What Is a Home Equity Line of Credit, and How Does It Work?
Unlike a loan, which provides a lump sum of cash, a line of credit is revolving. This means you can periodically borrow against it in varying amounts, up to a certain limit, also known as a credit limit. While a loan begins accruing interest on the full amount immediately, interest on a line of credit only applies to the amount borrowed in any given month, also known as a balance.
This is how credit cards operate: every transaction you charge to a credit card borrows against a line of credit. Your monthly bill shows how much you must repay, as well as your minimum monthly payment, and any interest. However, another common line of credit uses home equity to set your credit limit.
Table of Contents
- 1 What Is a HELOC?
- 2 How Does a Home Equity Line of Credit Work?
- 3 How To Get a Home Equity Line of Credit
What Is a HELOC?
A home equity line of credit (HELOC) is similar to a home equity loan, with a few minor differences. They both use the equity of your home to secure a loan with a lower interest rate, but a HELOC allows for more wiggle room on how much money you borrow at a time.
HELOC vs Mortgage
As you pay off your mortgage, you begin to build equity on your home. Equity is the difference between the value of your home and the amount of your mortgage that you’ve paid off. As you pay off your home, the part of your home you’ve paid off becomes a dollar amount that lenders are willing to trust you with as a loan or line of credit.
A mortgage is the initial bank loan taken to purchase a home that the homeowner is responsible for paying back, usually throughout the span of one to three decades. Depending on your credit score, a bank will loan you enough to purchase a home in a manageable price range for your income. The interest rate will vary based on your credit score, and the kind of home you’re buying.
A HELOC is a type of second mortgage that uses the part of your home that you own to secure a second loan at a lower interest rate. This line of credit has a limit that is usually about 80 percent of the equity you have gained, and it can be used as needed, which means the interest you pay is lower than the interest for a lump sum loan, like a mortgage.
HELOC vs Home Equity Loan
A home equity loan is a lump sum loan that a bank provides with a low interest rate by using your home as collateral in case you are unable to pay back what you’ve borrowed. This lump sum often comes with either a variable or fixed interest rate, and is paid back over a period of several years, similar to a mortgage.
A HELOC also uses your home to secure the loan and lower interest rates, however, they more commonly come with a variable interest rate, as the repayment plan is based on when and how much of the line of credit you use. The interest you end up paying on a HELOC is often lower than that of a home equity loan, because although you have access to the funds approved by the bank, you are not paying interest on a lump sum of money.
How Does a Home Equity Line of Credit Work?
Home Equity and Credit Limits
To be eligible for a HELOC, you usually need to have at least 20 percent equity in your home. Your credit limit depends on the amount of equity you have, and goes up and down as you borrow and repay the credit available to you.
If your lender allows you to access 85 percent of your home’s equity, you could determine your credit limit by calculating that to the value of your home and subtracting your mortgage balance. If you have a $300,000 home with a balance of $100,000 on your first mortgage, you could establish a HELOC for $155,000:
$300,000 x 85% = $255,000
$255,000 – $100,000 = $155,000
Home Equity Line of Credit Interest Rates
To find the best interest rate and plan that works for you, you should shop around and compare at least a few different lenders, starting with your current bank. The more research you do, the better deal you’ll find. For the lowest rate possible, make sure your credit score is in good shape and take care to pay any outstanding bills that may be affecting it.
As you get quotes from lenders, ask and take note of introductory offers and discounted rates that expire at the end of a given term. These are not the rates that matter when you are paying off a large sum of money. When working with variable interest rates, it’s important to check the caps on your interest rate to determine your ability to pay off the loan.
Paying Off a HELOC: Draw Period and Repayment Period
The draw period for a HELOC refers to the term of the loan in which you may use the line of credit, and the repayment period is the time after the draw period, in which you pay back what you borrowed. This can be anywhere from five to ten years. If your HELOC offers interest-only payments, you have to be diligent about paying the balance down regularly to regain your equity. Because you are using your house as collateral, ask about the conditions in which the lender can consider you in default and demand immediate full payment.
Using HELOC To Pay Off a Mortgage
You can use a HELOC to pay for anything you want, although it should really not be used for casual spending. Some common uses are home improvements or renovations, big purchases (such as a vehicle or other property), college tuition and debt consolidation. Depending on the lender, you may have access to your line of credit through a checkbook, an online transfer option or even an access card that works like a credit card and can be used to withdraw funds. This means you can use a HELOC to pay off a mortgage, although this can be risky with a variable interest rate.
How To Get a Home Equity Line of Credit
To open a home equity line of credit, some lenders will require a minimum credit score. You will also need a base level amount of equity in your home. You should note that once you use a HELOC, you’ll have less equity in your home and the bank will own part of your equity until your loan is paid back. The bank may require you to make an initial draw on the line of credit of a few thousand dollars to ensure you use the line and that they make money off of it.
Although it’s good to have an emergency fund, it’s typically a good idea to avoid getting a home equity line of credit unless you really need one. You should not use your home as collateral for a line of credit if you are a compulsive spender, as this can put your home at risk of foreclosure. If you’re considering a HELOC, take your time to shop around and understand the rates you may be paying in the future and the regulations surrounding the loan.
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This post was updated September 17, 2018. It was originally published August 23, 2018.