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What is a home equity line of credit (HELOC) and how does it work?

At a glance:

One of the most popular means of getting credit over the past decade or so has been the home equity line of credit.

These lines are being offered by more and more lenders. The source of the credit is the equity in your own home. By using this equity, you can qualify for a potentially large amount of credit at a relatively low interest rate. You can have it available when and how you want.

Because the line of credit is secured by your home, you may also qualify to deduct the interest from your taxable income.

What is a home equity line of credit (HELOC)?

A home equity line of credit (HELOC) is a line of credit that uses your home as collateral. It is a revolving line of credit rather than a closed-end loan.

What do homeowners use them for?

Homeowners use these lines of credit for many different purposes. Often, they will use them to finance large purchases, such as home add-ons, or educational expenses, or start-up business expenses. For many people, their home is their biggest asset, which makes it attractive as collateral for loans.

How to get one

Your lender will approve you for a certain credit line, which will become your credit limit. This is the maximum that you may borrow at any one time. The formula for determining the credit limit differs according to the lender. For example, one lender may calculate 75% of your home's appraised value and subtract the amount you owe on the mortgage.

That means if your home is appraised at $200,000 and you owe $100,000 on the mortgage, you may qualify for a line of credit of $50,000 ($200,000 x 0.75 = $150,000; $150,000 – $100,000 = $50,000). However, there are factors that may limit how much you actually qualify for. Your current debts, your credit history, and your income may also factor into how much you can qualify for.

The length of time during which you can draw from your HELOC will usually be fixed; many plans allow you to renew this draw period. If you still owe on your plan, you may be required to pay the entire amount at the end of the draw period.

Whether you are required to do this or whether you are allowed a repayment period afterward will be set in the contract. But once you are approved for the HELOC, you can begin to borrow from it when you want. Generally, you will draw on it with checks; depending on the plan, you may even be allowed a credit or debit card.

Interest rate charges and related HELOC features

A home equity line of credit usually uses a variable interest rate rather than a fixed one. The rate used is based on a particular index that is used in the market and is publicly available. The Prime Rate and the rate of US Treasury bills are two very commonly used indexes.

Because the HELOC rate is variable, it changes along with the rate of the underlying index used. To calculate the rate that you will pay, the lender will add a margin to the index; this margin may be 1 percentage point, 2 percentage points, or something similar.

Learn about the index used

As an informed investor, you will want to learn which index is used and how often it changes. You may also find it useful to know how it has fluctuated over the previous years. Of course, you will also want to know the margin amount used.

If your plan uses a variable rate, it is required by law to have a cap, or ceiling, on how high the interest rate may rise. As well, your plan may also impose its own limits on how high or low the interest rate may go, and even how high your payments may rise.

How to repay a HELOC

It is a principle of good personal finance to have a plan for how to pay back your home equity line of credit. Your minimum monthly payments will likely include a mix of principal (the original amount you borrowed) and interest.

Some plans are interest only: this means they allow payment of interest alone without any principal. That means that if you borrow, say, $20,000, you will have none of that paid back when your draw period ends.

Lenders will often allow a variety of payment options for you to choose from, and you can usually pay more than just the minimum.

You might have to make a balloon payment when the loan ends

With some HELOCs, once your draw period ends, you will be required to pay any amount still owed all at once. For example, if you originally had a line of credit for $10,000 and you still have $3,000 left on it when its term ends, you will be required to pay the $3,000 in one large "balloon payment," or refinance the loan to a closed-end loan.

If your HELOC uses a variable interest rate, be prepared for your monthly payments to change, unless your plan specifically allows uniform payments. A rise of even a few percentage points in the interest rate can add hundreds of dollars to what you pay in a year.

What if you sell your home?

What happens if you sell your home while your HELOC is still open? You will be required to pay off the line of credit in full, since your collateral will no longer be in your hands. Given that HELOCs may or may not come with upfront costs, you should do some calculating to determine whether to take one out if you are thinking of selling your home in the near future. If you are thinking of renting out a property with an open HELOC, be sure that your contract allows for this.

The difference between a HELOC and a second mortgage

While you are thinking about a home equity line of credit, it may pay to be aware of second mortgage loans as well. Unlike a HELOC, a second mortgage gives you a fixed sum of money to be paid back over a set time.

Equal payments are usually required on your part to pay off the full loan. Borrowers who need only a set amount rather than a revolving line of credit may find a second mortgage more attractive than a HELOC.

Compare costs

Compare the costs of the two. Do not rely just on the annual percentage rate (APR) of the two to make your decision. The APR on a HELOC is based only on the underlying interest rate. But the APR on a traditional second mortgage includes the interest rate and may include certain other finance charges.

Be aware, however, that HELOCs may include additional costs, too, even though they may be stated or presented differently.

Disclosures from lenders regarding HELOCs

Lenders must by law disclose to you certain important pieces of information about their home equity plans, such as the annual percentage rate (APR), the terms of payment, details about the variable interest rate (if your plan has one), costs, and any other terms.

This disclosure is required under the federal Truth in Lending Act. The required information is usually given to you when you apply, and some additional information will be given to you further along in the application process.

Another important fact is that no lender or anyone else may legally charge you a fee before you have received this information. If you have paid a fee but soon change your mind about the plan due to some change in the terms, the lender is required to return all fees that you have paid.

You can cancel

Once you have opened a home equity line of credit, you are allowed by law (under the Truth in Lending Act) to cancel it within three days of signing … for any reason. Simply inform your lender in writing. The lender must then return all fees you have paid to open the account as well as cancel its security interest in your home.

Summary of HELOCs

Using a credit line to borrow against the equity in your home has become a popular source of consumer credit, and lenders are offering these home equity credit lines in a variety of ways. Be sure to review the home equity contract carefully before you sign it.

Do not hesitate to ask questions about the terms and conditions of your financing. The more thoroughly you understand your contract, the better able you will be to handle any problems that may arise.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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