A detailed overview of what is a Home Equity Line of Credit? A loan that allows you to borrow against your home value to access money whenever needed.
If you are planning to have some home renovations, starting a small business, or looking for ways to get money to cover some significant medical expenses or paying for your kid’s college. In that case, you might want to think about utilizing the facility of home equity loans.
You can acquire home equity financing in two ways; loans and lines of credit. Home equity loan allows you to get a total amount of loan upfront, whereas the lines of credit offer a continuous source of financing that you can draw whenever needed.
Home equity and home equity lines of credit are types of loans that require your house as collateral. If you have paid a considerable portion of your mortgage, both kinds of loans can be a great source of borrowing money. Most home equity loans and home equity lines of credit permit you to borrow up to 85% of the value of your home. Your outstanding mortgage balance is subtracted from this amount. Since you use your home as collateral, equity loans and home equity lines of credit usually offer lower interest rates with fair policies.
Let’s have a detailed overview of what is home equity? What are home equity loans, and how does the home equity line of credit work?
What is equity in a home?
One of the most significant benefits of being a homeowner is that you can build equity over time. Equity can help you secure low-interest loans for your major expenses in the form of a second mortgage. These low-cost loans can be equity loans or lines of credit.
So the question is, what is equity in a home? Home equity is the value of your interest in your house. In simple terms, home equity is the difference between the fair market value of your home and your outstanding mortgage balance. Home equity is considered as a part of your net worth because it is basically your stack in your home.
How to calculate your home equity?
As complex as it seems, calculating home equity is not at all a challenging task. Anyone can calculate their home equity. Home equity can be determined in two ways; in percentage and total amount. The formula is easy.
If you want to calculate your home equity percentage, you will simply divide your current mortgage balance by your home fair market value. For example, your current mortgage balance is $200,000, and your home’s market value is $800,000. Your home equity percentage will be $200,000/$800,000 = 25%. This percentage is usually sufficient to qualify for a home equity line of credit or loan, as most lenders demand at least 20% equity.
Another way of calculating the home equity is by subtracting the amount of all the loans you secured over your house from its fair market value. For instance, you owe $150,000 on the mortgage for your home, and the fair market value of your home is now $500,000. Your home equity will be $500,000 – $150,000 = $350,000.
What are home equity loans?
A home equity loan is a secured loan that offers a fixed amount of money against your home equity. Home equity loans have fixed interest rates and repayment terms. It works similar to your original mortgage terms as you pay the loan back in equal and fixed monthly payments over a specified period of time. If, for any reason, you are unable to pay the loan as agreed in terms and conditions, your lender can take possession of your property.
The amount you are allowed to borrow as a home equity loan is restricted to 85% of the equity in your home. It also depends on your monthly income, the market value of your home, and your credit history. The interest rate of the home equity loan also depends on your credit history, regular income, payment history, and the total amount of the loan.
The spending of the borrowed money is not restricted by the terms and conditions of your lender. It is totally up to you how to spend the amount of the loan. You can use it for some major improvements in your home, buying a vehicle, paying for college, paying for another debt or its interest, or any other significant expense that is heavy on your pocket.
Once you have decided to get a home equity loan, choosing a lender is the first and foremost task at hand. You must ask around and consult with friends and family for recommendations and suggestions for lenders. You may also find brokers during the search process but be very clear about this thing that brokers can only help you in arranging the loan; they are NOT lenders. For choosing the most suitable lender, you should talk to mortgage companies, credit unions, banks, and savings and loans. After collecting the information, compare the terms and conditions of all the available lenders and decide the best one for you.
Thoroughly ask questions about the loan plans offered to you. Only knowing monthly payments and interest rates is not enough for you to successfully go through the whole loan process. Lenders could mean very high costs as well. Ask detailed questions about your annual percentage rate. Also, pay attention to various kinds of fees you will be giving, including processing, documentation, appraisal, funding, and brokers.
Another thing you must take into consideration is your credit score. Creditors use a credit scoring system to decide whether to sanction you a loan or not. Your credit score involves information about your credit experience, bill payment history, late payments, the accounts you have, how long you have had these accounts, and your outstanding debts. A credit scoring system awards points for each factor that helps determine which candidate is most likely to repay the loan. Your credit score profile is compared with the candidates having similar profiles. The more creditworthy you are, the better your chances are to get a loan.
