There are many options to consider when you need to free up cash for a project or purchase, such as credit card cash advances, personal loans, reverse mortgages and home equity loans. But have you ever considered a Home Equity Line of Credit (HELOC), which allows you to tap into your home equity to fund home improvements or renovations? If you haven’t, read on to discover how a HELOC works and why it may be a good option for you.
Key Takeaways
- A HELOC is a line of credit that is backed by the equity you have in your home, meaning your house is used as collateral to secure the loan.
- A HELOC is recommended for investments that will increase your wealth, such as home improvements. It's not recommended for day-to-day living expenses or expensive purchases like cars or vacations.
- HELOC rates are determined using a baseline rate, typically the prime rate, and your credit profile. Typically, the higher your credit score, the lower the rate.
- HELOC rates are variable, meaning they move up or down in accordance with the benchmark rate. Remember to check your HELOC's maximum rate when applying to avoid a costly surprise.
What is a HELOC?
A HELOC is a line of credit backed by the equity you have in your home: the value of your home minus what you owe on your mortgage. A HELOC uses your home equity as collateral and lets you borrow against it.
For example, let's say you make a down payment of 20% on a house worth $200,000 and take out a mortgage to cover the rest. That means you initially have $40,000 worth of equity in your home, which increases as you make monthly payments on your mortgage. If you have at least 20% equity in your home (and meet a few other requirements - read more here), you may qualify for a HELOC.
A HELOC consists of two phases. The first is the draw period, which usually lasts five to 10 years, and the repayment period, which can last 10 to 20 years. During the draw period, you are free to use your line of credit at your discretion, up to your limit. It functions much like a credit card: borrow cash, repay it and borrow again. You also only pay interest on what you use. When the draw period is over, the repayment phase begins. This is where you make monthly principal and interest payments to pay back what you've borrowed during the draw phase.
How are HELOC rates determined?
HELOC interest rates are determined based on a benchmark interest rate, typically the prime rate, as well as your credit profile. Depending on your credit score, the lender will add a markup to the benchmark rate. Typically, the lower your credit score, the higher the interest you’ll have to pay. If you have an excellent credit history, your rate could be as low as 3%, while if your credit is below average, it could be as high as 9-10%.
Because HELOCs are secured by home equity, the interest rates tend to be lower than with other types of loans. However, they are variable, meaning your rate will move up and down over time with the benchmark rate it is tied to. This means your monthly payments may increase, making it harder to keep up with payments. It is critical to consider this and check the maximum rate for your HELOC when deciding if it’s the right choice for you.
How do homeowners benefit from HELOCs?
The biggest benefit of a HELOC is the ability to withdraw funds as you go and only pay interest on what you use, unlike other loans that require you to take out a lump sum and pay interest on the entire balance from the get-go. In addition, if the HELOC funds are used to pay for home improvement projects and renovations, which boost the value of the property over time, the interest may be tax-deductible. To learn more, read here about when a HELOC may (or may not) be a good idea.
How do lenders benefit from offering HELOCs?
For lenders, HELOCs offer protection if things go downhill because the borrower’s property serves as collateral. If a borrower defaults on payments, the bank could ultimately take ownership of the home and sell it to pay off the loan. For this reason, it's best not to use the funds to pay for vacations, cars, groceries, or anything that will make it more difficult to pay off your monthly principal and interest payments.
Are you considering applying for a HELOC? With Aven's HELOC Card, you can get approved in in as fast as 15 minutes and have the card in your hands in a few days. Read more to learn whether it's what you're looking for!
