If you own a home, you’ve probably heard of a home equity line of credit, or HELOC, before. A HELOC can be confusing to those newer to homeownership. With that in mind, I’ve decided to put an end to the confusion once and for all. Below is your guide to home equity loans. It will cover what a home equity line of credit is, how it works, and how to qualify for one of your own.
What is a home equity line of credit?
A HELOC is essentially a second mortgage that functions similarly to a credit card. It’s a line of credit that allows you to borrow against the equity in your home, as needed. Typically, this type of credit is used to cover big expenses such as medical debt, home renovations, or financing a child’s education.
Since HELOCs are secured by your home, meaning that the lender can foreclose on you if you decide not to pay back the loan, they often come with better interest rates than most traditional credit cards. However, their interest rates are adjustable, so you’ll want to be sure to pay close attention to how much interest you could be paying over the life of the loan.
How does it work?
HELOCs handle repayment a little differently than traditional credit cards. Instead of paying off as much of the balance as possible each month, this type of credit comes with two separate payment periods, each with their own set of rules.
The first period is known as the “draw period.” During this time, you’re allowed to draw on the line of credit whenever you want. You also will likely only have to make payments on the interest accrued by the amount that you borrowed.
After the draw period is over, you enter what’s known as the “repayment period.” Now, your monthly payment will likely go up substantially because you’ll be responsible for repaying both the principal and the interest on whatever money you borrowed during the draw period. You’ll continue making these payments over the remaining life of the loan.
Qualifying for a HELOC
For the most part, qualifying for a home equity line of credit is a lot like qualifying for a mortgage. Your lender will want to see proof of income through tax documents and pay stubs, your credit history, and any records of your debts and assets.
However, there’s one other piece that your lender will look at, as well: the amount of equity you have in your home. (Remember, equity is the percentage of your home that you own outright.) In this case, the amount of equity that you’ve built up by paying down your mortgage will play a key role in determining how much money you’ll be allowed to borrow. Most lenders will only let you borrow against up to 85% of the equity you have in your home.
Finding your maximum credit limit works like this:
- It’s the amount your home is worth x the percentage of home equity you’re allowed to borrow – how much you owe on your home
- Let’s say your home is worth $300,000 (according to a recent appraisal) and you’re allowed to borrow up to 85% of your home equity, but you still have a $100,000 balance on your mortgage.
- $300,000 x 0.85 = 255,000
- $255,000 – $100,000 = $155,000
- In this case, you’d be approved for a $155,000 line of credit
The difference between a home equity line of credit and a home equity loan
Home equity lines of credit and home equity loans are similar in that they are both second mortgages on your home, but they function in different ways. Unlike the continuous line of credit that comes with a HELOC, home equity loans work in much the same way as your first mortgage. To start, the funds from a home equity loan are disbursed in one lump sum. Additionally, these loans often come with fixed interest rates and fixed monthly payments.
If you’re not sure which of the two is right for you, talk to your current loan officer and/or a financial advisor. They can help you take a more in-depth look at your options in order to decide which one will serve you the best.