A home equity line of credit (HELOC) is a line of credit extended to a homeowner that uses the borrower's home as collateral. Borrowers are pre-approved for a certain spending limit, based on household income and credit score, and may draw on this limit at their discretion. Interest is charged at a predetermined variable rate, which is usually based on prevailing prime rates.
Once there is a balance owing on the loan, the homeowner can choose the repayment schedule, as long as minimum interest payments are made monthly. The term of a HELOC can last anywhere from less than five to more than 20 years, at the end of which the entire remaining balance must be paid in full.
You only pay interest on what you actually borrow and there are no closing costs. You may borrow up to $100,000 (($50,000 if you are married filing separately) and deduct the interest from your income taxes.
BREAKING DOWN 'Home Equity Line Of Credit - HELOC'
When real estate values were surging in the 2000s, it was common for people to borrow against the equity in their residences. That slackened with the bursting of the housing bubble in 2007. But now, many regions of the United States, home values are continuing to rebound, swelling the home equity available to homeowners. In 2015, they drew $156 billion from home equity lines of credit (HELOC), which was the largest dollar amount since the Great Recession. The average HELOC established was a record $119,790.
The loan-to-value ratio for most secondary loans like HELOCs is usually set at 80%, although this can be higher in some instances for those who qualify. LTV is calculated by dividing the remaining loan balance of a mortgage by the present market value of the residence. Suppose you are five years into a 30-year mortgage plan on your home. A recent appraisal places the value of your house at $250,000, and you still have $195,000 left on the original $200,000 note. If there are no other debts registered with the house, you have $55,000 in home equity. Your LTV is 78%.
Basically this means you can borrow up to 80% of the appraised value of your home, minus the amount you still need to pay on your primary mortgage. Of course, the actual amount that is granted depends on the borrower’s financial condition and credit score. There are even some loans that can exceed 100% of the LTV ratio, but most financial planners caution borrowers against this form of loan, as they come with a high possibility of foreclosure, and any interest on a balance that exceeds the home's value cannot be tax-deductible.
Lenders are required to disclose how interest is calculated, the consequences of non-repayment, the terms and interest rate charged by the loan and other pertinent details such as the borrower’s right of rescission.
As a form of revolving credit, a home-equity line of credit works much like a credit card and, in fact, sometimes comes with one. Borrowers can withdraw money when they need it via this credit card or special checks.
HELOCs are often considered a type of home-equity loan. However, a home-equity loan works like a conventional fixed-rate mortgage. You borrow a set amount at a set interest rate and make equal payments for the entire loan term, which can last anywhere from five to 30 years. In contrast, a HELOC’s loan term has two parts: a draw period and a repayment period. The draw period, during which you can withdraw funds, might last 10 years and the repayment period might last another 20 years, making the HELOC a 30-year loan. Once the draw period ends, you cannot borrow more money.
During the HELOC’s draw period, you do have to make payments, but they tend to be small, often amounting to paying back just the interest. During the repayment period, payments become substantially higher, because you now are paying back principal. During the 20-year repayment period, you must repay all the money you’ve borrowed, plus interest at a variable rate. Some lenders give borrowers the option of converting a HELOC balance to a fixed interest rate loan at this point.
Even so, the monthly payment can almost double. According to a study conducted by TransUnion, the payment on an $80,000 HELOC at 7% annual percentage rate will cost $467 a month during the first 10 years when only interest payments are required. That jumps to $719 a month when the repayment period kicks in.
That jump in payments at the onset of the new period has resulted in payment shock for many an unprepared HELOC borrower. If the sums are large enough, it can even cause those in financial straits to default. And if they default on the payments, they could lose their homes – the collateral for the loan, remember.