A HELOC is a home equity line of credit, or just a home equity line. It is a loan set up as a line of credit with a maximum draw. Whereas a standard mortgage may allow you to borrow $150,000, paid out all at once at closing, a HELOC gives you the lender's promise to advance you up to $150,000 in amounts of your choosing. You may use your line of credit through a special credit card or by writing a check.
A HELOC has a draw period, (a time during which the borrower may use the line) followed by a repayment period, during which the loan is repaid.
The draw period typically lasts for 5 to 10 years, during which the borrower only pays interest charges. The repayment term may be 10 to 20 years, during which the borrower makes payments to the principal. Some HELOCs do require that the entire balance be repaid when the draw period ends.
While most HELOCs are second mortgages, they can be a first mortgage if a borrower uses it to refinance an existing mortgage.
A HELOC is different than a Home Equity Loan (HEL), which is simply a loan for a specific amount of money that is paid off like a mortgage and may not be re-borrowed.
Advantages of HELOCs
A HELOC is generally a good option to meet ongoing cash needs, such as medical bills. Borrowers who are self-employed or have irregular income also enjoy the flexibility of a credit line rather than a lump-sum loan.
- Convenient to draw funds out when needed.
- You will only be charged interest when you withdraw money.
- You may pay down the loan and re-borrow.
- Interest on a HELOC is tax deductible.
- Interest rates tend to be competitive.
Many people use HELOC’s for debt consolidation. While a HELOC often has an interest rate higher than the original mortgage, the rate will still usually be lower than that charged by a credit card company or short-term personal loan provider. Using a HELOC to pay off high interest debts can help borrowers save a substantial amount of interest. If you are considering this, just remember that your home will serve as collateral for the loan.
Disadvantages of a HELOC
A HELOC is not for every homeowner. Monthly payments on a HELOC can be difficult to predict, as they are tied to the Prime rate, and they do not have caps like a standard adjustable-rate mortgage. All HELOCs are adjustable-rate mortgages, and market changes can impact a HELOC rapidly.
HELOCs are also not recommended for borrowers on a fixed income who require a consistent monthly payment. In which this case a home equity loan is a better option.
Qualifications for a HELOC
A HELOC turns the equity in your home into collateral you can borrow against. You must meet the following general qualifications to obtain a home equity line of credit.
- Equity in your home. Some lenders will provide a HELOC for up to 125% of the equity, but most HELOCs should not use up more than 80% of a home's equity. The lender will have the home appraised to verify equity.
- Monthly housing expenses (HELOC plus mortgage payment, insurance, and property taxes) should not exceed 28% of your gross monthly income.
- All monthly debts, including credit card payments and child support, must not exceed 36% of your gross monthly income.
- Lenders typically require very good credit to approve a HELOC. For a loan against 100% of the home's equity, lenders may want a credit score of at least 700.
- Steady employment in the same industry or job for at least two years.