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What is a Home Equity Line of Credit (HELOC)?

definition

A home equity line of credit (HELOC) is a revolving line of credit secured against the equity (non-mortgaged value) of your home.

🤔 Understanding a home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a revolving source of funds using your home as collateral. The amount you can borrow with a HELOC is a percentage of the equity of your home. The percentage rate offered by your bank depends on factors such as the home itself and your credit. Each bank sets internal standards for that bank. The usual limit is around 85% of home value minus the debt owed on your first mortgage. A HELOC has both a credit limit and a time limit, also known as a draw time. The draw time is the length of time the loan is usable. During the draw time, you can borrow, repay, and borrow again, paying only interest on the amount borrowed. After the draw period, payments on the principal and interest are made.

example

Suppose John and Jane Doe own a home with a modest mortgage. Their first child, Joe, wants to go to college, but John and Jane don't have the funds. To pay for tuition, they take out a HELOC based on the equity in their home. A few years later, after repaying most of the money borrowed from the HELOC, they decide to remodel the bathroom, so they use the remaining balance in the HELOC to pay for the home remodel. This time, they choose to continue to make interest payments and do not pay back the principal until the payment period begins.

Takeaway

A home equity line of credit (HELOC) is like a credit card…

Credit cards are short term loans you can reuse. Your credit card has a spending limit (the credit limit), and you can spend any amount up to that limit. Then, after paying off some of the debt, you can reuse the available amount again. A HELOC lets you use a portion of the equity in your home as a credit limit and spend within that limit.

Tell me more...

How does a HELOC work?
What can a HELOC be used for?
What does a HELOC cost?
What is the three-day cancellation rule?
What is the difference between a home equity line of credit (HELOC) and a home equity loan?
How do you calculate home equity?
How much can I borrow with a HELOC?
Is a HELOC a good idea?
What are some alternatives to a HELOC?
Is interest on a HELOC tax-deductible?

How does a HELOC work?

A HELOC gives you access to funds borrowed against the equity in your home. It is a credit line you can use over and over for a set time. After application and approval, the loan has two periods — a draw period and a payment period.

During the draw period, usually, you may get money and spend money against the loan total at any time. Some loans may require minimum withdrawals. Most lenders provide a debit card or checkbook for you to access the funds. Payments for the interest on the amounts spent (not the full loan limit) will be charged, although some lenders also require principal payments at the same time.

During the draw period, borrowers can repay part (or all) of the borrowed funds and then reaccess the loan funds for other expenses, but each lender may have limits or conditions on the process. The draw period of a HELOC might be nearly as long as a mortgage, sometimes 20 years.

The principal and some interest are repaid on each payment in the repayment period, just like other mortgage monthly payments. However, the repayment period is sometimes a single pay off date rather than a length of time to make payments — Balloon payment HELOCs may require the repayment of the entire outstanding borrowed balance as one lump sum payment at the end of the draw period.

What can a HELOC be used for?

Home equity line of credit (HELOC) loans have unlimited uses. However, because it uses your home as collateral, most only use it for expenses out of reach by other methods. Typical uses include large projects related to the home or significant household expenses.

Home improvements, remodeling, and home additions to the property securing the loan are common, especially later in the primary mortgage when roofs wear out and kitchens or baths are considered out of date. The ease of accessing funds to pay multiple bills and interest rates often lower than credit cards puts debt consolidation as another everyday use for a HELOC.

What does a HELOC cost?

Like a mortgage, the cost of applying for a HELOC may include an application fee, title search, appraisal, attorneys' fees, and points (a percentage of the loan amount as a fee to get a better interest rate).

Other fees, such as annual membership or participation fees and transaction fees each time you access the loan value, may also be charged by the lender for the life of the loan. The Federal Truth in Lending Act requires that lenders tell borrowers loan terms at the time of application and that terms can not be changed (with exceptions for variable rates) between application and closing.

Interest rate terms and repayment terms affect HELOC costs. HELOCs can have variable interest rates or a fixed APR, although variable rates are more common. Repayment terms vary, but balloon payments (lump sums) at the end are most common. Some loans may include penalties on late repayments during the draw period or during the repayment period if it is not a balloon payment.

What is the three-day cancellation rule?

Complex loans can create misunderstandings at times. The United States government provides a way out for borrowers who decide they've misunderstood a loan or just have second thoughts. The three-day cancellation rule allows most borrowers using their primary residence for loan collateral to cancel the loan without penalty.

The clock starts on the three days as soon as you sign the contract, receive a Truth in Lending disclosure form showing the terms of the loan, and you are given two copies of the Truth in Lending notice that includes your right to cancel.

Once the clock starts, borrowers have until midnight on the third business day to cancel. Under the rule, Saturdays are considered business days, but national holidays and Sundays are not. In order to cancel, the notification must be made in writing (either mailed, electronically, or delivered in person) before the deadline.

