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Home Equity Line of Credit (HELOC)
Learn everything you need to know about HELOC loans so you can make an informed decision about the right loan for you. HELOC is very much like a second mortgage— a revolving line of credit that is secured through a home as collateral and accesses the existing equity in it.
What is a Home Equity Line of Credit
What is a Home Equity Line of Credit?
A home equity line of credit aka HELOC is a loan in which the lender agrees to lend a borrower maximum amount, to be repaid within an agreed period or term. The collateral is the borrower's equity in their house.
Think of a HELOC loan as being similar to using a credit card. Here, your lender will decide upon a maximum loan amount and you can take out as much money as you need — until you reach the limit. And, you make monthly repayments to pay back your loan. But the good news is that the interest rate on a HELOC is far lower than it is on a credit card. You can borrow up to 85% of the value of your home minus the amount you owe.
Here’s the simple math:
Suppose you have a $600,000 home with $400,000 balance on your first mortgage and your lender gives you access to up to 85% of your home’s equity. Your HELOC limit will come out to be $110,000.
$600,000 x 85% = $510,000
$510,000 – $400,000 = $110,000
If you’re a responsible homeowner with equity available against your house, a home equity line of credit is best for you. It can provide you with secured financing options with lower interest rates. The flexible draw period gives you the ease of paying back the loan as and when you desire.
Draw period
Fixed time during which you can access funds from your home equity line of credit. It is typically for 10 years plus 1 month from the date you open the account. Your annual percentage rate (APR) during the draw period is variable and tied to the Prime Rate (PR). Unless you choose to take a fixed-rate advance. In which case, the payment is more predictable and stable.
End of draw
The date on which your draw period ends and you can no longer access funds from your home equity line of credit.
Repayment period
After your draw period ends, the repayment period begins. No additional funds can be borrowed and the balance must be paid off over the remaining term. You may keep the same payment structure as that of the draw period — principal-plus-interest payment, at variable rate.
What is the eligibility criteria for HELOC?
To qualify for a HELOC, you need to have available equity in your home. The amount you owe against your home must be less than the actual value of your home.A lender generally looks at a few aspects of a borrower before sanctioning HELOC:
Prerequisites for sanctioning HELOC
Age
18 or above
Credit History
Record of timely repayments in the past
Citizenship
Legal US resident
Employment History
A permanent job with a steady source of income
Bank Account
Verifiable account with a reputed bank
Monthly Debts
A low debt-to-income ratio of 43%, or possibly up to 50%
Credit Score
620 or higher (300-575:Poor, 580-669:fair, 670-739:good,740-799:very good, 800-850: exceptional)
How does HELOC work?
How does a HELOC work?
The borrower can draw any amount of funds up to the credit limit. Typically, the funds are accessed via a check, but sometimes the creditor issues a credit card to use in order to draw funds.
A borrower can apply for a HELOC loan in addition to an existing mortgage. This is convenient when they do not want to refinance or pay off an existing mortgage. If the term of HELOC is 15 years, the draw period will be the initial 10 years. During the draw period, monthly repayments are usually interest-only payments. These will depend upon the outstanding balance and current interest rate. The borrower can always pay more than the monthly interest to reduce the balance.
Word of caution: It can be tempting to have access to a large amount of money, but repaying the loan needs to be planned well. You don't want to find yourself in a soup by falling behind on your payments, right?
What are the key features of HELOC?
Variable interest rate
HELOC has variable rate loans that are tied to short-term interest rates such as the Prime Rate. The rate can change daily as short-term rates fluctuate, but can usually be set monthly. In some cases when borrowers have strong qualifications and good collateral, they can obtain rates below the PR.
Actual interest rate charged
The amount is typically PR plus a fixed margin of 1% or 2%. The actual rate depends on the terms of the HELOC, and the borrower’s qualifications.
Home equity line of credit term
A HELOC term can be from 10 to 30 years. As explained, the draw period will be less than the total term. During the draw period, the borrower can draw funds up to the credit limit as needed, and repay as desired.
Balloon payment
Which means that if the balance is not paid off by the end of the term, the borrower will have to pay an amount equal to the outstanding balance and interest due as final payment.
Amortization
Where by creditors may spread the payments over the remaining term -- after the draw period -- and require a monthly principal and interest payment. The monthly payments will be the amount needed to pay off the balance over the remaining period at the current interest rate, and the payment will adjust as interest rates change.
What are the pros and cons of home equity line of credit?
The pros
- Ease of financing home renovation projects.
- Provides a great return on your investment.
- Adds equity to your home.
- Provides many financial options to choose from in order to remodel your home.
- The borrower is only charged interest on the amount of funds being used, as opposed to the total credit limit.
- Flexibility in terms of accessing and repaying funds as and when needed to manage interest expense.
- Borrower needs to only pay for portion of funds used.
- Lower interest-only payments during draw period.
- Easier, faster approval process than conventional and government loans.
- Lower rates than other forms of credit.
- Low upfront closing costs and fees.
- Allows borrower to keep existing 1st mortgage.
- Interest may be tax deductible as per IRS. For a better clarification, do seek advice of a tax professional.
- No prepayment/repayment penalties.
- Readily available loans from multiple sources in the market.
The cons
- Unpredictable monthly payments due to variable interest rates.
- Requires mortgage insurance which increases monthly payment and loan balance.
- Extra paperwork with full loan application, borrower documentation, appraisal and renovation details.
- Obtaining funds may take up to 45 working days.
- Borrower needs to have all details ready including cost estimates, selection of contractors selected before closing.
- Cannot be used on properties currently under construction.
- A dicey proposition if you have an unstable income or cannot afford upfront costs such as transaction fees or annual lender fees for an open HELOC.
- If your home value falls, you may end up owing more than your home’s value.
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