Homeowners can use their home equity line of credit (HELOC) as a source of cash to help them pay for important purchases.
HELOCs are similar to other loan products that tap into your home equity but work more like a credit card in that you only use what you need.
Keep reading to find out the requirements for a home equity line of credit, the pros and cons of a HELOC, and whether it might be the right financial tool for your situation.
What is a home equity line of credit (HELOC)?
A HELOC is a home loan that allows you to borrow money from the equity you’ve built up in your home.
HELOCs operate in much the same way as a credit card, allowing you to use cash or credit when you need it and pay interest on only the money you actually use.
They typically have low-interest rates, and many homeowners find them an excellent way to finance home improvements, consolidate debt, or pay for education, medical expenses, or other big-ticket purchases.
You can spend as much as you want up to the credit limit. And you’ll only pay interest on what you spend—not the entire amount. But unlike a credit card, your mortgage lender sets the credit limit for your HELOC, not your bank.
Borrowing against your home equity
Equity is how much of your home you own; it’s the difference between your home’s assessed value and the principal amount still outstanding on your mortgage. A HELOC allows you to borrow against that equity.
Most lenders allow homeowners to apply for up to 80% of the equity value. So, if your home equity is $100,000, you could apply for a HELOC of up to $80,000.
Your home’s equity can increase over time as you repay your mortgage or if your home’s value increases.
Your home as collateral
Collateral means offering something of value as security for a loan.
To be approved for a HELOC, the collateral—your home—must have an assessed value greater than the amount you want to borrow.
With a HELOC, your home becomes the guarantee for the money you want to borrow.
If you don’t repay the line of credit, your lender is legally entitled to claim your collateral and can foreclose on your home.
HELOCs work like revolving credit
Revolving credit is the term for credit you can continue to use so long as your account is in good standing.
Home equity loans give borrowers a one-time, lump sum payment. In contrast, a HELOC allows homeowners to spend from the line of credit again after repaying what they owe. This can be done for the duration of the line of credit.
Let’s look at an example of how you might use the funds from a HELOC to pay for upgrades to your home.
How to use a HELOC for home improvements
If you take out an $80,000 line of credit and spend $50,000 on home renovations, you would still have $30,000 available credit remaining in your HELOC.
However, once you repay the $50,000, you will once again have the entire $80,000 available to spend on more renovations.
Home equity loan vs line of credit
With a home equity loan, borrowers receive money once and must begin paying interest on the entire amount right away.
With a line of credit, homeowners have a potentially ongoing source of credit for the draw period and only begin to repay the principal after the HELOC closes.
An easy way to remember which is which—A HELOC works like a credit card and a home equity loan is more similar to a mortgage.
Unlike a credit card, HELOCs have a timeframe
A credit card doesn’t really have a fixed end date. So long as you keep your account in good standing, most credit card companies automatically renew accounts when the expiration date approaches.
Unlike credit cards, however, a home equity line of credit has a set end date. You can only spend the funds in your HELOC while it’s “open,” i.e., before the end date.
What is the home equity line of credit (HELOC) draw period?
It’s the set timeframe for accessing your credit and withdrawing money up to the credit limit.
While the length of your draw period can vary by lender, most mortgage lenders allow borrowers to have access to the funds somewhere between five and ten years.
During this time, you’ll be able to withdraw money from your HELOC, most often using a special debit or credit card.
What happens when the HELOC draw period ends?
During the draw period, you’re only required to pay interest on the borrowed money (referred to as interest-only payments).
When your HELOC closes and the draw period ends, you’ll begin repaying any outstanding balance plus interest, much like you did with your initial mortgage.
Try a home equity line of credit calculator to get an idea of your monthly payments. It works just like a home equity loan calculator or mortgage calculator.
Simply input basic information, such as how much you want to borrow and the interest rate you would like. The calculator does the rest. You can try different combinations of amounts and home equity line of credit interest rates to see what works best for you.
Home equity line of credit pros and cons
Home equity lines of credit can make financing home renovations or other major purchases less stressful. To know whether a HELOC is right for your family, it’s important to understand the main pros and cons before deciding.
Pros of HELOCs
- Lower interest rates than other loans
- Take out only what they need when they need it
- Borrow, repay, and borrow again for the duration of the draw period.
- Interest-only payments
- Easier to qualify for, softer credit score requirements
Cons of HELOCs
- Variable interest rates
- Payment amounts could increase if interest rates rise
- Fees, such as loan origination fees or ongoing maintenance fees
- Lender could foreclose on the house used as collateral if the homeowner fails to repay the loan
- Amount of credit available is capped at how much equity the borrower has in their home
Tap into your equity with AAA Banking
If you have questions about how a HELOC could help you, AAA Banking can help.
Get in touch today through our online contact form, talk to one of our licensed loan officers at (844) 793-1870, or drop us an email at HomeLoans@acg.aaa.com.
Our experienced mortgage loan officers are ready to help.
Photo by Mikhail Nilov