What's a HELOC Loan?
You’re a homeowner looking for loan. You’ve stumbled across the term HELOC loan and now you’re curious. What’s a HELOC loan and how can it help improve your home?
HELOC stands for: Home Equity Line of Credit. Home equity loans, including HELOC loans, allow homeowners to borrow money against the equity they’ve built up in their home. As with any type of loan, HELOC loans have their own set of pros and cons. Pros: there’s lots of flexibility for homeowners in borrowing, but cons: there are limitations and risks they take in doing so.
HELOC is a line of credit, and it’s a great idea for homeowners wanting to take on big house-related projects like a full-scale remodeling, repair or home improvement plan that would normally run up the expenses. Some examples of this are a kitchen remodel or roof replacement. Both of these can run a homeowner upwards of a couple of thousands of dollars.
How HELOC Works
If you’re interested in opting for a HELOC loan, you can expect it to work similarly to a credit card. There’s a credit limit to the amount borrowed as predetermined by the lender. As far as payments are concerned, the homeowners will pay the lender back the borrowed amounts plus interest. This is where the flexibility comes into play - homeowners have the option of withdrawing and making payments on a daily or even weekly basis.
The most variable factor is the HELOC credit limit. No two HELOC credit limits are the same, as it depends on numerous factors. In a similar fashion to other methods of borrowing, the lender will examine the credit standing of the homeowner in order to determine where the credit limit should be set at. One of these factors includes the homeowner’s credit (which includes credit score, credit history and the credit reports the lender can obtain) and unpaid debts.
However, it’s essential to note that no matter how good your credit is, the HELOC is capped by the amount of equity you’ve built. You could have a top-tier credit score and still wouldn’t increase your HELOC. For example, your home is valued at $500,000 and on your first mortgage you owe $400,000. Your home equity is valued at $100,000 - what you’ve paid thus far. However, you can stop dreaming about a credit limit of $100,000 because that’s not quite how banks work at lending out their HELOCs.
Banks will typically limit the amount you borrow to about 85% of the appraised value minus what you owe on your first mortgage, so this puts your HELOC credit limit at $40,000. That’s how banks get away with not lending you the complete amount of your equity.
The line of credit becomes available during what is called a draw period. The lender also sets the draw period, and it’s for the approved amount. The draw period is then followed by the repayment period. During the repayment period, there’s no longer the window of opportunity to take out more money on your line of credit. As the borrower, you must begin to and continue to make payments to whittle down the outstanding balance of your line of credit during this period.
The Length of a HELOC Loan
HELOC loans will vary in length, depending on both the lender and the borrower, but they can last as long as 30 years. This often includes a 10-year draw period and a 20-year repayment period, as the HELOC loan is split up into these two borrowing-repaying phases.
The draw period of a HELOC loan is usually 5 to 10 years. During the draw period, the borrower is only required to pay interested on their HELOC loan. The repayment periods are usually 10 to 20 years.
The repayment period requires the borrower to begin to make payments against the principal of their loan (the equation of these payments is typically a payment equal to the balance at the conclusion of the draw period, divided by the number of months in the repayment period). Some HELOC lenders require the balance to be paid in its completion at the end of the draw period and this could force them to refinance at this point of the loan.
Again, this is where HELOC loans become tricky, and borrowers must weigh the pros and cons before signing on. HELOCS can act like a second mortgage, and this is a lot to take on for the homeowner.
The Risks You Should Know With HELOC Loans
Taking out what's essentially considered a second mortgage is going to have its risks, and a HELOC loan is certainly not without them. With any loan, it’s always smart to understand the risks and advantages before becoming contracted with a lender, and a HELOC loan isn’t exception.
First, there are the additional fees. HELOC loans can include additional fees like annual fees, transaction fees and closing costs. This means, during your draw period, you could get slammed with fees when taking out funds, too. When researching HELOC loans, investigate the fine print as you would with any other loan and lender and pay attention to the various fees you could be seeing if you choose to sign with them. Some lenders are even open to negotiate, so don’t be afraid to ask.
Perhaps the biggest risk you’ll be taking is the most obvious one. A HELOC loan uses your own house as collateral. If you fail to make payments, you could lose your home. That’s a huge gamble, and when signing onto a HELOC loan, you absolutely must understand this first and foremost.
Another risk is the fluctuating interest rate. HELOC loans are directly tied to the prime rate, which won’t see change at all or can change multiple times in a year. The prime rate is affected by market factors that in turn, could also impact the HELOC’s interest rate over the course of its lifetime. If your HELOC loan is for 30 years, that’s an awful long time and a good possibility for exposure to change.
Is There an Alternative to a HELOC Loan?
A home equity loan is a cousin-loan to a HELOC. Like a HELOC loan, a home equity loan also relies on your home equity, uses your home as collateral, but the differences are stark. Instead, a home equity loan will pay out the funds in lump sums, up front, and for payments, there’s a set timeframe instead of relying on the borrower going through a draw period first.
The benefit of a home equity loan over a HELOC loan is also the interest rate. Unlike a HELOC loan, a home equity loan has a fixed interest rate, not a variable rate.
If you’re disciplined in financing and planning, there’s nothing wrong for opting for a HELOC loan. However, you have to be cautious about interest rates, market forces and understanding the consequences of falling back on your payments. HELOC loans have their advantages. Big projects can get done, expensive tuition can be paid and you can immensely increase the value of your home with a HELOC loan.