A home equity line of credit – a HELOC – is perhaps one of the most misunderstood financial instruments. Is it a kind of mortgage? Is it a credit account? What’s the difference between a HELOC and a home equity loan, for example, versus a credit card account? How can you use it? Sometimes, the best way of sorting out what something is involves understanding what it’s not. After all, a HELOC is, in fact, a hybrid.
Is it the same thing as a home equity loan?
You may hear people use the terms home equity loan and home equity line in the same breath, maybe even interchangeably. It’s typically the first point of confusion, as both are types of second mortgages. A home equity loan and a home equity line of credit, however, are two completely different things. The only elements that home equity loans and HELOCs really share in common are the facts that both are secured through the equity you have in your home and that both involve rather large sums.
What is the biggest difference between a loan and a line?
A HELOC’s disbursement architecture is what makes a home equity line of credit different from first mortgages and home equity loans. At a home equity loan closing, a lender delivers a lump sum representing the full value of the loan. If you take out a home equity loan for $30,000, for example, the lender will disburse the full $30,000 to you or the party you designate. In turn, the lender will use the total $30,000 figure for what is usually a fixed interest rate repayment plan.
In contrast, at a HELOC closing, the lender opens a line of credit for you. Much like a credit card account, if the lender approves you for $30,000, you now have access to $30,000. However, you don’t have to take all of it. Instead, you can use just a portion, and your lender will charge you a variable interest rate only for the amount you draw. You can later access additional funds up to your credit limit.
How is a HELOC like a credit card account?
In many ways, a HELOC works much like a credit card account. You have a credit limit. Your lender charges only for the amount that you draw, and in return you make monthly payments. Like a credit card, interest rates are variable, but historically, they’ve remained lower than those charged on credit cards. Most HELOC lenders in fact issue credit cards and accompanying checks to allow you to draw on the account. However, while a credit card issuer hopes that you’ll use your account, HELOC lenders usually require that you take at least a minimum draw at closing. Many also set minimum purchase amounts. By the way, yes, some HELOC lenders have promotional introductory rates and even give rewards points.
How is it different from a credit card account?
Just like a credit card, a HELOC is a revolving line of credit. So, even if you pay off all of your other credit cards, your HELOC will probably show on your credit report as a credit account. Despite that, FICO score calculations treat it differently. While the FICO system factors your credit card utilization rate – how much of your available credit you use – into your score, it doesn’t take your HELOC utilization ratio into account. The amount you draw, or use, from your HELOC’s available credit line is treated as a secured debt amount, regardless of whether you keep your draw below the target 20-percent utilization rate.
How is it like a mortgage or home equity loan?
Despite the line of credit and seeming flexibility, a HELOC is still a second mortgage. It’s a secured debt tied to the equity you have in your home. Just as traditional mortgages require that 20-percent down payment when you buy your house, lenders will want an appraisal to ensure that an added home equity line falls within similar loan to value thresholds. In addition, if you sell your home, you’ll have to satisfy your HELOC debt as well.
So, what is a HELOC?
What’s important to understand is that a HELOC is not a credit card, and it’s not a traditional loan either. While a HELOC offers the flexibility of a credit card, it also has a finite term divided into a draw period and a repayment period. The draw accounts for the first 5 to 10 years; you can spend to your limit while enjoying interest-only monthly payments. At the close of the draw period, however, the repayment period kicks in for the remainder of the term, with significantly higher monthly payments consistent with that time period’s interest rates.
What else do I need to know?
People use HELOCs to pay for everything from home repairs and updates to cars, credit card consolidations, medical expenses and educational loans. Some people apply funds to investments or retirement. Only you know your true financial situation and needs, but as you consider a home equity line, view it as what it is – a variable rate long-term loan with a full repayment period at a seemingly distant date that one day will arrive.