A Complete Guide On Home Equity Line of Credit (HELOC)

A Home Equity Line of Credit (HELOC) is a useful tool that offers homeowners a flexible and convenient borrowing option. HELOCs have gained considerable popularity due to its numerous benefits. Understanding how a HELOC works, its benefits, risks, and eligibility requirements can help homeowners and investors make informed decisions about leveraging funds to grow their wealth. This guide will help you understand what HELOCs are, how to qualify, and how to use it. 

What Is A HELOC?

A Home Equity Line of Credit (HELOC) is a revolving line of credit that allows homeowners to borrow money against the equity in their homes. Equity is the difference between the current market value of the property and the outstanding mortgage balance. With a HELOC, homeowners can access funds up to a predetermined credit limit, which is typically a percentage of the home’s appraised value, minus the outstanding mortgage balance.

How Does A HELOC Work?

A HELOC consists of two phases: the draw period and the repayment period. 

During the draw period, which typically lasts 5 to 10 years, the borrower can access funds up to their credit limit and is only required to make interest payments on the amount utilized. 

Once the draw period ends, the repayment period begins, usually lasting 10 to 20 years. You cannot borrow against the line of credit any longer, and must start paying back the borrowed sum. During this time, the borrower must make both principal and interest payments on the outstanding balance.

How To Qualify For A HELOC

To be eligible for a HELOC, there are certain criterias that homeowners need to meet. This criteria will vary from lender to lender.

• Enough equity in their home that’s determined by the lender’s loan-to-value (LTV) requirements.. A primary residence will typically allow 80-90% while an investment property would be 65% to 75%. If a primary residence is worth $300,000 and the homeowner has 35% equity, the homeowner could be able to qualify for up to a $75,000 credit line for a 90% LTV.
• A stable income and the ability to demonstrate their capacity to repay the loan.
• Credit score must be good – most lenders require a score of at least 620.
• A low debt-to-income (DTI) ratio that is determined by lender requirements. This is a borrower’s monthly debt payments to their monthly gross income. The typical DTI maximum is 43%.

Benefits Of HELOCs

HELOCs offer flexible and accessible funds that borrowers can draw money from as needed during the draw period. The payments are interest-only payments during the draw period so it brings the monthly debt cost down during the draw period while the principal must be paid back during the repayment period.

Although the HELOC can be used for many purposes like home improvement, debt consolidation, and even other investments, the interest paid can be used for tax deductions if it’s used for qualifying home improvements.

Risks With HELOCs

While there are many benefits with using HELOCs, there are risks.

Improper use of a HELOC can have a drastic impact such as failure to keep up with payments leading to a potential foreclosure, variable interest rates that can be unpredictable, property values declines tied to the HELOC, and unnecessary debt. 

The biggest risk is not being able to make payments (towards interest or the principal amount). Because HELOCs are typically variable rate lines of credit, a jump in interest rates will increase your debt service and can become a huge financial burden, especially when there’s a big principal balance.

Below is an example of how this can happen:

Interest Rates and Fees

HELOC interest rates are typically variable, meaning they can change over time based on fluctuations in the market. Rates are often tied to a benchmark index, such as the prime rate, with the lender adding a margin. The specific rate a borrower receives will depend on their credit score, the loan-to-value ratio, and the lender’s terms.

Fees associated with HELOCs can include origination fees for the lender originating the loan, annual fees to maintain the line of credit, appraisal fees to determine the current property value, and closing costs for recording fees and legal fees.

Conclusion

A Home Equity Line of Credit (HELOC) offers homeowners a flexible and potentially cost-effective way to access funds. However, it’s important to understand the risks associated with a HELOC along with the terms and conditions set by the lender.

Before pursuing a HELOC, homeowners should carefully consider how they will utilize the line of credit to ensure it aligns with their long-term goal. Leverage can be a powerful tool to expand your real estate portfolio, but it can also hurt investors as it’s another debt to eventually pay off.