Home Equity Line of Credit
If you have at least 20% equity and want to borrow money against your home's value, a home equity line of credit or HELOC can be an inexpensive and flexible option. A HELOC works much like a credit card with a limit based on your available equity. To qualify, you will likely need a minimum of 20% equity as well as good to excellent credit and a sufficient debt-to-income ratio.
How a HELOC Works
A HELOC is a revolving credit line from which you can borrow money and then pay all or some of the balance back to borrow again. HELOCs are a type of second mortgage and secured by your home as collateral. While similar to credit cards, HELOCs typically have variable interest rates. Your interest rate will likely be tied to the prime rate. When the prime rate goes up or down, your HELOC interest rate will also go down. The good news is HELOCs tend to have low interest rates as well as low or no closing costs. The interest you pay on your HELOC may even be tax deductible.
A home equity line of credit has two stages that are important to understand. The first period is known as the draw period and lasts for 5-10 years. During the draw period, you can borrow against your HELOC with interest-only minimum payments. While you can, you do not need to repay principal during the draw period.
The repayment period begins once the draw period is over. During the repayment period, your HELOC is like a standard loan in which you repay the principal and interest with monthly payments. The full balance must be repaid before the end of the term, which is usually 20 or 30 years after the start date of the HELOC.
Qualifying for a HELOC
While requirements vary by lender, qualifying for a home equity line of credit usually requires:
-- Loan-to-value ratio (LTV) or 80%. This means you have at least 20% equity. If your home is worth $300,000, you should owe less than $240,000, for example.
-- Sufficient income to cover your primary mortgage payment and HELOC payments.
-- Very good to excellent credit.
-- Low debt-to-income ratio (DTI).
HELOC vs Home Equity Loan
There are two primary ways to borrow against the equity in your home: a HELOC or a home equity loan. Both can be referred to as second mortgages as both are secured by your home just like your primary home loan. While both are popular options, they are very different in terms of how you access the money, how the loan is repaid, and the loan term.
A home equity loan works like a standard loan: you receive a one-time lump sum of money all at once and pay it back with fixed monthly payments and a fixed interest rate. A HELOC, by comparison, is more like a credit card: you get approved to borrow a certain amount for the life of the loan and withdraw money as you need it. As the principal is paid off, your credit revolves and becomes available.
A home equity loan is a good option if you have a fixed expense that is due fairly soon and you know how much you need to borrow. If you need money over a period of time, such as home renovations that will take years or college expenses, a line of credit can be the better option for greater flexibility. If you borrow fairly small amounts and pay back the principal quickly, a HELOC will also be more affordable than an equity loan.
Common Reasons to Choose a HELOC
Homeowners opt for HELOCs for many reasons:
-- Home renovations
-- Debt consolidation
-- College expenses
-- Buying a second home
-- Medical bills
-- Emergency access to money
You can use a HELOC for virtually any reason, but remember that a HELOC is a loan secured by your home. If you default on a home equity line of credit, you can lose your home. Make sure you understand the rate you will pay as well, especially if you are considering consolidating unsecured debt (like medical and credit card debt) into secured debt.
Pros and Cons of a Home Equity Line of Credit
There are many benefits of a HELOC compared to other options like a home equity loan. One of the greatest advantages of a HELOC is its flexibility. Rather than a lump sum loan, you can borrow exactly what you need as you need it, and make interest-only payments or pay down the principal quickly. This means you are only paying interest on what you borrow. The flexibility of a HELOC means you have access to a line of credit in an emergency or for ongoing expenses associated with home improvements, education, or anything else.
A HELOC is also one of the most affordable loan options available. While a HELOC has a variable interest rate, the interest is typically far lower than other loan options, including home equity loans. In addition to a low interest rate, there are potential tax benefits with a HELOC. Unlike most loans, the interest you pay may be tax deductible. A HELOC can also help you improve your credit score as you can get approved with less-than-stellar credit with sufficient equity and income.
Despite these benefits, there are drawbacks to consider. A HELOC is a secured loan which means you are putting up your home as collateral. If you default on the loan, you can lose your home. There is also a risk of racking up more debt because you have access to a high credit limit. Because a HELOC has a variable interest rate, there is uncertainty about the cost of your loan. If rates spike, your monthly loan payment may increase substantially and become unaffordable. There is also uncertainty with the loan program itself as changes in the value of your home or your credit score can cause your lender to reduce your credit line or freeze your HELOC, in which case the draw period ends and the repayment period begins.
If you want to access the equity in your home, a HELOC may be the best way to do it. A HELOC comes with a low interest rate, low closing costs, and the ultimate flexibility to fund your home improvement projects, vacation plans, or debt consolidation. Planning to take out a second mortgage? Contact Primacy Mortgage to speak with a knowledgeable loan officer who can help.