Home Equity Line of Credit

A “HELOC“, or “Home Equity Line of Credit,” is a type of home loan that allows a borrower to open up a line of credit using their home as collateral.

It differs from a conventional home loan for several different reasons. The main difference is that a HELOC is simply a line of credit that allows a homeowner to borrow up to a pre-determined amount set by the mortgage lender, whereas with a conventional mortgage, the amount borrowed is the total amount financed.

In other words, a HELOC is a lot like a credit card because of its revolving nature. When you open a credit card, the bank sets a certain limit, say $10,000. You don’t need to pay interest on the total amount, or even withdraw or spend any of the $10,000, but it is available if and when you need it.

That’s also how a HELOC works. Your bank or lender will give you a line of credit for a certain amount, say $100,000. And you can draw upon it as much as you’d like, up to that $100,000, if and when you want. It’s a good choice for homeowners because it gives them the option to use the line of credit if they need it, without having to pay interest if they don’t.

Home Equity Line of Credit vs. Home Equity Loan

With a conventional home equity loan, you receive a lump sum and make monthly mortgage payments on the total amount borrowed, usually at a fixed rate. A HELOC, on the other hand, not only gives the borrower the freedom to decide when and if to use the money, but also how much they need to pay back and when.

Term of a Home Equity Line of Credit

A HELOC normally has a 25 year term, with a draw period and a repayment period. The draw is typically the first 5 to 10 years, followed by the repayment period of 10 to 20 years. During the draw period, the homeowner can borrow as much as they’d like within the line amount, and can make interest-only payments on the amount drawn upon.

Interest Rate of a Home Equity Line of Credit

The HELOC interest rate is determined by the average daily balance and the prime rate plus the margin designated by the bank or lender. Most banks and lenders give borrowers prime rate with zero margin, or even less than prime. You’ll often see bank ads that say “prime -1%” or something to that effect. This is usually an introductory rate, and will often go up after the first few months.

If your loan scenario is a bit more high-risk, it could carry a margin of 4% or more, which when combined with the prime rate, can be quite hefty. Prime is currently 3.25%, so adding a margin of 4% would make the interest rate 7.25%, which isn’t a very desirable rate.

After the draw period, the borrower must pay off the principal of the HELOC, along with the interest. This period is known as the repayment period. Usually the loan balance is broken down into monthly payments, but there could also be a balloon payment because of the way the loan amortizes. Also note that some HELOCs don’t have a repayment period, so full payment is due at the end of the draw period.

Downsides of Home Equity Lines of Credit

Many borrowers steer clear of HELOCs for a number of reasons. The main reason being that a HELOC is an adjustable-rate mortgage, tied to prime. Whenever the Fed moves the prime rate, the rate on your HELOC will change. Usually it’s only .25% at a time, but the Fed raised the prime rate about 20 times in a row since 2004, pushing the rate from 4% to 8.25%, before it began to move the other way. So your interest rate can fluctuate greatly, even if the Fed moves prime in so-called “measured” amounts.

HELOCs generally adjust either monthly or quarterly, depending on the terms specified by the lender. Check your paperwork so you know what to expect after the Fed makes a move.

Also note that HELOCs don’t have periodic interest rate caps like standard adjustable-rate mortgages, just lifetime caps, so the rate can fluctuate as much as the Fed allows it to, up to 18% in California (it varies by state).

HELOCs also come with early closure fees of around $300, although they don’t usually carry a prepayment penalty.

Home Equity Lines of Credit Often Serve as Second Mortgages

Most HELOCs are set up as a line of credit behind an existing first mortgage. They are opened behind the existing mortgage as a source of funds to pay down credit cards or other revolving debt, or for home improvements and other household costs. HELOCs provides flexibility at a relatively low interest-rate compared to a standard credit card.

They can also be used as purchase-money second mortgages, meaning the full line amount is drawn upon at the time of closing. A purchase-money HELOC uses the entire credit line as a down payment, and the borrower must pay interest on it from day one.

For example, if a borrower wanted a zero-down mortgage on a $100,000 property, they would likely open a $80,000 first mortgage at 80 percent loan-to-value and a 20 percent second mortgage to cover the remaining $20,000.

Borrower generally choose HELOCs as purchase-money second mortgages usually because the interest rate is lower than those tied to fixed second mortgages. And a HELOC has an interest-only option which many fixed-end seconds don’t offer. HELOCs also don’t carry a prepayment penalty, whereas many fixed-end seconds do.

Some borrowers may even open a HELOC as a first mortgage, although it is less common and can be fairly risky for a homeowner.

HELOC advantages:

– lower rate than a fixed loan
– interest-only option
– no prepay
– ability to choose draw you want, when you want
– lower fees

HELOC disadvantages:

– adjustable rate
– no periodic caps on interest rate
– early closure fee
– minimum draw amounts


8 Comments

  1. Elizabeth Steiner Milligan February 21, 2016 at 1:45 pm -

    Thank-you Colin. What you said is what I thought but it made the world of difference to me to have your credibility behind it.

    Sure hope bankers don’t bundle HELOCs and sell them to pension funds and the government.

    I am a spec in the world of finance, but I need to watch out for that spec big time!

  2. Donna February 22, 2016 at 10:45 am -

    Colin,
    Thank you! The information you have provided has been very educational. May I have an opportunity to speak with you privately?

  3. Colin Robertson February 22, 2016 at 6:52 pm -

    Donna,

    I can barely keep up with the comments, but if you have a question go for it. I feel the public ones at least benefit more than just the person who asked.

  4. Colin Robertson February 22, 2016 at 7:20 pm -

    Elizabeth,

    I think the banks keep their HELOCs, which was a major problem for them until property values went back up. But fully-amortizing resets are still a potential problem for them.

  5. Donna February 23, 2016 at 10:19 pm -

    Colin,
    Of course….I understand. Looking for options to restructure an HELOC interest only into a term loan with a lower interest rate. HARP is in place to help consumers refinance Fannie Mae or Freddie Mac mortgages that are 80% loan-to-value and tied to higher interest rates than the current market. In this case, the Lender is not offering a “dig out” plan. Do you know of any recourse that a consumer would have against a situation whereby they have been disadvantaged and held to a high interest rate by the terms of a “variable” HELOC (6.75% floor rate), yet meet and exceed the qualifications outlined for HARP – specifically, never missed or was late on a payment, good credit score rating and 80% LTV? The Lender’s only “negotiation” with the borrower is to take further advantage of the situation and place them in a higher interest ARM plan.

  6. Colin Robertson February 24, 2016 at 7:00 pm -

    Donna,

    I assume most people who couldn’t get a loan mod or some sort of relief on their HELOC either walked away, foreclosed, short sold, or perhaps were able to gain enough equity over the years to consolidate the first and second mortgage into one new loan at a lower rate.

  7. Jane April 9, 2016 at 7:51 am -

    Colin,

    Why do banks almost insist you open a HELOC especially when they are aware you have paid off the mortgage.?

  8. Colin Robertson April 18, 2016 at 10:46 am -

    Jane,

    Probably to make more money like any other company that attempts to cross-sell products with the pitch that you can tap into your equity at any time to pay expenses and unforeseen costs that come up.

Leave A Response