What Is A HELOC and is it Right For You?

Posted by Justin Nolette on April 9, 2018

A home equity line of credit (HELOC) is one way homeowners can take advantage of the equity they have in their home without having to sell the home. It’s often referred to as a second mortgage. They’re appealing because they tend to have lower interest rates than more traditional types of loans, but the devil is in the details. Learn more about them to find out if a HELOC is right for you.

How HELOCs Work

Equity is the amount of your home you actually own. You get this figure by subtracting the current balance on your mortgage from the home’s value. A homeowner who still owes $150,000 on a $400,000 home, for instance, would have $250,000 equity in the home.

When you get a HELOC, the lender will usually allow you to borrow the amount of equity up to 85 percent of the value of the home. In the above example, 85 percent of the home’s $400,000 value is $340,000. Since the homeowner still owes $150,000, you subtract that amount. This means the homeowner would probably be able to borrow up to $190,000.

Even though the equity is technically your money, a HELOC is like a loan in that you have to pay interest on the money you’re borrowing.

The Difference Between a HELOC and a Home Equity Loan

When you get a home equity loan, you get a lump sum of money on which you make instalment payments. HELOCs are a line of credit. They’re more like credit cards. You have an upper limit, but you simply use the HELOC to make purchases. Usually, this means you’re spending only what you need, so you save on interest. You still have to make monthly payments on the amount you borrow.

What Is A HELOC and is it Right For You Concept ImageImportant Things to Consider

Many HELOCs come with variable interest rates. The initial rate may be low, but if rates go up, your monthly payment will also go up. Interest rates are tied to your credit score, so you may not qualify for the best rates. You’ll also have to pay certain fees when getting the HELOC, similar to the fees you had to pay when you took out your mortgage.

Why You Might Want a HELOC

Many people use HELOCs to make improvements or repairs to their homes. If you’re getting ready to sell your home, the HELOC will allow you to replace the roof or update some of the design elements. It’s rare to fully recoup your costs but fixing your home up and making it look appealing can help make a quick sale.

Sometimes, people use HELOCs to make a larger down payment on a brand-new home. If you were to build a new home, you may have to wait up to a year for the home to be built. You need to stay in your home during this time, but you also need to make a down payment to the builder. A HELOC makes this possible without tying up your current cash reserves. Once the new home is ready, you can sell your home and easily pay off the HELOC.

Possible Disadvantages

People who use HELOCs to get their home ready for a sale occasionally feel the pinch if the home doesn’t sell as quickly as they’d hoped. You’re responsible for making monthly payments until you sell the home, so you need to be certain your budget can handle this expense.

There’s also the possibility of the home losing some of its value or simply not selling for as much as you thought. That’s why the lender will usually only let you borrow up to 85 percent of the home’s value rather than the 95 percent loan-to-value ratio they allow with a traditional mortgage. However, home values sometimes dip below that, and some borrowers find themselves owing more than the home is worth.

Applying for a HELOC

If you’ve decided a HELOC is right for you, it’s time to start shopping around. You do not have to use the same bank that holds your current mortgage, though it’s always smart to check with them as they might have good deals for loyal customers. As you look at lenders, pay attention to the interest rates and any fees you’ll have to pay. For instance, some HELOCs come with an early penalty fee. If you’re hoping to use the money to fix up the home and sell it in a few months, you might be paying this fee.

HELOCs are the right choice for homeowners who need to access the equity they have in their homes while still living in them. A good lender will help you understand the options available to you.

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Photo credits: money, concept

Tags: buying new home

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