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    What is a HELOC? How Does it Work?

    Mortgage.infoBy Mortgage.infoNovember 3, 2022Updated:November 4, 2022No Comments5 Mins Read
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    A HELOC or home equity line of credit is a second mortgage on your home. Homeowners use it to turn their equity into cash. It’s a great way to use your home’s equity without being forced to sell your home or refinance your first mortgage.

    Understanding the HELOC

    A HELOC isn’t a fixed mortgage. Instead, it’s a revolving line of credit. You receive a credit line that you can draw on after you close. The draw period lasts for ten years.

    You can withdraw the entire credit line or a portion during that time. You’ll owe interest on any funds you withdraw and can make interest-only or principal and interest payments during this period. If you repay the line within your draw period, you can use the funds again if needed, much like a credit card.

    HELOC interest rates are variable. This means you could pay a different rate monthly or the same rate for a few months in a row, depending on the market.

    The interest rates are lower than rates on personal loans or credit cards, though, because it uses your home as collateral. If you default on the loan, the lender could start foreclosure proceedings.

    HELOC Loan Limits

    Most lenders allow you to borrow up to 85% of the home’s value, but this includes your first mortgage. For example, if your home is worth $300,000 and you have a $200,000 mortgage outstanding, you could borrow up to $55,000 in a HELOC for a total outstanding loan of $255,000.

    How to Qualify for a HELOC

    Qualifying for a HELOC is similar to qualifying for a first mortgage. However, you’re using your home as collateral, so you must prove the home’s value and qualifying factors to show you can afford to repay the loan.

    Lenders look for good credit scores, usually 680 or higher, and a low debt-to-income ratio. Because the loan takes a second lien position, they are second in line to get paid if you default. As a result, most lenders are careful about who they lend to in order to avoid a loss.

    Let the lender know if you have a high debt-to-income ratio but will use the line of credit to consolidate your consumer debt. If they pay your credit card debt off with your line of credit, they won’t count the consumer debt in your DTI to help you qualify.

    To get approved for a HELOC, you’ll provide lenders with the following documents:

    • Pay stubs to prove your current income
    • W-2s to prove your income history
    • Bank statements to prove your assets
    • Employment information to verify your employment status

    Your lender will also order an appraisal. This is an out-of-pocket cost, but it can help you secure the financing.

    A new appraisal may show that your home has a higher value, which could mean a higher HELOC loan amount.

    Finally, your lender will order title work. Like when you bought the home, they must make sure there aren’t any liens on the home. If there are any outstanding liens, you must satisfy them first before they’ll issue a HELOC.

    HELOC Interest Rates

    One unique aspect of HELOCs is the interest rate. Unlike a traditional first mortgage, HELOCs don’t have a fixed rate. Instead, the rate is variable and could change monthly. Lenders calculate your rate based on a predetermined index and margin.

    The index is a chosen financial indicator, such as the U.S. Prime Rate. The margin is a set number chosen by the lender that they add to the index.

    Each month, your interest rate is the index rate plus the margin. However, you only pay interest on the portion you withdrew. This occurs for the first ten years. After ten years, you can no longer draw on the loan and must make principal and interest payments.

    Some lenders allow borrowers to convert a portion of their HELOC funds to a fixed-rate loan. But this means you won’t be able to reuse those funds. The amount subject to a fixed rate will be unusable for the remainder of the term. So if you’ve used the funds as intended, you may be better off taking the fixed rate and saving money.

    The Difference Between a HELOC and Home Equity Loan

    When you have equity in your home, you have two options to borrow it. You can take out a HELOC or a home equity loan.

    A HELOC, or line of credit, has a variable rate and revolving funds. Like a credit card, you can use the funds how you want, and if you repay the principal, you can reuse the funds.

    A home equity line of credit is also a second mortgage; however, you don’t get the option to reuse the funds. Instead, you receive the funds in one lump sum when you close the loan. You pay principal and interest on the loan during the loan term, paying it off in 20 – 30 years. Many homeowners invest the funds when they receive them if they don’t need them at once.

    Final Thoughts

    A HELOC can be good if you need funds to pay off consumer debt, make home renovations, or pay for a large expense. They are easy to qualify for if you have over 20% equity in your home and decent credit.

    You can use the funds as needed or even save them as an emergency fund. Many homeowners liquidate their equity but don’t touch it unless there is an emergency. This ensures they have the money should they need it but leaves their equity unused unless absolutely necessary.

     

     

     

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