If you’re wondering, “how does a home equity line of credit work?” you’ve come to the right place.
The good news is that the basics for a home equity line of credit (HELOC) are simple. But, like most things, it helps to get a full picture of how they work so you can make an informed decision about whether or not you should get a HELOC.
We’ve compiled a list of commonly asked questions about HELOCs to help you understand the ins and outs as you consider one.
What Is a Home Equity Line of Credit?
As its name suggests, a HELOC is a line of credit that is secured by your home equity. The primary benefit you’ll receive is access to a revolving credit line. As an example, you can use the credit for large expenses, like a home renovation project, or paying off debts that have a higher interest rate, such as credit cards.
Many HELOCs have lower interest rates than other common loans. If you use the funds for home improvements, the interest is tax-deductible so long as you have less than $750,000 of home secured debt outstanding. If you use the funds for anything else – such as consolidating debts – then the interest expense is not deductible. Of course, tax laws change often so check with a tax professional to find out if interest deductibility is still an option.
A Home Equity Line of Credit Explained
If you have equity in your house, a home equity line of credit can enable you to borrow money against that equity.
What is home equity, you ask? Here’s how it works:
Let’s say you purchased a home for $200,000 and have an outstanding loan balance of $100,000. Assuming the home still appraises for $200,000, your current home equity is $100,000. As you pay off more of your home loan, your home equity continues to increase.
Along the same lines, if your home’s value increases from $200,000 to $300,000, your home equity of $100,000 becomes $200,000 ($300,000 home value – $100,000 loan balance). This equity is what banks base your credit line on when you apply for a HELOC.
Most banks won’t allow you to borrow more than 85% of your home’s value. So, in the example above, you can borrow up to $255,000 (85% of $300,000). Since you already have a mortgage for $100,000, this leaves an additional $155,000 you can take out as a HELOC ($255,000 borrowing limit – $100,000 existing mortgage).
How Does a Home Equity Line of Credit Work?
When you get a HELOC, the bank gives you a “draw period.” That’s the timeframe in which you can withdraw funds from your credit line. This time period can vary, though it is typically five to 10 years.
Once the draw period concludes, the repayment period begins. Repayment terms are commonly 10 to 20 years.
Since the HELOC is secured by the home, defaulting on your payments would result in being forced to sell your home or the lender could foreclose on it in order to sell it and get reimbursed for the outstanding balance.
The maximum you can receive on your credit line depends on how much equity there is in the home. Another factor is the lender’s risk analysis and how creditworthy they consider you. Most lenders allow you to borrow up to a cumulative loan-to-value ratio (CLTV) of 85%, meaning all loans against your home – including your HELOC – can’t exceed 85% of your home’s value.
How Can You Use a HELOC?
Many homeowners use their HELOC to complete home upgrades, such as a kitchen remodel. Others use their line of credit to consolidate other high-interest debt, such as credit cards.
Another common use for a HELOC is to use the credit to put a down payment on another home. This benefit allows you to buy another home before selling your current home. Later, you can pay off the HELOC when your first home is sold.
How Do HELOC Payments Work?
Once the draw period expires, you may have a choice to make one balloon payment for the outstanding balance or begin the repayment period, in which case the lender may restructure the debt into a traditional loan. In that case, you could repay the debt through monthly payments over 10 to 20 years.
Payment amounts may change if you make additional payments or due to changes in your balance and interest rate fluctuations. Savvy homeowners may wish to pay off more of the principal upfront to reduce the interest they end up paying over the long run.
What Are the Qualifications for a Home Equity Line of Credit?
The biggest qualifications for a HELOC are sufficient equity in your property and good credit.
The qualifications are somewhat similar to applying for a traditional mortgage. Banks require you to be a US citizen or permanent resident. You’ll need decent credit, typically 680 or above.
Lenders take a look at your cumulative loan-to-value ratio, which is the balance of your home-related debt (mortgage, HELOC, liens) compared to the value of your property. Also important is a borrower’s debt-to-income ratio, which should be 43% or less in most cases.
You may find varying qualifications among different lenders, but most financial institutions will want to see a strong mortgage payment history, good income, and at least a two-year employment history.
How Will I Have Access to Funds?
Depending on the lender, there may be a variety of options to access your HELOC funds. Some common options include having the funds transferred online to your account or giving you a credit card that taps into the funds directly. You also may be able to visit a local financial center.
You may even be able to pay for purchases and services using checks that are tied to your HELOC.
Is a Home Equity Line of Credit Best for Me?
Hopefully, this guide helped answer the basic questions related to how a home equity line of credit works. Ultimately, the decision on whether or not you should get a HELOC is up to you. A HELOC certainly isn’t for everyone and all scenarios.
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