A HELOC is an example of a loan where the homeowner is allowed to borrow money against the value of his or her home. It is extremely similar to the usage of a credit card since you are always able to use up to a certain limit of credit available to you. However, a HELOC is different from a credit card in the sense that your home acts as collateral for the borrowed money.
How a HELOC Works
A home equity line of credit has two phases: the draw period and the repayment period. The line of credit is available for use for a period the draw period which ranges from 10 years when you can borrow up to the amount of credit line. It is appropriate for you to pay back only the interest on the amount that you have borrowed. This functions in a similar manner as a credit card with a maximum limit of credit which after being reached is reactivated upon payment of some of the items purchased. When you take a loan of $10,000 and repay it in full, then the $10,000 is back in your disposal.
The long duration of the draw period allows you freedom on how to manage the loan. For instance, you may sign for a $50,000 HELOC but only use $10,000 to renovate a kitchen. One year later, when you damage your patio and require a replacement, you can access the HELOC without having to apply for a new loan.
This is followed by the repayment phase once the draw period is over. In this stage, you cannot borrow any amount from your line of credit. You are then required to start paying back the principal amount plus interest fees on your balance until its repayment period, which ranges between 10-20 years.
HELOC Credit Limit and Loan Terms
A HELOC is a revolving credit line that depends on the amount of home equity you have established in your home. It is often within the range of 75-90% of loan-to-value ratio or LTV. The LTV examines the ratio of how much one owes on his or her mortgage to the present value of the home.
For example:
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It means that out of the $300,000 that you borrowed, you have to pay $200,000 to get rid of the mortgage and you have $100,000 left to pay.
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The current value of your home is $250,000.
- Your LTV is 40 ($100,000 divided by $250,000)
If you opt for an 85 LTV HELOC, you may be eligible for a line of credit of up to $140,000 against a home valued at $250,000.
Terms such as interest rates, the draw period, and the repayment period may differ depending on the lender. HELOCs usually come with a flexible interest rate because they are usually indexed against a financial rate such as the prime rate. This means your rate can change along the length of the loan period, which is not favorable for some borrowers.
How to Get Approved for HELOC
The process of getting approved for a home equity line of credit is similar to the approval process for a first mortgage. The lender will review:
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Your credit score and history: Many expect their minimum FICO score to be 620.
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Your debt-to-income ratio: Compares your current liabilities to your gross monthly income.
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Your loan-to-value ratio: Compares your mortgage debt to home value
- Your equity in the home: You should have at least 15-20% equity.
The lender will also have to value your home to establish the current market price so as to ensure that there is adequate collateral to support the line of credit.
Unlike first mortgages, the interest rate on the second mortgage known as home equity line of credit (HELOC) is adjusted periodically to reflect the overall average interest rates. It means that repayment instalments you will be required to pay every month might vary over the lifetime of the loan.
Disadvantages and Flaws of HELOCs
While a HELOC can provide easy access to cash for home repairs or consolidating higher interest debts, there are some downsides to consider:While a HELOC can provide easy access to cash for home repairs or consolidating higher interest debts, there are some downsides to consider:
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Your home is vulnerable in the event that you fail to meet your obligations. Since you are using your home equity as collateral, it means that you stand to lose your home in case of default.
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The rates and payments for those services can also vary over a certain period. Variable rate lines expose you to the risk of rising interest rates.
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While it is relatively cheap to make some closing costs can be very expensive. You could be charged up-front fees between 2% and 5% of your line of credit.
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Debt control calls for discipline. This is why it is important not to be reckless and borrow through HELOCs with the mentality that it is free money.
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This line may freeze during drops in home values. If your home equity shrinks considerably, the lender can freeze it.
- Tax deductions are limited. Interest on home equity is deductible only to the extent of $100,000 of the borrowed amount per year.
There is a principle that goes with utilizing your home’s equity for the purpose of financing. However, HELOCs can serve as a cheap source of financing your equity than using other loans with higher interest rates. Restraining yourself as far as borrowings are concerned and timely payment also help in ensuring that the credit is always open for you.
