Last week, we talked extensively about mortgage refinancing. Often, refinancing offers homeowners the option to get an immediate monetary return from their home (or, more correctly, the equity they already have in it) without actually selling it. This works well for expenses or purchases because it’s usually less expensive than, say, credit card debt. This week, we’re going to talk about another loan product that can potentially save you even more.
Most home equity loans allow you to borrow money using the equity in your home as collateral. A home equity line of credit (also known as a HELOC) is a little bit different. A HELOC is exactly what the name implies: it’s a line of credit rather than a lump sum loaned to you all at once. These allow you to borrow on an as-needed basis, up to the loan’s limit, over the term of the loan (usually 5 to 20 years). It’s a lot like a credit card. In fact, your lender will actually issue you a small plastic card that looks just like a credit card, to allow you to access your money easily.
This works well for those who want to borrow money but don’t know exactly how much they’ll need, or for people who don’t need to borrow a lump sum all at once and will be paying for something over time —i.e. medical bills, college tuition, or major additions to their home.
For example, let’s say you want to add a major renovation to your home. As we discussed last week, this is a smart use of refinancing products because you’re leveraging your equity to ultimately increase the value of your home. If the projected cost is, $25,000, you could set up a HELOC for that amount and pay for the materials, services, and labor over time, as the bills come due.
HELOC are best used for home renovations or for big, unforeseen expenses that you don’t have the cash reserves to cover. It’s usually not a good idea to use a HELOC for everyday living expenses or if you just need a very small line of credit.
So how exactly does a HELOC work? The total you can borrow depends on how much equity you have in your home, but this is done on the lender’s terms. A lender will usually allow you to borrow approximately 75%-85% of the home’s appraised value, minus what you still owe on it. As with most home refinancing, you’ll either be charged a fee to take care of the appraisal, or be responsible for it yourself.
So let’s say you have a home that’s been appraised at $200,000, and you still owe $80,000 on it. Your bank would take 75% of your home’s value – which comes to $150,000 – and then subtract the $80,000 you still owe on it, leaving $70,000. The bank would then set up a HELOC with a limit of $70,000, of which you could borrow portions at a time.
Home equity isn’t the only factor lenders look at, though. Again, this is a line of credit, and subject to all the considerations that would ordinarily apply. When determining your actual credit limit, the lender will also consider your ability to repay the loan by looking at your income, debts, and credit history. So this means that the amount you’re approved for might not necessarily be the usual percentage of your home’s value.
You might find that a HELOC provides a certain set of advantages depending on your position. In most cases, payments are relatively flexible. Different lending institutions have different requirements, but some will allow you to make interest-only payments until the term of the loan is up. After that, you’ll be required to pay off the entire thing. Some may require that you pay a percentage of the principal as you go.
Probably the biggest advantage to a HELOC is that you pay interest only on what you borrow. This is important because the smaller the principal balance, the less you’ll pay total in interest over time. This means that if you’re not sure exactly how much financing you’re going to need, you can go with a HELOC and not risk overpaying interest on funds you didn’t actually need.
Another advantage is that your credit revolves, which means that once you’ve paid off a certain amount, you can borrow that much more again. As an example, let’s say you received a $40,000 home equity line of credit to make some home improvements. If you borrow $10,000 to fix the roof and pay it back within a year, you’ll still have a $40,000 line of credit.
Average interest rates for home equity credit lines are generally lower than for other types of home loans, because the lenders risk is lower. After all, your home is their collateral, and you already have a track record of how well you pay it off for the bank to review.
As advantageous as HELOCs can be, they’re not without risks. If you don’t pay off your HELOC under the terms you’ve agreed to, the lender can foreclose on your home. It doesn’t matter how much you’ve paid on your first mortgage; a HELOC is considered a second mortgage. This means you need to be honest with yourself about your needs and financial position when it comes to considering whether or not to take on this risk.
There’s also exposure to interest rate risk. All HELOCs are adjustable rate mortgages (ARMs), but they’re much riskier than standard ARMs. Changes in the market impact HELOCs very quickly, often more quickly than other ARMs. If the prime rate changes on April 30, the HELOC rate will change effective May 1. Some HELOCs have a guaranteed introductory rate, but these hold for only a few months.
Standard ARMs, on the other hand, are available with initial fixed-rate periods as long as 10 years. They also have rate adjustment caps, which limit the size of any rate change, and maximum rates no higher than 6% above the initial rates. HELOCs have no adjustment caps, and the maximum rate is 18%.
The risks of HELOCs are such that you want to be absolutely certain of your financial position before taking the plunge on one. There’s another inherent risk to HELOCs, which was starkly revealed during the 2008 housing crisis: the lender has the right to cut an unused credit line. When property values began sharply declining during the crisis, many lenders did cut their unused credit lines, and borrowers found that they did not have the loan commitment they thought they had.
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