To avoid the troubles you will face if your loan application gets rejected by a lender, you should always negotiate with more than one lender. Discuss their fee, repayments, and interest rates and assure them that you are the best person to get in business with.
What is a home equity line of credit?
A home equity line of credit is a line of credit that works on the exact mechanism as a credit card. HELOC is a revolving line of credit in which you can borrow a specific amount of your home equity whenever the money is needed. Unlike home equity loans, HELOC offers you to borrow the money whenever you want and repay in installments slowly over a period of time, usually with a variable interest rate.
If you opt for a HELOC, you get a handy emergency source of money as you can borrow as much money as you need at any particular time. Most banks allow you to use several ways to access that money, whether by writing a cheque, making an online transfer, or using a credit card linked with your account. The only limitation is that you cannot exceed your credit limit. The most considerable convenience in HELOC is that you only have to make payments on the amount you have borrowed, not the total amount under your credit limit.
Some home equity lines of credit also offer certain kinds of tax benefits. You must consult a tax consultant for the details of tax benefits before signing into a home equity line of credit. Similar to home equity loans, HELOC requires your home collateral against the money you get. Therefore, if your repayments are late or, for some reason, you are unable to pay the money back, this will put your home in jeopardy.
If your home equity line of credit has a large balloon payment ( a lump sum due at the end of a loan) in its terms and conditions, you might have to take another loan to pay for that or put your house at risk. If you plan to sell your home, most HELOCs require you to pay off your credit lines at the time of the sale.
Home equity loan vs. line of credit: Which one is better?
Home equity and home equity lines of credit both can be excellent and secure options to acquire money in the time of need. Home equity allows you to obtain a loan of a lump sum amount, whereas HELOC will enable you to take out money whenever needed, under your credit limit.
Whether getting a home equity loan or a HELOC depends on your needs and financial situation. Let’s draw a comparison between home equity loans and home equity lines of credit which will help you choose the right type of source of funding for you.
A home equity loan is better if;
- You have an exact estimate of the amount required for any project and need to borrow the total amount.
- You are comfortable with a fixed interest rate throughout the repayment period.
- Your lifestyle and income support a fixed monthly payment.
- You plan to merge a high-interest credit card debt at a lower interest rate and repay it with fixed repayment terms.
A home equity line of credit is better if;
- You prefer the luxury of borrowing as much or as little as you want and whenever you need it.
- You don’t have any issue with fluctuating repayments or variable interest rates.
- You have some upcoming expenses coming in, and you don’t want to borrow money before you are ready.
- You want to pay interest only on the amount you draw.
How do you qualify for a home equity line of credit?
The basic requirements to qualify for a home equity loan and home equity line of credit are almost the same. Although the terms and conditions vary by lenders, there are some common factors that help in determining the qualification criteria of HELOC and home equity. These factors are the percentage of equity in the home, low debt-to-income ratio, good credit history, reliable sources of income, and an overall credit score.
Equity is the difference between your home’s market value and the amount of mortgage you owe. This is one of the essential calculations that lenders consider critical in determining whether or not to lend you the money. The equity percentage helps in generating the loan-to-value ratio (LTV).
For calculating LTV, let’s suppose you have a $100,000 loan balance and the value of your home is $400,000. Your LTV will be $100,000/$400,000 = 0.25 or 25%. Since your LTV ratio is 25%, which means your equity in the home is 75%.
The LTV also helps in determining how much money you can borrow. Most lenders allow you to borrow up to 85% of the equity in your home. Considering the above example, your home equity is $300,000 ($400,000-$100,000), so you can borrow 85% of $300,000, which is $240,000. Some lenders may also allow up to 90% of the equity as a loan.
If you think your home equity is comparatively lesser, you can increase your home equity by paying mortgage payments timely and more than the minimum payment required or even by upgrading your home’s situation.
A credit score includes your credit history, bill payment history, late payments, outstanding debts, accounts you have and for how long you have been using those accounts, etc. A favorable credit score plays an essential role in getting a loan. If you have a credit score higher than 700, it is very likely that you will qualify for getting the HELOC.
Some lenders also approve homeowners with a credit score between 620-699, and a few even consider a credit score below 620. However, a low credit score requires higher equity in the home to qualify for a HELOC. A low credit score may lead you to have a bad credit home equity funding, which is not only short-term but also has relatively lower loan amounts and higher interest rates.
