What Is A Home Equity Line Of Credit?
When someone needs to borrow money to cover a large purchase or unexpected expense, they usually apply for a credit card or a personal loan. But homeowners have the option to apply for a home equity line of credit (HELOC).
By taking out a second mortgage, homeowners borrow a certain amount of money based on their home’s value. Like a credit card, homeowners pay back these borrowed funds either upfront or in monthly installments.
HELOC means that banks lend money against the equity of the homeowner’s property. Equity is what the homeowner still owes on their primary mortgage subtracted from the value of the home. In cases of those who pay their home off completely, the HELOC becomes the primary mortgage instead of the secondary one.
Whether or not the HELOC is the primary or secondary mortgage, failing to repay the loan will result in foreclosure.
How Does A HELOC Work?
As mentioned previously, HELOCs are similar to credit cards. A HELOC is a versatile option that lets homeowners borrow against their home’s equity, pay it back, and do it again. This type of loan is more versatile, thanks to adjustable interest rates. So when the baseline interest rate rises or falls, the HELOC interest rate will change with it.
When lenders establish the interest rate, they take the index rate and add a certain percentage on top of it (the margin) based on your creditworthiness. The better your credit score, the smaller the margin. Homeowners should always request the margin before they agree to a HELOC.
Since variable rates may cause higher interest rates, homeowners should estimate how high their monthly payments could potentially get. To do this, assess how much interest rates can fluctuate in a given period (the periodic cap) and the most interest they could pay during the loan term (the lifetime cap).
The silver lining is that, like a credit card, homeowners are only subject to interest on what they spend, not the entire amount of the loan.
How To Qualify For A HELOC
Each lender will have different guidelines, but generally, homeowners need:
- A debt-to-income ratio at or below 40%
- A credit score at or above 620
- A home value that’s a minimum of 15% more than owed
How To Get A HELOC
Homeowners will find that applying for a HELOC works similarly to buying a home or refinancing a mortgage. The lender will request much of the same information to determine creditworthiness.
Here is how homeowners can get a HELOC:
- Use a HELOC calculator to find out if they have enough equity
- Shop and compare HELOC lenders
- Have the required information and files ready beforehand to make the process easier
- Start the application
- After applying, the lender will send disclosure documents. Homeowners should read them thoroughly and write down questions for the lender. Homeowners should ensure the HELOC is right for them
- The length of the underwriting process varies from as little as a few hours to several weeks. Homeowners may need to hire an appraiser to verify their home’s value
- Finally, homeowners can close the loan and access the funds once they complete the last of the paperwork
How Much Can Homeowners Borrow With A HELOC?
The amount of the HELOC depends on a few things:
- The value of the home
- The rate of that value that the lender lets homeowners borrow against
- The amount homeowners still owe on their primary mortgage
These two equations can help homeowners estimate how much they can get from a HELOC:
- The value of the home X Percentage of value lender allows to borrow = Maximum amount of borrowable equity
- The maximum amount of borrowable equity — remaining balance on the mortgage = total amount available to borrow
How To Repay A HELOC
A HELOC consists of the draw and repayment periods. In the draw period, homeowners can access the borrowed funds through checks, transfers, or credit cards connected to their account. Homeowners pay interest on the monthly minimum payment, but they have the option to pay the principal. The draw period is typically a decade, though it can differ.
On the other hand, homeowners lose access to this line of credit during the repayment period. During this time, they begin the process of repaying the borrowed funds with principal and interest. The principal of the loan can cause monthly payments to increase significantly. For many homeowners, the repayment period lasts 20 years, though it can vary, too.
When the loan ends, homeowners may owe the lender a large amount of money (a balloon payment) that accounts for the principal they didn’t pay during the term. Before homeowners sign a HELOC, they should request a term extension or the chance to refinance so they can repay this amount if they can’t afford it.
- Lewis, Holden. “HELOC: Understanding Home Equity Lines of Credit.” NerdWallet, 14 July 2020, www.nerdwallet.com/article/mortgages/heloc-home-equity-line-of-credit.