What is a HELOC?

You may have heard of HELOC or cashing in your home equity. But there are a few ways to do so. 

If you’re exploring financing options for an upcoming expense, you might wonder about the best way to access the equity in your home. 

If you’re asking yourself, “What is a HELOC,” this article is for you—we’ll look at what a HELOC is and how it works.

What does HELOC stand for?

HELOC is an acronym for home equity line of credit—a way to borrow money and use your home as collateral. 

Interest rates for HELOCs are lower than credit cards and many other personal loans, which makes them a valuable financial tool for many borrowers.

Let’s look at an example. 

If your home’s appraised value is $250,000 and you still owe $150,000 on your mortgage, you have $100,000 equity in your home. 

Borrowing up to 80% of the equity in a home is a common line of credit limit, so in this example, you could take out a home equity line of credit of up to $80,000.

How does a HELOC work?

Credit card interest rates are some of the highest rates available. Even “cheap” credit card interest rates start around 15%, although most people pay much more. 

Store credit cards, like those for home renovation centers, typically have interest rates almost double the “cheap” credit cards. High-interest rates can make paying for important purchases, such as home renovations or unexpected medical expenses, cost prohibitive. 

With a HELOC, you can access the equity you’ve built up in your home at a better interest rate to fund purchases or repairs, consolidate debt, or do anything else you consider important. 

When you get a HELOC, your lender will specify a credit limit. HELOCs are very similar to credit cards—you can borrow from your HELOC as long as you are within the “draw” period and have available credit. 

The draw period is the period you have access to the credit. Borrowers only pay interest on the funds they spend during that time—not the entire credit limit amount.

The big advantage of a HELOC over other loan types is a significantly lower interest rate, allowing you to reduce financing costs. 

HELOCs with adjustable rates may see fluctuations in interest rates. However, a fixed-rate HELOC has the same interest rate for the lifetime of the line of credit. 

Your HELOC is considered “open” during the draw period. And during that time frame, you can borrow as much or as little as you want—and only make interest payments on what you actually spend. 

You can, however, pay off your balance during the draw period, which replenishes the available credit, much like a credit card.

For example, if your HELOC has a limit of $80,000 and you spend $10,000, you only have to pay interest on the $10,000 during the draw period. In this example, you would have $70,00 available credit remaining. However, if you repaid the $10,000, you would again have the entire $80,000 to spend on anything you wanted. 

When your HELOC’s draw period finishes, the repayment period begins. This is when you have to repay any outstanding balance, i.e., the loan principal amount plus interest. 

Is a HELOC the same as a home equity loan?

In many ways, a home equity loan is very similar to a HELOC—it allows you to tap into your home’s equity and borrow funds. 

But a home equity loan differs from a HELOC in two key areas.

With a home equity loan, you get a single, lump-sum cash payment when your application is approved. Borrowers pay interest on the total loan amount and must begin repaying it immediately. 

Whereas with a HELOC, you only pay interest on the funds you actually use and only begin repaying the line of credit once the draw period is finished. 

How does a HELOC work?

Once your HELOC application is approved, your HELOC’s draw period begins.

Draw period

During the draw period, borrowers can use the line of credit for anything they consider worthwhile, like consolidating debt (or paying it off) or making home improvements. 

Draw periods can last for 10 years, and you’ll only have to pay interest on what you actually borrow during this time. 

Draw period ends

Once your draw period ends, your access to funds will also end. 

Repayment period

The repayment period begins immediately after the draw period. Different lenders offer shorter or longer timeframes. This is when you’ll repay any outstanding balance on your line of credit, principal, and interest.

HELOC requirements

While HELOC requirements will vary depending on which lender you choose, borrowers generally need

• 20% home equity
• Credit scores above 680, although select lenders will consider scores between 621 to 679
• Maximum debt-to-income ratio (DTI) of 45% (some lenders will consider higher DTIs)

Reliable payment history

When lenders evaluate a potential borrower’s ability to repay a loan, payment history is always a factor. As a result, borrowers with a history of missed or late payments may find it challenging to qualify for a HELOC. 

HELOC vs. mortgage—which has the better interest rate?

A HELOC usually has a better interest rate than home equity loans, personal loans, credit cards, etc. 

Along with market activity, a borrower’s credit score impacts the mortgage rates and HELOC rates they can receive. 

Borrowers with high credit scores typically get the best HELOC rates, which can be lower than conventional mortgage rates. 

For example, a borrower with a credit score in the high 700s might be eligible for a HELOC rate of 6.1%. In contrast, a borrower with a credit score in the mid-600s might be eligible for a mortgage interest rate of 6.5% 

When is a HELOC the right choice?

A HELOC might be the right choice if you have more than 20% equity in your home and looking for a line of credit with a lower interest rate.

AAA Banking can help with your decision 

If you’re thinking about turning the equity in your home into useable funds, contact the loan officers at AAA Banking today. 

We’ll walk you through the options and ensure you the information you need to decide whether a HELOC is right for your financial situation.

Image by Freepik