Debt-to-income ratio (DTI)
Lenders also consider your debt-to-income ratio before approving a HELOC. To calculate your DTI, lenders sum up all the monthly payments associated with the house, which are homeowner insurance, taxes, homeowner association charges, interest, and mortgage, along with any other kind of outstanding debt. The debt total is divided by the gross monthly income, and a DTI is generated. The lower the DTI, the better it is, and you are more likely to qualify for a HELOC.
Reliable payment history
Lenders always ensure that they are not taking too much risk by approving home equity or HELOC for any candidate. For this purpose, they make sure about the payment history of the candidate. They may look up how frequently you pay your bills on time. Even if you have a great credit score, a frequency of late payments makes you less likely to qualify for the HELOC. It is because HELOC is the second mortgage, so lenders are already second in line in case of a foreclosure.
Most lenders prefer you to have a minimum monthly income in order to make sure that you will be able to repay the debt on time. Your income level also helps to determine the amount of debt you can borrow. Boosting your income or having a stable and higher income also increases your debt-to-income ratio, increasing the chances of getting a loan. Lenders may also ask you to provide proof of your income for verification.
How to get a home equity line of credit?
The process of getting a home equity line of credit is similar to acquiring or refinancing a mortgage. You are required to prove your creditworthiness and provide the same documentation as in a mortgage. Following is the step-by-step guide of how to get a HELOC?
- Calculate your home equity and determine if it is sufficient to get a HELOC.
- Search for HELOC lenders and compare their offers.
- Gather all the essential documents with you to start the process smoothly.
- Apply for a HELOC with the selected lender.
- Upon receiving the disclosure documents, take your time and read them thoroughly and carefully. Ask questions to your lender about the bank account, initial draw, monthly payments, maximum/minimum withdrawal, etc.
- The process may take days or even weeks. It may even involve the appraisal to verify your home’s value.
- Loan closing is the final step when you sign the paper and can start using your HELOC.
How much money can you borrow on a home equity credit line?
Once you get the figures of your home equity, you can apply for home equity loans or lines of credit with your home equity as collateral. The maximum amount you can borrow depends on the value of your home. The more the value of your home is, the more the amount of debt you will most likely get. The amount of money you will get also depends on your lender and whether you plan to take home equity loans or HELOC. Most lenders allow you to get a loan up to 85% of your home equity, but some may also take up this percentage to 90%.
The terms and conditions by your lenders will explain to you about minimum/maximum withdrawal limits once your account is opened. Make sure to confirm the withdrawals method – cheques, credit card, or both, with your lender.
What is the interest rate for HELOC?
The interest rate of the home equity line of credit is mainly variable, but some lenders may ask for a fixed-rate interest.
Variable interest rate
The variable interest rates offer smaller monthly payments initially, but the charges may go up in the remaining repayment period. If you opt for a variable interest rate, you must check for the interest rate changes at one point in time and for a lifetime of the repayments. In addition to that, make sure to ask your lender about which index they use for measuring the interest rate and how often it changes.
Fixed interest rate
Some lenders allow you to convert the remaining portion of your HELOC debt into a fixed-rate debt, which results in stable and predictable payments every month. It saves you from the after-effects of a sudden rise in interest rates.
Discounted interest rate
Sometimes, some lenders also offer a discounted interest rate for an initial period, for instance, six months. In the discounted rate period, your monthly payments are lower, and so is the interest rate. Once the discounted rate period is over, your interest matches the market interest rates resulting in higher monthly payments. While signing up for a HELOC, you must ensure this with your lender whether or not you are being offered a discounted interest rate so that you can be prepared for the higher payments after the discounted period is over.
What are the upfront closing costs of HELOC?
When you sign up for a home equity line of credit, you pay some expenses, including title search, application fee, processing cost, attorney’s charges, appraisals, and points ( a percentage of the loan amount). These costs are known as upfront costs of HELOC. These costs increase your loan cost, mainly when you borrow a smaller amount from the line of credit. You can also negotiate with your lender to share some of the upfront costs with you.
What are the continuing costs of HELOC?
Along with the upfront costs of the home equity line of credit, some lenders may also ask you to pay a fee throughout the lifespan of your HELOC. These costs may include participation fee, annual membership fee, and the transaction fee, which is charged whenever you draw some money from your HELOC account. Similar to upfront fees, these fees also add to the cost of your HELOC loan.
How do you pay back a home equity line of credit?