What is the difference between a home equity line of credit (HELOC) and a home equity loan?

Both home equity loans and home equity lines of credit (HELOCs) are forms of loans using the equity in your home as collateral. Both are secured by your home and work based on a percentage of the equity in your home. Both include closing costs and fees. Failure to repay either loan puts your home at risk of pre-foreclosure and foreclosure.

While a HELOC lets you borrow, repay, and borrow again, a home equity loan is a lump sum loan paid at one time. Home equity loans usually offer fixed interest rates with regular payments instead of the variable interest rates and balloon payments frequently found with HELOCs, often making figuring monthly payments easier.

How do you calculate home equity?

The equity in your home means the market value of your home minus debt secured by the house. Often, only the first mortgage counts towards the liability for the home equity calculation. Note that it is current market value, not what you paid for the home, that determines equity. Home equity changes over time as both debt and markets change.

For example, a house with a $500,000 market value and a $300,000 mortgage balance has $200,000 home equity. Paying down debt increases home equity. However, downturns in market value decrease equity, sometimes severely.

Negative equity, owing more than the home is worth on the market, often happens through a combination of heavy borrowing and market downturns. An often overlooked part of market value, when looking at home equity, is home condition. Poorly maintained or damaged homes suffer from lower market values compared to similar homes in good condition.

How much can I borrow with a HELOC?

Before the real estate bubble collapsed in 2008, many lenders offered HELOCs of 100% or more of home equity. When the value of the home market dropped suddenly, many borrowers were left upside down in their mortgages and HELOCs, that is, they owed more than the home's current real estate market value — Their homes had negative equity. Many foreclosures followed that collapse.

New regulations and lender caution led to caps of 80% to 85% for most borrowers. The exact percentage offered usually varies by lender and their underwriting standards. Your income, other debts, credit score, condition of the home, and other factors make up likely items considered when a lender evaluates your application. Rarely, a lender may offer a HELOC or home equity loan based on future home equity value. These offers carry a lot of risks as future home equity value isn't guaranteed.

Is a HELOC a good idea?

HELOCs aren't for everyone. There are both pros and cons to HELOCs.

Pros:

Lower cost interest compared to credit cards often counts as the first pro for HELOCs. Flexibility is another big plus — If a homeowner already has an open HELOC when an emergency hits, it may offer a fast way to pay for medical bills or other unexpected expenses, hopefully, to be paid off quickly. The ability to borrow only part of the HELOC value, repay part of it and reuse it offers a flexibility that makes it a valid option that is simple to use for many homeowners, especially for significant home improvement projects. In some cases, such as using the HELOC funds for home improvement, interest on the loan may be tax deductible at the end of the year as well.

Cons:

However, cons of HELOCs are equally strong. HELOCs are not without risk. Since your home secures a HELOC, the risk of losing the home through foreclosure is very real. For most consumers, risking the house to pay for a car or other temporary items doesn't make sense. Balloon payments at the end of the loan, initial closing costs, fees, and variable interest rates are also concerns that can outweigh low interest rates. It also bears noting that even though home improvement projects might raise the value of the home, a market downturn could still put the house into negative equity if too much was borrowed earlier. Finally, slow loan approval times for HELOCs may lower usefulness to homeowners if funds are needed quickly.

What are some alternatives to a HELOC?

HELOCs are only one loan option. When considering a loan using your home as security, refinancing, second mortgages (a mortgage taken out on home value in addition to the primary mortgage), and home equity loans — a lump sum loan against home equity — are alternatives.

For refinancing, sometimes, the house can be refinanced for less than is currently owed with cash returned for the extra amount. Common unsecured loan options include credit cards and personal loans.

Personal loans usually aren't secured, but a lender might offer a secured personal loan at times. Often, these have higher interest rates than mortgages and shorter terms, but involve fewer fees.

Credit cards, notorious for high interest rates, offer revolving credit (borrow, pay, borrow again within a limit) and quick approvals. However, many credit cards do not charge interest on purchases paid for before the next billing cycle, so they can be an excellent short term option for those disciplined enough to pay them off each billing cycle.

Is interest on a HELOC tax-deductible?

In many cases, the interest from a HELOC is tax-deductible. The Tax Cuts and Jobs Act of 2017 allows deducting HELOC interest, but only if the funds were used to improve the home securing the HELOC, or used to buy or build the house used to secure the HELOC.

For example, if you added a garage onto your home using a HELOC, the interest would probably be deductible. However, if you used the funds to pay college tuition, the interest paid on the HELOC might not be deductible. The new law keeps former regulations requiring the HELOC to be secured by the primary or secondary home (called a qualified residence), and it has restrictions on amounts of the loan as well. You should work with your tax advisor concerning your specific situation.

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