What Is a HELOC?
07/06/2018 Jerrica Kowcheck
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A Home Equity Line of Credit (HELOC) is one of the most common ways to borrow money against the value of your home. It is similar to a credit card in that you can use it to buy things that you need now, and repay it with interest at a later time. Obtaining a HELOC requires (among other factors) that you have reasonable equity in your home.
What is Equity, and How Can You Access it?
Equity is the value of your home above and beyond what you still owe on your mortgage. For example, if your home is worth 200,000, and you only owe 100,000 left on your mortgage, you have 100,000 in equity. Equity can also be discussed in terms of LTV ratio, which is calculated by dividing your loan balance by the current value of your home. In the example above, you would have 50% loan to value.
Equity is a big part of why buying a home is considered to be a good investment—paying off part of your mortgage each month allows you to increase your net worth automatically. It’s a fairly effortless way to save, but what if you want to access some of those funds you have saved up?
Home Equity Loan vs HELOC
The two most common options for getting cash based on equity are a home equity loan or a HELOC. What are the differences?
A home equity loan is a type of "closed-end" credit (similar to the first lien you have on your home). Similar to a mortgage, you apply, receive a single large payment, a fixed interest rate, and fixed monthly payments to repay the loan.
A HELOC is a type of “open-end” credit similar to that of a credit card, albeit secured by the home. HELOCs are more flexible than home equity loans in that you can use them as little or as much as you need to, and once you make your payments the credit is there for you to use again and again.
As mentioned above, a HELOC has more in common with credit cards than home equity loans. Many HELOCs even come with a card (or checks) that you can use to make purchases. HELOCs will also impact your credit in the same way as any other loan or credit card: it can increase your DTI ratio.
You will need to pay interest on your HELOC, but that interest may be tax deductible under the new tax law if you use your HELOC funds to update or improve the home that secures the loan.
For HELOCs, most homeowners will need to have at least 80% LTV in their home. To use the same example of a $200,000 home, owing less than 160,000 on your mortgage should make it fairly easy to access some of the equity in your home.
As with any loan or line of credit application, lenders will also look at other factors, such as your total DTI ratio, household income, and credit score. You may also have to pay certain fees similar to mortgage closing costs.
It’s also important to remember that HELOCs come with risks. If you can’t make your payments, you could lose your home as HELOC default is grounds for foreclosure.
HELOC on Investment Property
If you have an investment or rental property, a HELOC might sound like a great way to update that property. However, many lenders will not offer HELOCs on investment properties. In order to get one, investment property owners may need to clear significant hurdles such as showing that they have liquid funds equal to the HELOC, or a higher LTV ratio.
Want to get into the investment property game? Check out these tips from real estate investing experts.
Draw and Repayment: Two HELOC Terms You Need to Know
Once you have applied for and been approved for your HELOC, you can start using it. This first period of spending is called the draw period. It can last between five and ten years, depending on your HELOC terms. During the draw period, your lenders may allow you to make small interest-only payments.
The next stage is called the repayment phase. This is when you might be required to make a large, lump-sum payment on your HELOC balance. You also may need to begin making regular monthly payments toward the total principal and interest. If you do decide to take out a HELOC, make sure that you have budgeted for and are ready for the repayment phase.
Some homeowners may choose to keep their line of credit active and continue the draw period. Your lender may be willing to do this, provided that the equity in your home (and your credit score) are still in good shape.
HELOCs aren’t the only way to get money from your home: Cash-Out Refinancing is another option to explore, and may better suit your financial situation.
The Best (and Worst) Ways to Use Your HELOC
Although most people use their HELOC to pay for home renovations or repairs, there are actually no limits on what you can use your home equity line of credit to pay for. However, just because you can use it for anything, doesn’t mean you should. Instead of buying a boat, for example, first consider these budget-friendly uses of your HELOC funds:
- Home renovations or repairs that increase the value of your home
- Paying down debt with higher interest rates
- Access to emergency fund cash that prevents taking on high interest debt
In contrast, it is not always the best idea to buy a car, pay for a big vacation, or buy other consumer goods with a HELOC. Unlike the items above which will add value to your home or improve your overall financial health, vehicles begin depreciating immediately and a past vacation has no financial value.
Want to renovate using a HELOC? Not all remodels are created equal; find out if your renovations ideas are an ROI-worthy investment.
Can a HELOC Help You?
In a healthy housing market, many homeowners find themselves with large amounts of home equity that could be used to fund valuable projects. If you want to put your investment to work for you, a HELOC can be an easy way to access the funds you need. To learn more about your options, contact a PennyMac Loan Officer.