There are two phases of a home equity line of credit: The draw period and the repayment period.
The draw phase
The draw phase is the duration of your HELOC loan in which you can take out funds using a cheque, credit card, or online transfer. During the draw phase, the monthly cost is usually the interest only, but you can also add some of the principal amounts as well. The length of the draw period varies by lender, but it is mostly ten years.
Your monthly payments will keep on changing if your credit line has a variable interest rate. If you are paying an amount of principal in your monthly payment, make sure with your lender whether this monthly amount will cover your whole debt or you will owe an additional principal amount at the end of the period. You should also ask the lender about late-payment penalties and under what circumstances he will consider you in default and ask for an immediate total return of the whole amount borrowed.
The repayment phase
In the repayment phase, you cannot borrow any more money from the line of credit. It is the phase where you start paying back the loan in monthly installments that involve interest and the principal amount. Since the principal amount is added to monthly payments, the monthly payment can rise sharply. The duration of the repayment phase is usually 20 years.
At the end of the loan, you may have to pay a considerable amount – balloon payment – which includes any remaining principal amount which was not paid during the life of the loan. If you think you will not be able to meet the substantial balloon payments at the end, you might want to renegotiate the terms and conditions of repayment with your lender. You must ensure to discuss the terms of refinancing the unpaid principal and renewal of the plan at the start of signing in for a HELOC.
What protection do you get in HELOC?
While applying for a home equity line of credit or any other loan, the Federal Truth in Lending Act is the best protection you can have. The law ensures that the lenders tell you everything about the plan’s cost and terms and conditions when starting an application. They must disclose the payment terms, APR, charges for opening an account, appraisal fee, credit report, or attorney’s fee. This law saves you from the changes in the terms and conditions. Lenders will refund all the fees you paid if you decide not to enter into a HELOC plan due to any changes in the terms and conditions.
Before you sign into the loan, read the terms and conditions thoroughly, and if you find this is not what you needed or expected, you can choose not to sign. You can cancel your home equity loans or lines of credit within three days of even after signing the loan paper without any penalty. This is called the three-day cancellation rule.
The Three-Day cancellation rule
Federal law allows you to reconsider your loan terms and cancel the deal within three days of signing without any penalty. If you are using your principal residence as collateral, you can cancel the loan for any reason.
The right to cancel remains active till midnight of the third working day after signing the deal. The day one starts after you have signed your credit contract, received the Truth in Lending disclosure form including all information, and get two copies of Truth in Lending discussing your right to cancel.
Is getting a HELOC a good idea?
Getting a home equity line of credit is good or not; that depends on your circumstances and financial condition. There are some benefits associated with HELOC. If the HELOC is used for home repair and primary renovations, it will increase your home value. Moreover, the interest in HELOC is also tax-deductible if the loan is being used on buying or improving your home.
Is HELOC bad for you?
HELOC can be harmful if you are unable to make repayments and increases the chances of foreclosure. You should not take a HELOC if;
- You have an unstable income because, in that case, you won’t be able to keep up with the monthly payments.
- You cannot afford the hundreds of dollars of upfront costs of getting a HELOC
- You are seeking a smaller amount of money.
- You cannot afford the increase in the interest amount due to changes in the variable interest rate.
- You are planning to use HELOC to meet your day-to-day expenses
Does HELOC hurt credit score?
A home equity line of credit works similar to a credit card, but some bureaus consider HELOC as installment loans instead of a line of credit. Therefore, borrowing 100% of your HELOC does not affect your credit score as exceeding a credit card limit does. Signing a HELOC will temporarily reduce your credit score, but if you make the repayments on time and do not utilize full credit, your credit score will improve back over time.
Home equity lines of credit can be a piece of good news for people who are unsure about how much money they need to borrow and prefer to pay interest only on the amount they use. If you decide to choose a HELOC, make sure to understand everything about how it works, how the monthly payments are settled, and how the change in interest rate affects the size of your monthly payments. If the things you want to use your HELOC on are worth bearing a high-interest rate and high monthly payments, then HELOC is the best option for you.
You should also look at your past borrowing behavior and how you plan to use the money from HELOC. If your borrowing behaviors are hurtful to your financial condition, then getting a HELOC will adversely impact your pocket, and you will default.
Finally, be very careful and check your home equity line of credit statements on a regular basis. Make sure your statements are in sync with the money you draw, and you are not facing any identity theft.