How Home Equity Lines of Credit Work

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By David

If you’re looking for ways to get cash to pay off your high-interest debts, a home equity line of credit (HELOC) could be just the ticket. Indeed, HELOCs are not just for home renovations.

In all, what you’d be doing is borrowing against the credit you’ve established in your home, which will be used for collateral. With that said, here’s how home equity lines of credit work.

What is a Home Equity Line of Credit?

As we say, a HELOC permits you to borrow cash from the equity built up in your home. Equity is the difference between the balance of your mortgage and your home’s value. If approved, you get a line of credit that you can use for significant expenses or to consolidate debts with generally higher rates. Such debts often include credit cards.

These loans typically carry a lower interest rate than many other loan types because your home is linked as collateral. So, you must make sure that you can make your payments.

In addition, the interest you pay may be tax deductible. Talk to a tax professional about the latest on that.

How Do HELOCs Work?

HELOCS work basically like a credit card in that as you repay what you owe, the amount of available credit you have gets replenished. Therefore, you can borrow against your equity as needed, in amounts that are up to you, up to the credit limit you set up at closing. The borrowing can occur throughout your draw period, which is usually 10 years. When that ends, the repayment period begins. That period lasts about 20 years.

How Do I Determine How Much I Can Borrow?

It’s a good idea to employ a HELOC loan calculator to figure out how much you can borrow via a HELOC loan, and view what your payments would be for a variety of HELOC loan options. In fact, you can use the efficient HELOC calculator.

What are Eligibility Requirements?

How much you can borrow hinges on your income, credit score and history, monthly debts, and your equity. First, just because you own a home doesn’t mean you have equity. Thus, the total you owe on your home must be less than your home’s value. Typically, you’re allowed to borrow up to 85 percent of your home’s value, less the amount you owe.

Your Interest Rate

It’s true that some lenders permit you to convert part of variable-rate balance on your home equity line of credit to a fixed rate. This means that your payments will be predictable, and you won’t have to concern yourself with upward spiraling interest rates.

More likely, your home equity loan will carry a variable line of credit, meaning that the interest rate can vary from month to month. Such a rate is figured using an index as well as a margin.

Banks use an index, which is a financial indicator, to establish rates on many disparate loans. Most banks use as their index the prime rate, which as of July 28th was 5.50 percent. The Wall Street Journal publishes a prime rate daily that is used by most banks.

Then there’s the margin, which is tacked onto the index and remains fixed throughout the loan’s life. The margin is the number of percentage points that are added to set your rate after the initial rate period ends.

Withdrawing Money

Withdrawing money from your HELOC triggers monthly bills that will include your principal and interest, as well as a minimum payment amount. Depending on your balance and rate, the amount due monthly may vary. The amount may also change if, when you can, you make extra payments on the principal. Doing so can help you save on charged interest as well as help you to pare your overall debt faster.

What Else Should I Know?

Be sure to ask your lender whether there will be any HELOC expenses such as an up-front fee, application fee, annual fee, or cancellation or early closure fee.

Now that you know how home equity lines of credit work, assess your financial situation, check your credit report, decide whether you want a variable or fixed rate, then try to line up a lender that suits your needs.