As a homeowner, you may find yourself wondering: what is a HELOC loan and how does it work?
If you’re planning to make a major home improvement or looking for a smart way to cover a large expense, you have several options for borrowing money. A HELOC may be a good fit for you.
As home values rise, more and more people are looking at the HELOC as a potential option for accessing credit. An estimated 10 million consumers will take out HELOCs between 2018 and 2022, more than double the rate seen in the previous five-year period. Here’s everything you need to know about HELOCs and how they work.
What is a HELOC?
HELOC stands for Home Equity Line of Credit or simply Home Equity Line.
HELOC loans allow you to borrow money against the equity you’ve built in your home. Your home’s equity is the difference between the value of your home and your mortgage balance.
Many homeowners opt for a HELOC because they are often given lower interest rates than other types of loans, such as a personal loan, which is unsecured.
With a HELOC, it’s critical to understand that in exchange for the lower rate, your home acts as collateral for the loan. This is also known as a “secured” loan. If you are unable to pay back the principal and interest on the HELOC, the lender has the right to pursue foreclosure proceedings—which means you could lose your home.
How does a HELOC work?
A HELOC works similarly to a credit card in the sense that you have the option to borrow money over time up to a set credit limit. It serves as a revolving loan, giving you access to a cash pool you can borrow from often, rather than borrowing a fixed amount in one instance. Then, you pay back the borrowed amount over time, plus interest.
If you have a credit card, you’re already familiar with the general concept: Credit cards are a widely used form of revolving debt. However, unlike a HELOC, your ability to borrow using a credit card does not terminate after a certain time period. With HELOCs, there is a defined draw period from which you can borrow. That will be outlined in your HELOC term. The average draw period is from 5 to 10 years.
Once your loan has closed, the lender will typically give you special checks or a specific debit or credit card. Many lenders have withdrawal requirements, such as a minimum withdrawal amount or an initial withdrawal maximum.
What is a HELOC loan used for?
Home improvements are the #1 reason homeowners take out HELOCs. You can use the funds to build your dream kitchen, remodel a bathroom, or make outdoor renovations.
Considering the value of your home increases as you make renovations, a HELOC may help you gain a positive return on investment in the long run if you plan to sell your home.
However, HELOCs are not limited to just real estate-related transactions. Although your home is used as collateral, you can use a HELOC to consolidate loans or finance a large expense like a wedding, vacation, or car.
However, keep in mind a relatively new law that states that the interest you pay on a HELOC is only tax-deductible if you use the funds to pay for a home improvement expense. It’s best to consult a tax advisor if you have any questions about the potential tax-deductibility of your HELOC.
HELOCs vs. Personal Loans
Many people are often stuck when deciding between a HELOC or a personal loan, which is another popular borrowing option. Both HELOCs and personal loans involve borrowing a set amount of money over time and then paying it back with interest.
The main difference is that HELOCs typically have variable interest rates, meaning the rate can change over time. Personal loans usually have fixed interest rates that are locked in from the beginning of your loan. Plus, personal loans do not require collateral, as HELOCs do with your home.
However, HELOCs typically have lower interest rates than personal loans since you’re using your home as collateral. Plus, using a HELOC toward home improvements will help you increase your home’s value as you renovate it, giving you a better bang for your buck if you go to sell later on. You can also gain tax benefits by using your HELOC toward home renovations.
It’s important to explore your options and talk to a lender about which loan is best for you. Your decision should be based on how quickly you need the cash, how you’d like to receive the money, and whether you’d like to use your home as collateral.
How much can you borrow in a HELOC?
One of the ways your credit limit is typically established is by taking a percentage of your home’s appraised value and subtracting the balance owed on an existing mortgage.
Lenders also consider your ability to repay the loan by looking at your credit history, income, and other debts and financial obligations, which typically means you need a debt-to-income ratio of 50% or better and a FICO score above 660.
For example, let’s say your home is worth $300,000 and you have a balance of $100,000 on your current mortgage. A lender typically allows you to access a maximum of 80% of the home’s value, less your current mortgage balance. Using that model, here’s an example of how much you could potentially borrow with a HELOC based on these values:
How much does a HELOC cost?
As with nearly all loans, you’ll pay interest on any amount you borrow. Because your home is “securing” the loan, interest rates for HELOCs are often lower than for unsecured loans. HELOCs generally have variable interest rates, which means they can go up or down over time according to a benchmark rate. Some loans also come with an interest rate cap (maximum) and floor (minimum), or a “hybrid” option which allows you to lock in a fixed interest rate for a certain period of time.
You’ll also likely have to pay other fees to take out a HELOC, so be sure to check with your lender. The Consumer Financial Protection Bureau has a helpful worksheet that can help you examine and compare the costs of a HELOC.
Depending on your financial situation, a HELOC could be a great option to meet your needs. As with all financial products, be sure that you understand all terms and conditions before taking out a HELOC.
Paying Back Your HELOC
Depending on the terms of the HELOC, there are usually two repayment options during the draw period:
Option 1: Pay only interest on the balance that you have borrowed. You can borrow funds up to the established limit.
Option 2: Pay back the amount you borrowed (the principal) as well as interest owed. As you pay off the principal, you can access more credit, just like with a credit card. Returning to our example above with a $140,000 credit limit: If you withdraw $10,000, your available credit is now $130,000. If you pay $5,000 toward the principal during the draw period, you would now have $135,000 in available credit. Note that you would be responsible for monthly payments of the accrued interest on the $10,000 that you withdrew according to the terms of the HELOC.
Once the draw period ends and you can no longer withdraw money, you enter the repayment period–which typically lasts about 10-20 years.
During the repayment period, you begin paying back both the amount you borrowed and interest. If you were making interest-only payments during the draw period, your monthly payment during the repayment phase is likely to be significantly larger.
Some HELOCs may offer the ability to have a fixed monthly payment during the repayment period. Under these programs, you may be required to make a sizable “balloon” payment at the end of the repayment period if the fixed monthly payment is not sufficient to repay the entire outstanding principal and interest.