Everything you need to know about a Home Equity Line of Credit
So you need a long-term loan. Your initial reaction is to mozy on down to the local bank and apply for a loan. You agree on terms of a normal loan before finalizing the agreement: repayment period, monthly payments, and costs. You naively think this is your sole option, your dead end to getting that money you need. Aha! But wait… there's more: a fork in the road perhaps. If you're a homeowner, you may be eligible for a HELOC.
How a HELOC works
A HELOC (home equity line of credit) allows you to borrow money against your home. It's a revolving line of credit, meaning it's not an installment loan like a mortgage or personal loan that you borrow and pay back during a set period of time. Instead, it's secured by your home and you can tap into it as you need it, and leave it alone when you don't.
With a HELOC, you are using the equity in your home as collateral. And, you'll typically get a lower interest rate than if you got a traditional loan. It’s like when you go kayaking and they make you leave your ID card as collateral: you're not going to steal the equipment because then you won’t get your ID back.
Using the equity in your house as collateral follows the same idea: you pay the loan amount back and you keep your equity stake in your home. (Psst, equity in your home is the amount between your home’s total value and the current balance of your mortgage.)
The draw period
Like a credit card, you can borrow from your HELOC—up to a limit. (More on that limit below.) But, unlike credit cards, you can only access the funds for a certain period of time, called the draw period. Most HELOCs give you a 10-year draw period, during which you can access as much money as you need up to your total available credit line. When the draw period ends, you will repay the amount you borrowed.
So, during the draw period, you don't have to pay back the principal you borrow, only your interest owed. And, with a HELOC, you don't have to start using the money immediately; you can borrow from it at any time during the draw period.
The repayment phase
After you finish drawing from this line of credit, you’ll start chipping away at your principal repayment. This phase typically extends 10-20 years, though you can always pay it back faster. When you pay off the principal—first, do a happy dance, because, dang!—the funds will be allocated back to your line account.
The revolving (door) line of credit
As you (now) know, your line of credit will be replenished as you repay the outstanding balance. Uh oh, what if disaster strikes and you need to borrow against it? Sure! You can borrow any amount you need (up to the credit limit) during the draw period. From there, you'll repay it in the next period.
Do you qualify for a HELOC?
In order to qualify for a HELOC, the amount you owe on your home must be less than the value of your home. Essentially, you need to have paid off half your house already. If you’re not quite there yet, keep this information in mind for when your house matures a little more.
Generally, you can borrow up to 85 percent of the value of your home, less the amount you owe on your mortgage. So, if your home value is $100,000 and you owe $50,000 on your mortgage, you can borrow up to $15,000 from your HELOC. (Come nerd out with us 🤓: Subtract what you still owe on your home ($50,000) from 85 percent of your home value ($85,000) and you’re left with $15,000. As always, your credit score will factor into the exact specifications to which your lender agrees. (Psst, if you need help keeping your credit score in shape, have a look at Tips to Building Good Credit. And, be sure you don’t fall into any traps!)
Does a HELOC affect your credit?
The quick answer: yes and no. There’s always risk involved whenever you’re borrowing money, especially if you're borrowing against your home. As long as you're fulfilling your payments in a timely manner, a HELOC won't negatively affect your home ownership or credit.
You can actually increase your credit score (which is good!) by using your HELOC funds to pay off high interest credit card debt. This is, of course, assuming the HELOC has a lower rate than your credit card.
As long as you're making your payments on time, you'll also lower your credit utilization ratio, which in turn increases your credit score. (Your credit utilization ratio is just a fancy term of saying whether or not you typically max out your credit cards. A high ratio means you're often maxing out, or near-maxing out, your credit cards. High ratio = bad, low ratio = good.)
Of course, the opposite of that is true. You will decrease your credit score (which is bad!) with a HELOC if you don't make your payments on time.
Below are two simple ways to minimize your risk when using a HELOC:
Make consistent repayments
Pay attention to the terms
When it comes down to it, a HELOC has the same risk as a normal loan. But, this time around, your main asset is your home. We recommend you pay close attention to the terms and the repayment process, as you can find yourself in hot water if you find yourself unable to pay the loan back. The worst case scenario if you can't make your payments on your HELOC is losing your home. So, make sure you pay attention to the fine print here!
Can you afford a HELOC?
Is a HELOC right for you? Hopefully, we’ve helped you determine the answer to that. In short: do you qualify, are you comfortable with the risk involved, and are you confident you’ll be able to pay it back on time? If you answered “yes” to each of those three questions, a HELOC may be right for you. You can use your HELOC for lots of things, of course, but the first thing we recommend you do is think through your plan.
Your lender combines your HELOC loan and your mortgage into one loan balance. So, ahead of inking that HELOC, make sure you can afford the monthly payments.
And, keep in mind the interest on your HELOC may be tax-deductible if you use it to improve your home. (Disclaimer alert! It's always important to consult a tax advisor to double-check the regulations for your situation.)
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