What Is A Home Equity Line Of Credit (HELOC)?

You must be well aware that when you own a home, you get the benefit of home equity. You can borrow funds keeping this home equity as collateral. Home Equity Line Of Credit (HELOC) is like a second mortgage that you take on the balance of home equity that’s left after your first mortgage. People take a home equity line of credit for many different reasons like home renovations, getting a new car, or funding a child’s education.

Both home equity loans and home equity lines of credit use the equity of your home as security but there are differences between these two. A HELOC is different from a conventional loan in terms of interest rates, repayments, closing costs, etc. If used smartly, a HELOC can also be used to claim tax deductions. From the benefits of a HELOC to qualifying for it, we’ve covered everything in this article for you!

Understanding Home Equity Loans

To understand what a HELOC is, you must first understand the concept of a home equity loan. It’s a lump sum amount you get against your home equity, that is the amount between your home’s value and the remaining mortgage balance.

Home equity loans are good for those who need money for a large one-time expense. Such loans have fixed interest rates so you know exactly how much you have to pay every month. When you go for a home equity loan, there are many closing costs to bear like loan processing fees, appraisal fees, recording fees, etc.

There’s also something called points that you’ve to pay at the closing time. Every point is 1% of your loan value, say you’re borrowing a loan of $50,000, one point will be $500 which you’ll have to pay with all other closing costs. These points are actually good for you since they lower your interest rate in the long run. But if you’re planning to pay off your loan earlier, you can negotiate with your lender for fewer points!

People who choose to get home equity loans usually know how much they need and often need it for a high one-time expense, like renovating the house. But what if you have the requirement of a smaller sum? Or what if you have requirements for a combination of expenses over a longer time period? What do you turn to when you need a small infusion of cash? HELOC is the answer!

How Home Equity Line Of Credit (HELOC) Works

A HELOC is where you borrow small amounts of money over a draw period. This is borrowed against the available equity of your home by keeping it as collateral. Unlike a home equity loan, you can borrow small amounts whenever you want or whenever the need for an emergency arises.

To understand this better, let us elaborate on the phases of a home equity line of credit. There’s the draw period and then there’s a repayment period. In the draw period, which is usually 10 years, you withdraw funds as and when you require and pay for only the interest. When the repayment period begins, which usually goes on for 20 years, you start repaying the principal and the interest.

You have an option to withdraw how much money you require, or none at all if your bank hasn’t set a minimum withdrawal limit. So now you don’t have to repay the principal or interest for the money you never borrowed. This means you will be covered for those 10 years in case emergency expenses arise! If you borrow only $30,000 in those 10 years, pay the principal and interest only for that amount in the repayment period.

You can look at this as a credit card that you can use whenever you need funds. You can access those funds through a number of funds, like through online transfers, writing checks, or using a credit card. During the draw period, your payments go only towards the interest, but you can opt to pay towards the principal. This helps since an increased installment amount during the repayment period won’t look like a burden. One thing to remember is that unlike the fixed interest rates in home equity loans, the interest rates in home equity lines of credit are variable.

Difference Between Home Equity Loans and HELOCs

If you’re confused about whether to go for a home equity loan or a HELOC, we’ve put together a comparison so you know exactly what you’re in for!

  Home Equity Loan Home Equity Line Of Credit
Ideal
for
A one-time lumpsum
need of money where you know the defined amount you need.
A situation where you need different amounts of multiple funds over a period of time.
DisbursementOne lump sum amount.A pre-approved amount with a minimum draw limit specified at closing.
Interest ratesFixed interest rates. Interest rates are higher than rates for HELOCs.Varying or adjustable interest rates according to banks; the banks may also offer a fixed rate for some time. Interest rates are lower than rates for home equity loans.
RepaymentFixed monthly payments.Payments towards interest during the draw period and full monthly payments in the repayment period.
Closing costsCosts 2-5% of the loan amount, usually costs same as the closing costs of the first mortgage.Usually not applicable. When it does, they’re smaller than the closing costs for conventional loans or one-time loans.
PointsPoints payable to lenders, beneficial since they lower interest rates. No points payable.

Benefits Of Home Equity Line Of Credit

You need a good credit score and a provable income if you want to qualify for a HELOC, but once you do, there are many benefits!

Low HELOC Rates

You can take advantage of the low-interest rates. It’s great for debt consolidation since you’ll have lower initial rates than credit cards. Some of the best HELOCs come with rates as low as 5 percent!

Tax Deductions

The interest you pay towards a HELOC or home equity loan is tax-deductible if you use that money towards home improvement projects. By using that money to improve your home, you automatically increase the value of your home and thus add to its equity.

Flexible Withdrawals

Unlike home equity loans or other one-time loans, with HELOC, you borrow only how much you require and when the need arises. This way you end up paying principal and interest amounts only for the amount you borrowed. In conventional loans, you need to pay for the lumpsum amount, irrespective of whether you actually used all those funds or not.

