HELOC: Home Equity Line Of Credit in Home Loans

Understanding a Home Equity Line of Credit (HELOC)

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A Home Equity Line of Credit, also known as a HELOC, allows you to use the value you’ve built up in your home in order to secure a revolving line of credit. Individuals and families often use a HELOC to pay for serious expenses (like healthcare or college tuition) or to consolidate high-interest loans (like credit card debt). In addition, some people use HELOCs to pay for things like landscaping and new roofs, which may be able to increase your home's curb appeal. 

How much money can you get from a home equity line of credit?

Usually, you can get a loan worth about 85% of the equity in your home. That means about 85% of your home’s current value -- minus what you still owe on your mortgage. If you have less-than-stellar credit, you may not be able to get the full 85%. 

So, if you have a home valued at $300,000, with $150,000 remaining to pay on your mortgage, you have $150,000 in home equity ($300,000- $150,000). Assuming you’re allowed to get a HELOC for the full 85% of your home equity, you would be able to get a loan of $127,500 ($150,000 * 0.85).

How is the interest rate for a HELOC calculated?

First off, it’s important to realize that most HELOCs have variable, instead of fixed, interest rates. Usually, your lender will base this variable rate off of an index rate-- a rate that is tied to a specific benchmark. Common index rates include the prime rate, the rate at which American banks lend to their most creditworthy clients, and the LIBOR rate, the rate at which banks lend money to each other for short-term loans on London’s money markets. Banks will base your rate on one of these index rates, and then add an upcharge based on your specific creditworthiness.

Knowing that, it’s important to keep in mind that with a HELOC, your monthly payments could rise (or, better yet, fall) with the fluctuations of these index rates. HELOCs nearly always have a cap, or a limit, on how much and how fast your interest rate can increase. Thought it might never come to that, it’s important you make sure that you can still afford the maximum rate that your HELOC might reach -- otherwise, you could get in big trouble.

While there are HELOCs with fixed-rate options, these only allow you to lock in a small portion of your home equity, and you’re usually required to use it for home repair purposes.  

What’s the difference between a HELOC and a home equity loan?

A HELOC is designed for maximum flexibility, and, as a revolving line of credit, you can tap it at any time -- or not at all. Unlike a HELOC, a home equity loan can give you a large, lump-sum of cash. Also, unlike HELOCs, home equity loans also usually have fixed interest rates.

What happens if I can’t repay my HELOC?

In a worst-case scenario, if you don’t repay your HELOC, a lender could legally force you to sell your home.

Can you refinance a HELOC? 

Yes. Unlike some other kinds of loans (like conventional mortgages), HELOCs have two stages. Stage 1 is called the draw period; during this period, a borrower only pays interest on the loan. This period can often last between 10 and 20 years and is the only period in which a borrower can withdraw funds from the HELOC. During stage 2, called the amortization period, borrowers pay both the principal and the interest on the HELOC. Due to this, your payments can rise abruptly -- often by 100% or more, and that can be a shock if you’re not expecting it.

So, in order to reduce the sudden increase in payment, many borrowers decide to refinance their HELOC. There are several ways to do this. First, you can do a straightforward refinance of your HELOC, which puts you back into the drawing period -- but doesn’t change the fact that you’ll still have to pay off the principal someday.

If that’s not ideal for you, another solution is to get a home equity loan to pay off the HELOC. In other situations, you may want to refinance both the HELOC and your original mortgage into an entirely new mortgage loan.

What is a balloon payment on a HELOC loan?

Before you sign a HELOC loan agreement, determine whether you’ll be paying all of your principal off during the amortization (second) period. Some HELOCs may charge you a large lump sum due at the end of the entire loan -- and often, borrowers aren’t ready to pay it -- so they actually end up refinancing the entire HELOC in order to put off paying the balloon payment.

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