A home equity line of credit (HELOC) is a type of loan, which gives homeowners the opportunity to borrow money against the value of their house. As I said, it operates like a credit card in that you are provided with credit limits which you can tap whenever. It is an available amount of money as you gradually pay off the principal that such credit facility makes available for one’s use.
How a HELOC Works A HELOC works in a way that you are offering your home as security for the line of credit. If you already have a mortgage, the lender will assess the property to find out what it is worth in the market and how much of the property you have paid for if any. Usable equity refers to the amount between the mortgage balance owed and the fair market value of the property.
For instance, if your home is worth $300,000, but you have a mortgage balance of $180,000, then your home equity is $120,000 ($300,000 – $180,000). In most cases, the lender will allow you borrow up to 85% of the appraised value; therefore, you may be able to obtain a HELOC of up to $102,000.
HELOCs are initiated with a draw period, which can be up to 10 years where one can borrow money against the line of credit. When you borrow funds during the draw period, the only cost you incur is interest on the amount borrowed. At the end of the draw period, you might be required to repay the entire amount within 20 years.
Benefits of a HELOC Ease of use – As compared to the cash out mortgage refinance, you do not have to take the whole amount at once. You can draw what you need when you need it in so far as the materials are within your reach.
Revolving credit – The interest rates for the HELOC are usually lower than the credit card or personal loan interest rates.
Interest deductions – The borrower may be allowed to deduct the interest on a HELOC on their taxes in the event that the money is used to finance home improvements.
No home appraisal needed – A home appraisal is not needed once you open the HELOC to take further draws.
Uses for HELOC Funds Given that a HELOC secures your house, the purpose of acquiring the cash is to invest in projects that maintain or enhance your home’s value. Here are some examples of acceptable uses:Here are some examples of acceptable uses:
Residential Repairs and Improvements - Renovations, remodels, improvements, additions, and the like.
Debt consolidation – Pay off higher interest credit cards or loans, Debt consolidation requires that individuals take a single consolidated loan to pay off all other high interest credit cards or loans.
College tuition – Large expenditures for education for yourself or your dependents.
Out of pocket expenses - Large expenditures incurred towards serious health issues that were not fully reimbursable by insurance.
Emergency expenses – Large unexpected expenses that are incurred by the household.
Business ventures – Capital to start one’s own business or to expand the size of the business.
Down payment – Provide for a down payment on a second home or even on an investment property.
Some Factors to Consider Before Taking up a HELOC While a HELOC can provide easy access to funds in a pinch
there are some potential downsides to be aware of
Reduced credit limit – This is one major disadvantage of mortgage since if you use it to finance your home, your credit limit reduces as you pay your bill.
Adjustable rates – HELOC interest rates are generally adjusted based on a benchmark such as the prime rate.
Closing costs – There is always the cost of establishing the line of credit, which will involve the cost of appraisal as well as origination charges.
Trouble in repaying – It becomes very hard to repay in case the value of the house decreases or is lower than the amount borrowed.
Possibility of losing the home – In case you are unable to make the payments, the house can be repossessed by the lender.
If one wants to obtain a HELOC, how can they do so? To qualify for a home equity line of credit, you’ll generally need:To qualify for a home equity line of credit, you’ll generally need:
Credit score - Credit scores anywhere between mid 600s FICO are usually acceptable. Hence, it can be summarized that higher scores get better rates.
Home equity – Most of the HELOC lenders will expect the homeowner to have at least 15-20% equity in the home built for approval.
Housing costs - This refers to the cost of rent or mortgage which should not be more than a specified portion of the individual’s income, about 43%.
Fixed monthly cash flow – You have to be able to reasonably budget for a new HELOC payment by having fixed monthly cash inflows.
HELOC Requirements While specific HELOC criteria can vary slightly by lender, here are typical requirements:
Property Type – Single family residences, townhouses, units in PUDs, duplexes or triplexes are allowed by most lenders. Condos and manufactured homes may also be acceptable. As a rule, investment holdings are taken out.
Credit Score – The minimum scores vary between 620 to 680. More than 700 scores get the best rates.
Equity Level – It should be at least 15% in most cases. In general, the greater the equity you have, the more you are allowed to borrow.
New Loan-to-Value – Most programs restrict the mortgage amount in addition to the HELOC ratio to between 80-90% of the home’s appraised value.
Debt-to-Income Ratio – This ratio is the kind of debt that lenders consider in relation to income. In the case of DTI standards they are normally between 36 percent and 50 percent.
Credit Worthiness - When underwriting a HELOC, the lender must determine the current fair market value of your home.
Mortgage Position – The HELOC must be a second mortgage behind an existing first mortgage.
How Much Does a HELOC Cost? Typical HELOC costs include:
Interest rate – Most of them have a flexible rate based on Prime Rate or LIBOR that can go from 3% to 18% and beyond.
Origination fee – the one-time fee to establish the HELOC, ranging from $75 to $1,000+.
Marketing pack – Usually costs $200 to $400 to compile an information pack about the home for potential buyers.
Early termination fee – this is charges by some lenders in case you close the HELOC immediately after its opening.
Other fees for transfer tax, title, document, attorney, or recording fees.
Annual fee – Usually ranging between $50 to $100 per year to keep the line of credit open.
Daily interest – Interest is charged from the very day that funds are borrowed.
HELOC Tax Benefits Another advantage of a HELOC is the tax benefit on the interest that is paid on the money borrowed. To qualify for the tax deduction:To qualify for the tax deduction:
HELOC funds cannot be used for any purpose other than to finance home improvement. Debt consolidation or for other purposes do not fall under this category.
It is only allowed if married and filing jointly to be able to claim the deduction.
However, you can only deduct an interest on the first hundred thousand dollars that you borrowed. Amounts charged for loan origination also fall under the cap.
You cannot have the HELOC interest in addition to the mortgage loan interest. Whenever you have been in a position to deduct both, then you should select one or the other.
How to buy the Best HELOC Lender When shopping for HELOC lenders, key factors to compare include:
Interest rates and charges – Look at the annual percentage rate, the origination costs, and any annual fees.
Credit requirements - Analyze each lender’s credit policies and score requirements.
Loan amounts – Find out which lenders offer the highest LTV ratio so that you can get the most of your borrowing power.
Repayment details – Look at the length of the draw and repayment periods offered by different lenders.
Ease - Check whether the lender permits more than one draw and early repayment without additional charges.
Online access – Most lenders make it possible to prequalify and apply for a loan from the comfort of one’s home.
Customer service – This is very important since it involves the checking of reviews and complaints on the lender.
It is recommended to obtain HELOC rate quotes from 3-4 credit institutions to determine the most favorable conditions.