Option For Principal Payment

Ideally, you pay only towards the interest during your draw period, but HELOC is pretty flexible and you can pay towards principal too. This reduces your liability towards the principal as you enter the repayment phase.

Fewer Restrictions On Use Of Funds

There’s no compulsion to use your HELOC towards home improvements alone. It’s secured by your home equity but doesn’t force you to put your funds only for the home. You can use it for debt consolidation, travel, education, or any other emergency expenses when savings run out.

Maintains A Credit Score

Qualifying for a HELOC and regularly paying your monthly payments will reflect a good credit history. This goes a long way in maintaining and showing a good credit score.

Applying For A Home Equity Line Of Credit (HELOC)

After knowing all those benefits, you sure wish you qualify for HELOC. A basic mark to qualify is to have available home equity, which means the amount you owe at the moment on your home must be lesser than the value of your home. Usually, you can borrow up to 80% of the value of your home minus the amount you already owe.

For example, if your home values $100,000, and you already owe $50,000 on your first mortgage, then you can qualify to borrow $30,000 in the form of a HELOC.

($100,000 x 0.80 = $80,000 – $50,000 = $30,000)

Your employment history, income, and credit score are then checked. After this, it’s determined what your rate will be, the better your credit score, the lower your rate because the chances of you defaulting on your payments will be less.

You can apply for a HELOC just as you would for a second mortgage. It’s better you study multiple lenders and research your options. There will be an appraisal conducted on your home, your employment history and income will be studied. It’s better you check your credit reports from time to time so you won’t be in for a shock. Once everything is in place, you’ll get a call from your lender!

Once you get all the documents, read everything and go through all terms before you sign. There’s a mandatory three-day cancellation rule, whether you’re going for a home equity loan or a HELOC. If you do change your mind during this three-day window, you should notify the lender in writing by mailing them. But remember to do it before midnight on the third day!

Also See: How to get Mortgage when you are Self-Employed

Issues With Paying Back Your Loan

When you start facing issues with keeping up with the payments, you should let your lender know as soon as possible. If you keep ignoring the problem, you risk losing your home if you don’t repay your loan. Most lenders don’t want you to default on your payments and thus try to contact you with solutions.

You can go with modifications like adjustment to interest rates, terms or monthly payments to make repayment easier. People often end up extending the period of their repayment as it reduces their monthly payments and thus reduces their monthly liabilities. But remember that in this cycle, you’ll end up paying more!

See Also: How to Pay-off Mortgage Faster

Risks Associated With Home Equity Line Of Credit (HELOC)

Like all good things, HELOC too has its other side. However sugar-coated it might look to you, it does have its cons. You’re using your home equity as collateral, so if markets collapse and home values go down, you end up in more debt than what your home equity can now cover. You also risk overspending during the draw period, you’ll realize this during the repayment period when the monthly installments shoot up and you end up regretting the unnecessary expense you made.

Conclusion

Before you apply for a HELOC, study your financial habits and only then go for a loan. Try to not get attracted to HELOCs just because the interest rates seem low at the moment as it comes with variable interest rates. You should remind yourself that you place your home at risk and thus must use HELOC towards expenses you cannot escape. Don’t spend on an overseas vacation or an expensive sports car, think if all that is worth putting your home equity on the line or not!

FAQs On Home Equity Line Of Credit (HELOC)

Is There A Difference Between Home Equity Loan And Home Equity Line Of Credit?

Yes, there is. Home equity loan lends you a lump sum one-time amount for a fixed dedicated expense at a fixed interest rate. A home equity line of credit is a revolving line of credit that is lent to you over a period of years at variable interest rates.

How To Qualify For A Home Equity Line Of Credit?

You should have good employment history and a source of income. The lender will conduct an appraisal of your home and study your income, employment history, and your credit score to check if you qualify for a home equity line of credit.

What If I Fail To Repay My Home Equity Line Of Credit?

If you fail to keep up with your repayments, you’ll be given options to modify your loan like extending the repayment period or modifying the terms of the loan. In worst cases, you face severe financial consequences or risk foreclosure.

Can I Claim Tax Deductions On Home Equity Line Of Credit?

Yes! You can claim tax deductions on the interest you pay for your home equity line of credit. But this is applicable only if you use your HELOC towards making substantial improvements to your property through home renovations or additions.

Written by


Rostislav Shetman is the founder of 9Kilo Moving. He has been in the moving and relocation industry for more than 25 years, making him an expert in his field. Rostislav started as a helper, dispatcher and driver and has worked his way up to owning his own company. He takes great pride in his work and enjoys helping people relocate across the United States of America. When he's not working, Rostislav enjoys spending time with his family and friends. They are the light of his life and bring him happiness every day.