When you need to borrow money quickly to cover an expense or large purchase, you may first consider taking out a personal loan or using a credit card. While both of these types of financing can be great options for certain situations, they also carry high-interest rates that can greatly increase the cost of borrowing the money you need. Depending on what you need extra money for and if you're a homeowner, you may want to consider tapping the equity in your home by taking out a home equity line of credit (HELOC) instead. So, what is a home equity line of credit?
A home equity line of credit allows you to borrow against the equity in your home by withdrawing funds on an as-needed basis. Similar to a home equity loan, which allows for you to receive money in one lump sum, a HELOC allows for you to access your home equity, but you only have to borrow what you need at the time. While a home equity loan may be good for large expenses like home renovations, a HELOC gives you the option to budget out your expenses, only paying interest on the exact amount of money that you need.
How Does a Home Equity Line of Credit Work?
A home equity line of credit, or HELOC, is a secondary type of financing that includes a revolving line of credit secured by a lien secondary to a mortgage.
You must have equity in your home in order to apply and you also need to put your home up as collateral for the line of credit.
Depending on the amount of debt you currently owe, how much equity you have in your home, and your creditworthiness, you may be able to borrow up to 75-85 percent of the appraised value of your home, minus the amount you owe on your first mortgage.
For example, if the appraised value of your home is $200,000, the lender may discount 75 percent of the appraised value (or $150,000. If you have $60,000 left on your mortgage, the formula to calculate your potential home equity line of credit may go as follows:
|Appraised Value of Home||$200,000|
|Percentage of Appraised Value||75%|
|Dollar Amount of Appraised Value||$150,000 = ($200,000 x .75)|
|Less Balance Owed on Mortgage||$60,000|
|Potential Line of Credit||$90,000 = ($150,000 - $60,000)|
If you get approved, you'll be given a loan limit that you can borrow against each month like a credit card. You can borrow the money you need by either writing a check or using a credit card that's linked to your loan account during what's called a draw period (usually lasts 10 years).
You may not exceed your credit limit and you can only make payments on the amount you borrow. After the draw period is over, the repayment period begins. This usually lasts around 20 years depending on your term. If you sell your home, you'll often be required to pay off your HELOC immediately.
With a HELOC, you will most likely have a variable interest rate. This means that your monthly payments may start out low, but could vary if interest rates change. With a fixed interest rate, your monthly payments may seem high at first, but they will be consistent throughout the life of the loan.
Home Equity Line of Credit Qualifications
Lenders offer HELOCs in a variety of ways, which means the qualifications you need to meet can vary depending on who you choose as your lender. However, there are a few general qualifications you can expect to be asked to meet if you're interested in applying for a HELOC.
First, you need to have good credit. Lenders want to know that you have a solid credit history of repaying your debts. It's crucial that you check your credit score and credit report before applying. You should take the time to clear up any discrepancies or pay off any accounts you owe money on that could be hurting your credit.
Next, you need the loan-to-value (LTV) ratio, which is the amount remaining on your mortgage versus the appraised value of your home. This will help lenders determine how much you can borrow. You'll need an LTV ratio of at least 80% to qualify for a HELOC with most lenders.
Your debt-to-income (DTI) ratio will also be considered. This is the ratio between your overall debts and your income.
In addition, your assets and sources of income will be considered. You'll need to show proof of a steady income that demonstrates you can repay the money you borrow. Assets you may have like a boat, car, rental property, or other investments may help lenders feel more secure about loaning you money.
Home Equity Line of Credit Costs
Getting a HELOC does come with a few costs you need to consider, similar to the closing costs you paid when you first obtained your mortgage. There's a property appraisal fee in order to get your house appraised and determine its current value. You'll usually have to pay a non-refundable application fee, which can vary depending on your lender.
Other fees include closing costs like attorney fees, title search, mortgage preparation and filing, and property and title insurance.
You may also have to pay fees throughout the life of the loan, including an annual membership or participation fee, and a transaction fee whenever you withdraw funds from the home equity line of credit.
Typically, a home equity line of credit's closing costs totals 2 to 5 percent of the loan. Feel free to ask your lender ahead of time so that you know how much to expect on closing costs. See if you can negotiate to get lower fees or if your lender can cover some of them.
The fees you have to pay could easily add to hundreds of dollars (or more) to the overall cost of your line of credit. So, if you only want to access a small portion of your equity, the extra costs associated with the loan could significantly increase the amount you have to pay.
On the other hand, interest rates tend to be lower for a HELOC, which can help keep costs down. Since you're putting your house up for collateral, the risk is lower, meaning that lenders can give you a better interest rate.
When Should a Home Equity Line of Credit Be Used?
A home equity line of credit can be used for various reasons.
Let's say you need to help fund your child's college education. Giving the rising costs of higher education and the student loan crisis, you can tap the equity in your home to secure a lower rate and a tax deduction while helping your son or daughter pay for college.
If you need to remodel your home, one of your best options will be to apply for a HELOC so you can get cash to complete the project, courtesy of your home's growing value. It should come to no surprise to homeowners that renovations can be costly and often unpredictable. With a line of credit, you can borrow only what you need as expenses come up.
Another good use for a HELOC would be if you wanted to utilize the lower interest rate to consolidate or refinance debt. If you have a high-interest auto loan or lots of credit card debt, getting a HELOC with a much lower interest rate can help you pay off your debt faster and save more money in the process.
If the value of your home is steadily growing while you pay your mortgage down and you have financial needs, but lack the cash to pay for them, a home equity line of credit can be a solid option that can help you to avoid the high-interest rates of personal loans and credit cards.