Home Equity Line of Credit (HELOC) Definition

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit (HELOC) is a revolving credit line that allows a homeowner to borrow against their home equity, essentially using it as collateral.

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How Does a HELOC Work?

A HELOC works by offering a homeowner to borrow against their home equity, essentially using their equity as collateral.

A HELOC is a revolving line of credit. Like a credit card, a HELOC has a withdrawal limit based on the borrowers’ home equity and other qualifications; the stronger these qualifications, the higher the limit. The withdrawable funds are replenished when the borrower repays their outstanding balance.

However, unlike a credit card, a HELOC has additional features that offer more convenience (and potentially, a greater credit limit) to borrowers.

HELOC Timeline

A HELOC consists of two periods or phases: a period where they can withdraw money (the draw period) and a period where they have to repay their outstanding balance, plus interest, on the money they have withdrawn (the repayment period).

HELOC money withdrawal

During the draw period, the borrower may withdraw any amount of money whenever they need to, up to a designated credit limit. To refresh this limit, the borrower can repay what they borrowed; they may choose to pay the principal amount and the interest to clear the balance faster. In addition, even if the borrower has finished paying for the last withdrawal, they may still withdraw cash as long as the credit limit has not been reached.

Note that some lenders may require a minimum withdrawal amount or an upfront withdrawal.

When the draw period ends, the lender may choose to renew the line of credit or not. Otherwise, the borrower will enter the repayment period.

During the repayment period, borrowers must pay all outstanding debt, including all incurred interest. The lender may ask the borrower to pay it all at once or in a monthly scheme, depending on the terms of the HELOC.

The length of a HELOC may vary; some may run for up to 30 years (with a 10-year draw period and a 20-year repayment period).

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HELOC vs. Home Equity Loan: Their Differences

They may sound alike, but they are quite different. One of the key differences between HELOC and a home equity loan is the interest rates. A HELOC does not have a fixed interest rate, unlike a home equity loan[1]. However, this variable interest rate may either be a benefit or not, depending on general market conditions.

In terms of repayment, HELOCs require borrowers to pay for the interest and principal amount starting from the first year of the repayment period up to the last year. On the other hand, a home equity loan only requires borrowers to pay for the interest during the first 5-10 years, then the principal amount during the remaining years. Unlike a HELOC, the repayment period for a home equity loan can last up to 30 years.

Qualifications for a HELOC

Lenders account for a few factors when approving a HELOC application. This includes the borrower’s home equity, loan-to-value (LTV) ratio, debt-to-income ratio, and combined loan-to-value ratio (CLTV). These factors are explained below:

  • Home equity. In simple terms, home equity is the portion of the home that the homeowner actually “owns.” This portion is calculated based on the difference between its appraised value and the mortgage balance[2]. For example, a borrower with a $250,000 home in the market but with about $25,000 left in their mortgage means the borrower has 90% equity on their home—in other words, they own 90% of their home. The less the homeowner’s balance on their mortgage, the better the financing options and the greater the credit limit. To qualify for a HELOC, lenders prefer borrowers with at least 85% equity.
  • Loan-to-value ratio. A loan-to-value ratio is determined by dividing the borrower’s current mortgage balance by the appraised value of the property. The ideal LTV that will be approved for a HELOC is 80% or less. For an LTV that exceeds 80%, the bank might require a Private Mortgage Insurance (PMI), which protects the lender if the borrower fails to pay.
  • Debt-to-income ratio. This figure represents the borrower’s total monthly income versus their monthly debt obligations, including bills, amortization, and other loans. This gives the lender an idea of whether the borrower can pay the loan on top of other financial obligations. An ideal debt-to-income ratio is 43% or less[3], with no more than 28% for loans. The better the borrower’s position in this metric, the higher the HELOC limit that may be offered.
  • Combined loan-to-value ratio. Lenders use the CLTV to assess the risk of the borrower defaulting on a HELOC. The CLTV can be determined by dividing the total principal balances of all the borrower’s loans by the appraised value of the borrower’s house. This means that the lower the CLTV, the better. Lenders require 85% or less CLTV for borrowers to qualify for HELOC; for borrowers with 85% or above, they can pay in lump sum toward any of their loan balances and get a lower CLTV.

What Are Suitable Uses for HELOCs?

