How Does a Home Equity Line of Credit Work?
Often referred to as HELOCs, home equity lines of credit are essentially second mortgages. They allow homeowners to borrow most of the equity they’ve built up in their home without having to sell that home or alter the terms of the mortgage. Once your lender approves a HELOC, you can use as much or as little of the credit available to you as you choose. A HELOC is not something to be used casually, however, as it is secured debt tied to the value of your home.
Estimating Available Line of Credit
Lending institutions have fairly straightforward ratios for calculating the available value for a homeowner’s line of credit. Typically, you can borrow about 80 percent of the current value of your home minus the amount you still owe on the mortgage. The catch is that the amount of the credit line usually must stay within the lender’s chosen percentage ratio.
The term current value of your home can be confusing, as it has little to do with how much you originally paid for your home. Instead, an appraiser evaluates your home against recent comparable sales in your area to calculate an appraised value that fits with the current housing market. That appraised home value impacts the maximum amount you can access through a HELOC:
- If your house has held its value or appreciated, you should have some equity. Perhaps you bought a house 10 years ago, for example, for $300,000. It now appraises at $310,000, but you still owe $220,000. To estimate a starting maximum credit line amount using 80 percent, the formula would be $310,000 x 0.80 – $220,000 = $28,000.
- If your home is in an area experiencing a depressed housing market, the loss in appraised value of your home will reduce your potential line of credit. This time, let’s say that your $300,000 house now appraises at $275,000, but you still owe that same $220,000. To estimate another starting maximum amount, the formula would be $275,000 x 0.80 – $220,000 = $0.
Beyond calculating the loan to value ratio, lenders also adjust HELOC terms to correspond with an applicant’s income, debt load and credit score.
Understanding Upfront Costs
While HELOCs don’t carry traditional closing costs, they do have upfront costs that vary by lender. At the very least, you’ll probably have to pay out of pocket for the mandatory home appraisal. You may also have to pay an origination fee as well as an annual fee. Upfront costs for HELOCs are usually less than those for a home equity loan or mortgage, for example, but you’ll also be paying a variable rate of interest once you use your line of credit.
Calculating Interest and Payments
A HELOC is actually a revolving line of secured credit. It works much like a credit card, with a variable interest rate that consistently rises and falls with the prime rate. You pay only on the portion of the line of credit that you’ve used – your balance – but:
- Your HELOC’s APR, or interest rate, will actually be an indexed prime rate plus a margin of percentage points specified in your HELOC’s terms.
- Interest is calculated on daily balances, and interest rate changes may be applied monthly or quarterly. Most loans have periodic caps to limit incremental increases in interest rates, but HELOCs rarely have them.
- Your HELOC’s lifetime interest rate cap determines how much your lender can adjust the interest rate over the term of the credit line. States regulate ceilings, but they’re typically as high as 18 percent.
- HELOCs usually have a minimum draw amount that you must take at closing.
Following Timeline Constraints
HELOC activity must conform to established timelines. A line of credit may have an introductory period. It will also have a draw period, a repayment period and an overall term.
- Introductory periods offer attractive – even sub-prime – introductory rates that typically are limited to the first 6 months or so of the initial draw period.
- The draw period denotes the first 5 to 10 years, when you can spend HELOC funds. You may be able to opt for monthly payments that are interest-only or a very low percentage of the balance comprising interest and principal. You may also be able to lock in a fixed rate option for the remainder of the term.
- The repayment period is usually the latter 10 to 20 years of the term, when you’ll make substantially larger monthly payments with principal and interest to satisfy the debt.
- The term is the overall life of the HELOC, commonly 25 years.
Using Your HELOC Wisely
HELOCs can be effective financial tools when used wisely. Any interest paid may be tax-deductible. Too, interest rates on HELOCs have traditionally remained below those of credit cards. However, HELOCs by their very nature come with certain limiting conditions:
- Though not a primary mortgage, HELOCs are secured debt. They’re second mortgages tied to the equity in your home. Using them to pay for credit card balances, for example, transforms unsecured debt that could be erased in bankruptcy into secured debt that cannot.
- If you want to sell your home, funds from that sale must satisfy your primary mortgage first, but the HELOC will also have to be settled. A HELOC can make refinancing a home through a competitor more complex as well.
- Lenders can use changes in your credit rating, declining real estate values or even the death of an earning spouse as sufficient cause to reduce, freeze or close a HELOC and demand satisfaction for outstanding balances.
How Does a Home Equity Line of Credit Work?
So, how does a home equity line of credit work? Before you sign and initial the paperwork, before you write the check or insert the card, before you make that first minimum draw, be sure you can answer that question. The Truth in Lending Act mandates that lenders disclose all loan cost information to consumers in easily understood terms, so take the time to ask questions and read your HELOC terms – right down to the fine print.