Home equity can be a major benefit of buying a home. You can find many amazing places to rent, but if you’re the tenant and not the owner, then you won’t benefit when the property value goes up.
The difference between your current home value and the amount of your mortgage loan is called equity. The equity in your home can be cash in your pocket with a home equity line of credit (HELOC).
What is a HELOC? Check out this guide to understanding when and how to use a home equity line of credit.
What is a HELOC?
When the value of your home goes up this is called appreciation. When you make monthly mortgage payments, that simultaneously reduces the amount you owe the bank. Appreciating home values give homeowners access to loan products beyond their current mortgage.
One of the more common loan products is a home equity line of credit or HELOC. Lenders are willing to offer you money with the understanding that you have an asset you can sell in case you can’t repay your loan.
For example, if you lose your job, selling a home with equity should get you enough money to pay off your mortgage and any lenders who allow you to borrow against the equity.
Equity loans are a type of secured credit making them less of a risk for lenders. Secured loans are far easier to get than unsecured loans for people with average financial history.
The Cost of Equity Loans
The decision to pursue an equity loan like a HELOC is a major one. It’s probably a bigger deal in some markets than other because of fluctuating home values.
Having your house on the line as collateral for debt means you’re opening the door for potential liens. Let’s say the housing prices in your market drops and you need to sell right away.
You’ll be on the hook for the entire balance of your mortgage, plus the additional loan even if the equity is no longer in the home. This means the lender can put a lien on your home.
Liens give lenders rights to your home which makes it harder to sell. You’ll be forced to repay debt faster or risk a standstill with the lender.
The HELOC Process
Just because secured loans are easier to get doesn’t mean there’s no vetting process. You’ll still need a solid financial history in order to qualify.
The amount you qualify for and terms are what determine the fees you pay. For example, with amazing credit and a steady income, the cost to borrow money is cheaper.
Low-interest rates mean you’ll pay lower payments than someone with an average credit score. Prepare for the application process as you would a first mortgage loan.
Overall, the underwriting is usually less intense than when you first applied for a home loan but can be just as long. The good part about the process is that you aren’t waiting on pins and needles for approval as you did with your first mortgage.
You’re already in your home so you can rest easy waiting for the approval process to be completed.
How to Get Approved for a HELOC
Build your credit score while shopping around for a HELOC with good rates. The underwriting team with your lender will want to see an accurate appraisal and good credit history.
Don’t expect a loan of 100 percent of the equity in your home. Most banks cap their loan to value ratio so they’re not a risk.
Overestimating the value of a home is a lose-lose for everyone involved because fluctuating markets happen unexpectedly.
Lenders typically offer no more than 80 percent of the estimated equity in a home in the form of a HELOC.
This percentage isn’t universal so be sure to ask your lender for its combined loan to value ratio (CLTV).
Unlike a conventional loan, HELOCs are a revolving source of cash.
They operate similarly to a credit card since you can spend money, repay it, and have access to the full amount again.
This is a major perk for homeowners needing an ongoing source of cash. There are a variety of ways a HELOC can be accessed.
Some banks provide an online transfer option while others allow you to write checks from the line of credit. The money belongs to the bank so it’ll remain in a protected account until you need to make withdrawals.
Repayment schedules are generally monthly unless you work out an alternate deal with your bank. There are little closing costs when it comes to a HELOC. Some lenders don’t charge fees at all.
A major downside of HELOCs is variable interest rates. With variable interest rates, you don’t know exactly what your payment amount will be each month.
These fluctuating payments can quickly become a financial burden if you’re carrying a high balance. A select number of lenders offer fixed rates but these are less common.
Should I Get a HELOC?
There are pros and cons to opening a HELOC. One pro is that your access to funds remains flexible.
You won’t have to worry that once you spend the money you can never get access to funds again. Next, the funds you don’t use won’t accrue interest.
This means you’re only paying interest on the money you use.
If you get a HELOC for $20,000 but only use $5,000 of the available balance, you pay interest only on the $5,000.
HELOCs are a great source of emergency funds if you ever need it. Keep in mind that some banks might complicate the situation by requiring that you make a minimum withdrawal.
If you’re not HELOC savvy, it’s best to avoid these types of HELOCs.
Can I Afford a HELOC?
An important thing to consider when exploring ‘what is a HELOC’ is whether it’s affordable. You’ll be issued a draw period for the line of credit once it’s approved. The draw period is usually around 10 years.
The draw period is the amount of time you have access to the line of credit. You’ll only make interest-only payments during this time. An interest-only payment is a payment made to cover the interest that accrues on the loan.
Interest-only payments don’t reduce the overall balance of what you owe which is called the principal.
You can pay a little extra towards the principal balance you owe, but won’t owe the entire balance until the end of the draw period. This is tricky if you don’t have self control financially.
It can mean having access to a large lump sum of money on which you don’t owe much initially. Because you’re making payments only toward the interest, you may have a false sense of confidence about how much you can afford.
For example, with a credit score of 780 or above, you’ll have no problem qualifying for today’s lowest interest rate of 2.8 percent. Your payments on a $50,000 line of credit would be around $116 per month during your draw period.
Once the draw period ends, your payments jump to $478 per month because the payment now includes payments toward both the interest and principal balance.
But you’ll get an extended 20 year repayment period for the entire balance you owe after the draw period is over. At this time, the principal and interest are due making your payments larger than the interest-only period. Once the draw period is over, you can’t withdraw any more of the available funds.
Do you have any other questions about what a HELOC is? If so, ask them in comments below and let’s discuss.