What is a HELOC (Home Equity Line of Credit) Loan?

What is a HELOC?

A home equity line of credit (HELOC) is a revolving source of funds, similar to a credit card, where you can borrow as you see fit. The HELOC is secured against the equity in your home, and can be considered as a “second mortgage”. The equity is the difference between your home’s value and the value of your mortgage, meaning it is the amount that you have already paid off and now own. HELOCs offer variable interest rates, but banks can choose to fix them for a number of years depending on their policy. Since the loan is secured against the value of your house, lenders are willing to offer a lower interest rate for the loan, making a HELOC a low cost option for a loan.

Due to the COVID-19 pandemic, some banks chose to stop accepting HELOC applications as of May 1, 2020; therefore,  if you are interested in getting one, make sure to check with your bank to see what your specific options are. 

How does a HELOC work?

In order to qualify for a HELOC, banks will evaluate you based on the value of your property and your creditworthiness. This is known as the combined loan-to-value ratio (CLTV). Your creditworthiness is based on your employment history, income, and credit score. Be aware that if the housing market falls, homeowners with a high CLTV could go underwater on their loans. This means that you don’t have enough home equity to use as collateral for your loan because the value of your home fell.

A HELOC typically has 2 phases, the draw phase and the repayment phase. In the draw phase, which is usually 10 years in a 30 year HELOC, you can access the credit available as often as you want. The bank requires small, interest only payments during this period. There are some banks that may offer the option to begin paying back the principal as well. There are a variety of ways that banks will let you access the funds. It may be through online transfer, writing a check or using a credit card connected to your account. Make sure to ask your bank when getting a HELOC so that you are clear on how to access the funds from day one. 

At the end of the draw phase, you can ask for an extension, otherwise the repayment period will begin. During this time, usually 20 years in a 30 year HELOC, you cannot take out any more funds. You make regular payments to repay all the money you borrowed (the principal) and the interest (based on the variable interest rate). At this point, some banks may offer to convert the HELOC into a fixed rate loan so that there is less uncertainty regarding interest.

What can I use a HELOC for?

The good thing about a HELOC is that it can be used for most things. You can use them as a source of funds for renovations or remodelings, which will help you add value to the house that you already own. You can also use a HELOC to consolidate high interest rate debt such as credit card debt. Essentially, you can replace a high cost loan with this low cost, secured line of credit, making it easier and cheaper to pay off your debt. You can even use a HELOC for big purchases such as a vacation, however make sure you spend within your limits so that you are able to pay back the debt. Defaulting on a HELOC can result in the loss of your house. 

Pros and Cons of a HELOC

The pros:

• You can continue to borrow from a single line of credit during a period of time, so you do not have to apply for separate loans each time you want to draw on more funds.
• HELOCs are a good place to get low cost emergency funds from, as the interest rates are usually low, and you can borrow a large amount if need be.
• The cost to get funds from a HELOC is lower than other loans because it is secured against the value of your house.
• You can control exactly how much money you want to withdraw, so you can use what you need. Note that some HELOCs can sometimes have a minimum withdrawal amount.
• You can borrow a high amount of cash at one time.
• There is flexibility with how you use the money, which means it can go towards most expenses. 

The cons

• It is easy to keep drawing money and spending on things you don’t (or maybe do) need. As a result, you could build up a lot of interest, and when the repayment phase begins, you could be unprepared for the amount you have to pay each month.
• When you use your home as collateral, you shrink the value of your equity, so you own less of your home.
• If you default on the loan, you could lose your home.

Takeaways

HELOCs are a good source of cash for those who own equity in their home and want a low cost way to borrow money. You can withdraw the money and spend it how you want, and can even use it to potentially add value to your house in the process. Just be aware of how much you are borrowing, as a revolving line of credit makes it easy to borrow more than you can afford.