Perhaps one of the most noticeable benefits of owning a home is that your residential property helps accrue equity gradually. You can make the most of that equity by obtaining a second mortgage on your property such as a home equity line of credit – also commonly known as a HELOC. In this article, we’ll be focusing exclusively on the fundamentals of a home equity line of credit (HELOC).
A HELOC is one type of revolving credit account, and functions very similarly, in some respects, to credit cards – where funds are accessible on a recurring basis, up to your credit limit. Homeowners usually take out a HELOC to pay for a home renovation or to pay off or consolidate other loans.
HELOC: How Does This Line of Credit Work?
A HELOC, unlike a conventional mortgage loan which provides you funds in a lump sum, offers you funds on a recurring or on-going basis. So, the convenience of HELOC by and large is that it functions almost like a credit card, letting you access funds as and when you need them. Most banks and financial lending institutions give you the ability to access HELOC funds via an online or mobile banking service, a traditional check, or through a wire transfer.
HELOC vs Home Equity Loan vs Credit Cards
HELOCs, in contrast to a home equity loan or mortgage, usually come with a variable rate of interest, and generally have no or low closing costs at the time that you open the credit line. Just like credit cards, HELOCs have a credit ceiling or limit which means that you cannot spend beyond the approved upper limit. A HELOC, similar to a credit card, renews your available credit each time you make payment against the outstanding amount on your line of credit. A HELOC differs from a credit card, however, in that the former allows you to borrow or rather seek a second mortgage against your home’s equity. In this way, a HELOC is secured or collateralized by the equity in your home, whereas credit cards are typically unsecured lines of credit.
Benefits & Drawbacks of a HELOC
Before applying for a HELOC carefully consider the benefits and drawbacks that are associated with this line of credit category.
One benefit of HELOCs is that they can serve as an excellent source of emergency funds, enabling you to borrow against the equity in your home whenever you wish. In times of financial stress, a HELOC can provide that safety net that so many of us need from time to time. Particularly in recent times, where so many Americans have been furloughed or laid off, being able to use your HELOC as a source of emergency funds can be extremely helpful!
Conversely, a drawback to HELOCs is that the equity you’ve amassed in your home over time may be drastically reduced when you borrow funds with a HELOC, depending on the amount borrowed and the current equity in your home. Be aware that, because the home itself serves as collateral for a HELOC, the failure to repay a HELOC can have serious consequences, including foreclosure and loss of the property.
How to Qualify for a HELOC?
The most basic requirement to get a HELOC? You have to be a homeowner with adequate equity in your home. Most people only qualify for a HELOC if their home’s market value is higher than the amount they have borrowed or mortgaged on the property. Generally, banks and lending institutions won’t let you borrow more than 80% of the total value of your home.
Home’s Valuation & Your Financial Track Record
To put things in perspective, you’ll typically qualify for borrowing up to 80% of your home’s current value. If the amount you owe on your primary mortgage is 70% of the total value of your home, then you would be able to take out a HELOC for that 10% difference. For example, if your home’s value is $300,000, and you currently owe $210,000 (70%), then you can take out a HELOC for $30,000, as this would bring you up to owing $240,000 (80% of the home’s total value).
In addition to home valuation, your bank or lending institution will also ask for standard home loan underwriting documentation showing your monthly income along with debts, employment history, and credit score.
A typical home equity line of credit normally has two phases – a “draw period” and “repayment period”. The draw period typically lasts for 5-10 years, during which you can keep borrowing money up to your approved limit, repaying the amount, and then borrowing and repaying repeatedly as you wish. Once the draw period expires, you’re not allowed to take out funds anymore. This is called the “repayment period”.
In terms of calculating interest, the majority of banks and lending institutions charge a variable rate of interest for a HELOC, while some lenders may have a fixed interest rate for a specified number of years. The rate of interest is based on many factors, and will often vary from one lender to the other. It is advisable to do your research on-line to check the current interest rate for a HELOC at sites like Bankrate.com or Investopedia.com.
Your credit score also has a very significant impact on the interest rate you’re likely to pay. You should work towards improving your credit score as much as you can in order to qualify for a lower rate of interest on your HELOC.
A HELOC may be the right choice for you, depending on your need for funds, especially how much you need, how much equity you have in your home, along with several other factors.
We hope this article has been of some use to you as you consider your borrowing options!
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