A home equity line of credit (HELOC) can be an excellent way to access some of the money you have tied up in your home. But these are complicated financial products. So here are answers to some of the most common questions borrowers ask.
1. What Is Equity?
Home equity is quite simply the dollar amount by which the current market value of your home exceeds the current balance(s) on the mortgage(s) secured on it. So, suppose your home would be appraised today at $200,000, and the amount you owe this morning on your mortgage(s) is $120,000: You have $80,000 in equity, and can probably use a proportion of that as security for further cheap borrowing. If your mortgage balance is greater than your home's worth (it's "underwater"), you have "negative equity" so you won't be eligible for home equity borrowing.
2. What Is Home Equity Borrowing?
Assuming your credit score's reasonably okay, and you can show you have the income to make payments, you can usually use a proportion of the equity in your home to borrow money at low interest rates for any purpose. The reason you can get those low rates is that you have to "secure" your new loan with your equity, so the lender stands an excellent chance of getting its money back if things go wrong. But that also means the lender can foreclose on your home if things actually do go wrong: if you fall too far behind on payments or otherwise significantly breach the loan agreement.
3. What Are the Different Sorts of Home Equity Borrowing?
There are three main sorts of home equity borrowing:
- Cash-out refinance: This is when you get a whole new mortgage for more than your existing one. You must use your new one to pay down completely your existing one, but can then use the rest of the money, less costs, for anything you want.
- Home equity loan: You keep your existing mortgage, and this becomes a second mortgage. Literally, they're sometimes called second mortgages.
- HELOC: Again, you keep your existing mortgage, but one of these provides a more flexible form of borrowing than the others. Read on for more details.
Reverse mortgages could be regarded as a fourth form of home equity borrowing, but they're available only to those age 62 years or above.
4. How Much Can I Borrow?
Different lenders have different rules, but most want the total value of your home equity borrowing (including your mortgage) to be in a range between 75 percent and 80 percent of the current market value of your home. The amount you can borrow may also be limited by your credit score and your ability to prove you can comfortably afford to make payments.
5. What About Set-Up Costs and Lead Times?
It can take months and cost thousands to put a new mortgage in place in a cash-out refinancing, but one of these is likely to provide the lowest annual percentage rate (APR). Home equity loans and lines of credit can often be set up within weeks at a cost of hundreds. They usually have slightly higher APRs than first mortgages, but those rates are generally way lower than those for unsecured personal loans and credit cards. Some HELOCs also have ongoing maintenance fees and cancellation fees, so watch out for those.
6. What's the Difference Between Home Equity Loans and HELOCs?
Home equity loans provide you with a lump sum, which is typically repayable in equal monthly installments over the term of the loan. A HELOC is more flexible, because -- like a credit card -- it's a form of "revolving" credit: You are given a credit limit, and can use as much or as little of that as you want, and only pay interest on the outstanding balance. You can borrow, repay, and re-borrow up to your credit limit as often as you wish. For more details, see "When Home Equity Lines of Credit (HELOCs) Are Better than Home Equity Loans."
7. Do HELOCs Have Variable Rates?
Traditionally, pretty much all HELOCs had variable rates, meaning your interest rate could rise or fall in line with the wider loan market. However, many lenders now offer "hybrid" versions, where the rate is fixed for an agreed period, and can only float up or down when that expires. Look out too for caps that limit how far rates can float. Find out more in "Home Equity Lines of Credit and Interest Rates."
8. What Are "Draw" and "Repayment" Periods?
To start with, during your "draw" period, which is specified in you agreement but typically lasts five to 10 years, you have to pay only interest on your HELOC borrowing, though you're free to pay down the "principal" (the amount you've borrowed) too. When the draw period ends, you enter the "repayment" period, which is often 10 to 20 years. During that, you can't borrow any more, and you're obliged to pay down the principal and the interest. If your balance is substantial, transitioning between these periods can be a financial shock, especially if your home hasn't appreciated in value sufficiently to allow you to refinance with a new home equity loan or line of credit. Check out "Cash Out Refinancing May Be Best Solution to Looming HELOC Crisis."
9. Can HELOCs Be Tax-Efficient?
They sure can. If you use your borrowing to improve or buy your home, you can deduct up to $1 million in interest payments, according to NOLO, a legal website. And you can deduct up to $100,000 if you use the loan for other purposes. However, check your personal circumstances with a tax professional before committing, especially if you're subject to Alternative Minimum Tax, because you may not be eligible for some deductions. There are more details on the IRS's website.
10. What Are Some Common Uses of This Borrowing?
You can use the proceeds of a HELOC loan for anything. People often use them for home improvements, loan consolidation, vacations, vehicle or boat purchases, weddings, medical expenses, starting or funding a business and their kids' education. Some even borrow so they can invest.