A HELOC is a long-term loan option suitable for those anticipating some projects that need funding or those who need to pay debts with higher interest rates. HELOCs are ideal for ongoing projects, like a house renovation or home improvement or even to pay for medical treatment. A HELOC is an excellent option to pay off medical expenses as its funds replenish as long as the balance is paid along with interest.

HELOC renovation

HELOC is also a suitable financing option for education. Since it has lower interest rates, it can be a better option than a credit card. HELOC can also be used to pay high-interest debts such as credit cards, although borrowers should avoid racking up more debts and piling up bills on top of one another.

Finally, a HELOC is an ideal source of funds, especially for those who need long-term financing but do not want a lump sum. Although it has a long repayment period, borrowers who have paid all their balances during the draw period no longer have to pay additional fees when the draw period ends.

Pros and Cons of HELOCs

HELOC applications have boomed thanks to a lot of benefits, such as:

  • Secured loan. Since HELOC depends on home equity as collateral, lenders offer lower interest rates.
  • Flexible payment terms. During the draw period, borrowers may pay only the interest from their withdrawal or pay the interest along with the principal amount to replenish the balance.
  • Less interest. Unlike other loans given in a lump sum, the advantage of HELOC is that the interest is charged only for the money withdrawn.
  • Ease of tracking expenses. Unlike loans that offer a lump sum, borrowers have control over the funds they withdraw and when they will withdraw. This can make it easier for struggling homeowners to manage their finances and avoid incurring more debt.

But like any consumer loan product, HELOCs also have disadvantages, such as:

  • Minimum withdrawal required. Some lenders require a minimum amount for withdrawal or an upfront withdrawal.
  • Interest rates are unstable. The interest rate for HELOCs depends on the current market trends. The market value of the house can increase or decrease along with the interest rates. However, borrowers can take advantage of this by paying as much balance as they could when interest rates drop.
  • Additional fees may be charged. Since HELOCs work like a credit card, some lenders may require additional payments for early closure, cancellation, and annual fees.
  • May easily affect credit score. Although HELOCs provide flexible payment terms, lenders are strict when it comes to missed payments, and it can immediately reflect on the borrower’s credit score.

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Should You Apply for a HELOC?

Although HELOCs require borrowers to set their home equity as collateral, it provides them with better options for managing their finances while having access to emergency funds. HELOCs also have generally lower interest rates than other forms of debt[4], making them an ideal loan option for those who are confident to pay on time for lower rates.

HELOC low interest

On the other hand, HELOCs have strict payment deadlines and usually do not allow for grace periods, which is why banks and lenders ensure that HELOC applicants can pay for a long-term loan. When applying for a HELOC, it is advisable for a borrower to work on their credit score first by paying off some of their existing debts, including their mortgage balance, to obtain favorable credit limits.

Takeaways

The home equity line of credit, or HELOC, is a type of secured loan that functions like a credit card with the home equity serving as the collateral. This allows the borrower to borrow against the equity of the home over a predetermined draw period.

Compared to a lump sum loan, HELOC offers more flexibility and ease of expense tracking to the borrower because you only take out the amount you need. This type of loan can be used for medical expenses, schooling expenses, repayment of loans with higher interest rates, or home repairs. Borrowers who can repay before the start of the payment period can avoid accruing higher interests. The flexible interest rates that come with a HELOC also make it an attractive loan type for those who can make higher repayments when the interest drops.

Sources

  1. Ceizyk, D. (2020.) Comparing a Home Equity Loan vs. a Home Equity Line of Credit (HELOC). LendingTree. Retrieved from https://www.lendingtree.com/home/home-equity/home-equity-loan-vs-home-equity-line-of-credit/
  2. Bankrate. (n.d.) How to Calculate Your Home’s Equity & Loan-to-Value (LTV) Tips. Retrieved from https://www.ml.com/articles/how-to-calculate-your-home-equity-and-why-it-matters.html
  3. Consumer Financial Protection Bureau. (2019.) What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important? Retrieved from https://www.consumerfinance.gov/ask-cfpb/what-is-a-debt-to-income-ratio-why-is-the-43-debt-to-income-ratio-important-en-1791/
  4. Bank of America. (n.d.) Is a home equity line of credit right for me? Better Money Habits. Retrieved from https://bettermoneyhabits.bankofamerica.com/en/home-ownership/benefits-of-using-home-equity

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