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 equity 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 a homeowner can draw from, up to a pre-determined amount set by the mortgage lender, whereas with a typical 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 balance nature. When you open a credit card, the bank sets a certain credit 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 or as little as you’d like, up to that $100,000, if and when you want.
Generally, you will be required to make an initial minimum draw, say $10,000 or $25,000, depending on the total line amount. This ensures the bank actually makes money on the transaction, and doesn’t just give you a line of credit you never touch.
At that point, you can borrow from it, pay it back, and then borrow again. Or never touch it and just set it aside for a rainy day.
Additionally, most HELOCs allow you to make just the interest-only payment, instead of having to pay back the principal. This keeps payments low while also giving homeowners access to much needed cash.
It’s a flexible choice because you get the option to use the line of credit if you need it, without having to pay interest if you don’t.
Most people use the funds to pay for things like college tuition, home improvements, higher-interest rate debt, or to fund another home purchase.
Accessing Your Funds with a HELOC
Once your HELOC is open, you’ll have a variety of options to access the funds.
Most banks will provide you with an access card that works kind of like an ATM debit/credit card. You can make purchases with it and/or withdraw cash at a branch location.
You may also be given the option to transfer funds to a linked bank account, or be given checks that can be written to anyone for any purpose, which are deducted from your credit line.
There may be a bill pay option if you want to use the funds to pay bills, or an option to transfer funds over the phone.
In any case, it should be pretty easy and convenient (and usually free) to access your money.
Interest Rate on a Home Equity Line of Credit
A HELOC’s interest rate is determined by the prime rate plus the margin designated by the bank or lender.
Many banks will offer borrowers the 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. Of course, this is usually an introductory rate, and will often go up after the first few months or year.
After that promo period, expect a margin greater than zero plus prime. For example, you might see something like prime + 2%. Prime is currently 4.25%, so the fully-indexed rate would be 6.25%. A well-qualified borrower may get a rate as low as prime + 0.5%.
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. That would make the interest rate 8.25%, which isn’t a very desirable rate.
When shopping for a HELOC, pay close attention to the margin since it’s the one number that you can control. The prime rate is the same for everyone.
Tip: Ask for the margin during the draw period and the repayment period. Sometimes lenders will impose a higher margin during the latter period, which can get expensive!
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).
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. There is usually a minimum payment, just like a credit card.
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 simply due at the end of the draw period.
Home Equity Lines of Credit Often Serve as Second Mortgages
Most HELOCs are opened behind an existing first mortgage as a source of funds to pay down credit cards or other revolving debt, or for home improvements and other household costs. HELOCs provide flexibility at a relatively low interest-rate compared to a standard credit card.
They can also be used as purchase-money second mortgages to extend financing and allow the homeowner to put less money down on a hom purchase.
In this common scenario, the HELOC utilizes the entire credit line as the down payment, and the borrower must pay interest on the full amount from day one.
For example, if a borrower wanted a zero-down mortgage on a $100,000 property, they could open a $80,000 first mortgage at 80 percent loan-to-value and a 20 percent second mortgage (the HELOC) to cover the remaining $20,000.
Some borrowers may even open a HELOC as a first mortgage, although it is less common and can be fairly risky for a homeowner if the prime rate rises rapidly.
Home Equity Line of Credit vs. Home Equity Loan
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.
Borrowers generally choose HELOCs as purchase-money second mortgages because the interest rate is lower than closed-end fixed second mortgages.
And HELOCs have an interest-only option which many fixed-end seconds don’t offer. HELOCs also don’t carry prepayment penalties, whereas many fixed-end seconds do.
Once the borrower pays down the HELOC, they also have the option to draw upon it again if they need additional funds, something a home equity loan doesn’t offer.
Common HELOC Fees
Another negative to HELOCs are the associated fees. Some of them require you to order an appraisal, which can amount to several hundred dollars. Others will charge closing costs and an origination fee.
There may also be an annual fee on your HELOC, which could range from $50 to $100 or more per year. Over time that can add up.
HELOCs also tend to come with early closure fees of around $300-$500, although they don’t usually carry an explicit prepayment penalty.
This means if you close your equity line just 1-3 years into the loan, the bank will charge this fee. Again, they want to make money off the deal, so if you close the line too quickly, they’ll probably charge you for it.
Sometimes the fee will be equivalent to what they would have charged for closing costs. For example, they may say you can get a HELOC without closing costs, but charge you those fees later if the line isn’t kept open for a minimum period of time.
– lower rate than a fixed loan
– interest-only option
– no prepay
– ability to choose draw amount you want, when you want
– able to borrow multiple times from same line
– lower closing costs
– adjustable rate
– no periodic caps on interest rate
– rate can adjust much higher
– early closure fees
– minimum draw amounts
– annual fees