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

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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.

A HELOC is a type of loan that 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.

What is a home equity line of credit?

A HELOC is a line of credit that’s based on the available equity in your home. Unlike a home equity loan, which involves borrowing a fixed, lump-sum amount, a HELOC is a revolving form of credit. It 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.

How does a HELOC work?

When you’re approved for a HELOC and have been given a credit limit, you can draw funds from the account using dedicated checks or a draw card throughout the established draw period. During the draw period, you’ll need to at least make minimum monthly payments on the home equity line of credit.

“A home equity line of credit provides access to funds that can be withdrawn as a borrower needs them over a fixed ‘draw’ period, typically 10 years,” says Jon Giles, senior vice president of home equity lending at TD Bank.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. Most HELOC plans let you repay the remaining balance over a period of 10 to 20 years. However, some plan terms require a lump-sum payment to clear the entire HELOC debt. This is called a “balloon payment.”

What determines a HELOC’s credit limit?

A HELOC’s credit limit is typically based on three factors: the available equity in the home, the borrower’s debt-to-income ratio and the borrower’s credit score.

For borrowers with good credit, lenders may be willing to lend up to 85 percent of the home’s value, minus any outstanding mortgage balances. For instance, 85 percent of a home worth $400,000 is $340,000. A mortgage balance of $100,000 would bring the HELOC’s credit limit to $240,000.

What is a variable interest rate on a HELOC?

Like credit cards, HELOCs come with a variable interest rate, which means that your monthly payment will vary depending on the current interest rate and how much you borrow at any given time.

The variable interest rate on your loan is partly determined by publicly shared indexes, like the U.S. prime rate. The prime rate is set by collective financial institutions and is influenced by fluctuations in the federal funds rate (the rate that banks charge other banks for short-term loans).

Because the prime rate is affected by market and economic conditions, it causes your HELOC’s interest rate to increase or decrease over time. As interest rates change and you draw on your HELOC account, the monthly payment that’s due will also change. However, there is a legal cap on how much your rate can increase over the plan’s lifetime.

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 time period 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 to 30 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.

What is an example of a HELOC?

If you’re considering opening a home equity line of credit, you’ll need to know what your credit limit might look like. Here’s an example of how a HELOC might be calculated:

  • Home’s current appraised value: $500,000.
  • 90 percent of appraised value: $500,000 x 0.90 = $450,000.
  • Amount you still owe on your mortgage:  $300,000.
  • 90 percent of home’s appraised value minus amount owed: $450,000 – $300,000 = $150,000.

In this sample calculation, the HELOC would offer up to $150,000 as a potential credit limit.

The risks of a 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.

HELOC alternatives

For those not fully comfortable with a variable-rate 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.

Cash-out refinance

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.

Personal loan

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.

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