line of credit provides access to funds that can be withdrawn as a borrower needs them over a fixed ‘draw’ period, typically 10 years,” says Jon Giles, senior vice president of Home Equity Lending at TD Bank. After that, borrowers enter a repayment period, during which they’ll no longer be able to access funds and will instead focus on repaying the principal.
Like credit cards, HELOCs also come with a variable interest rate, and your monthly payment will vary depending on the current interest rate and how much you borrow at any given time.
What determines a HELOC’s credit limit?
“Most lenders will extend a credit line for up to 90 percent of a home’s value, but borrowers can secure lower interest rates at 80 percent or less,” says Giles. From there, lenders will subtract the remaining mortgage balance to determine your credit limit.
For instance, if you have a home valued at $500,000 and your lender offers you 90 percent of your home’s value, you would start with this calculation:
$500,000 x 0.90 = $450,000
Once you have that number, subtract your remaining mortgage balance. If you still owe $300,000 on your home, you would make this calculation:
$450,000 – $300,000 = $150,000
That $150,000 is your potential credit limit.
How can you spend HELOC funds?
Use of HELOC funds is up to the borrower’s discretion; the money can be tapped to pay for home improvement projects, debt consolidation, major purchases or education expenses.
“We always recommend that borrowers look at responsible uses of their home equity,” says Giles. “These include purchases or projects that return value to the borrower – such as a home renovation that would make their home more marketable and improve their quality of life.” You may also consider using your funds to consolidate debt at a lower interest rate.
What is the length of a HELOC?
A HELOC has two main periods: the draw period and the repayment period. These two periods combined typically last up to 25 years.
During the draw period, which usually lasts five to 10 years, you can access the money as needed and are only required to make interest payments — although if you choose to pay back parts of your principal as well, you’ll cut back on your monthly payment during the repayment period.
The repayment period normally lasts from 10 to 20 years, during which you’ll be responsible for paying back your principal, along with interest. While in the repayment period you’ll no longer be able to access funds, and your monthly payment will be higher than during the draw period.
Are there any additional fees?
Depending on the lender, you may encounter lender fees, annual fees, origination fees, inactivity fees and more. Some lenders may also entice you with an introductory period that offers fixed or unusually low rates for a certain period of time. While this could make the lender more attractive, make sure that the offer you get post-introductory period is still competitive.
When shopping around with multiple lenders, take note of any additional fees and factor them into your quote to make sure you’re getting the best HELOC rate.
The risks of HELOC
There are some drawbacks to be aware of when considering a HELOC, including the fact that the money comes with a variable interest rate.
“A borrower who takes out an adjustable-rate HELOC may see their interest rates fluctuate, so it’s important to evaluate your comfort level with this potential variability,” says Giles. This differs from a home equity loan, which gives you a lump sum upfront but also typically guarantees a fixed interest rate throughout the life of the loan.
Another drawback associated with HELOCs is the fact that you’re using your home as collateral for the loan, meaning that if you default on the loan, your home is at risk.
HELOCs also require discipline. Because the money doesn’t need to be repaid until the repayment period, you may not see the full impact of your borrowing — especially if you elect to pay only interest during the draw period. If you’re not mindful of your borrowing, the monthly principal payments during the repayment period may come as a shock.
For those not fully comfortable with a variable-interest HELOC, there are a few alternatives.
Home equity loan
A home equity loan is essentially a second mortgage. The proceeds from this loan are paid out in a single lump sum, and once you’ve received the money, you start repaying the debt right away at a fixed interest rate.
The main benefit of a home equity loan versus a HELOC is that it offers a fixed monthly payment. In other words, you will know exactly how much must be paid each month, and your interest rate will never fluctuate.
A cash-out refinance replaces your existing mortgage with a new, higher-balance loan. Often lenders will allow you to refinance and borrow as much as 80 percent of your home’s value, providing you with the difference in cash.
For example, if your home is valued at $400,000 and the balance owed is $200,000, a cash-out refinance could allow you to establish a new loan for $320,000 (80 percent of your home’s value) and obtain $120,000 in cash (your new loan minus your outstanding loan balance). The closing costs and other fees associated with refinancing would also be deducted from the $120,000.
Keep in mind that you’ll be paying more interest each month, since you’re increasing the amount of your loan, but know that cash-out refinance could be a good option if you need a large sum of money upfront.
A personal loan comes with a fixed interest rate and provides a lump sum of money immediately. It’s also unsecured debt, so unlike a HELOC, it’s not backed by collateral — meaning your house is not at risk if you fall behind on payments.
Personal loans offer a fixed repayment schedule and fixed interest rates, but interest rates will also typically be higher than those of secured loans. However, if you like the peace of mind that comes with a loan that’s not tied to your property, a personal loan could be a good choice.
The bottom line
HELOCs are worth looking into if you want the freedom of borrowing as little or as much as you want, and doing so on your timeline. But keep in mind that HELOCs require discipline, and a variable interest rate makes them slightly more volatile than home equity loans. Still, if you’re looking for access to funds for ongoing projects or expenses, try getting quotes from a few lenders to see what they can offer you.