Is a Home Equity Line of Credit the Right Choice?
As a homeowner, it comes with the territory that you must make repairs and improvements to your home. You might need a new roof installed, or perhaps you want to renovate the kitchen. These types of projects cost money, but luckily, you can use the equity in your home to pay for the them.
There are several different products available for people who want a loan based on the equity in their home. One of the most common is a Home Equity Line of Credit (HELOC), a product that many homeowners have used to make improvements to a home.
What is a HELOC?
A HELOC functions somewhat like a credit card. You are given a line of credit based on the equity in your home. Rather than getting the money as a lump sum, you draw on the money when you need funds. Homeowners often use a HELOC to pay a contractor. The money is drawn from the bank when the contractor completes a certain amount of work, but there are no restrictions on where you can spend the money. You can buy a new car or take a vacation to Europe. As long as you qualify for the line of credit, you are free to use the money. The only stipulation is that you pay the loan back.
HELOC versus a Home Equity Loan
People often confuse a HELOC and an equity loan. An equity loan is a lump sum payment and can be considered a second mortgage. You usually have a fixed monthly payment, and the rate is often fixed, as well.
However, a HELOC usually has a variable interest rate and is not paid in a lump sum. The interest rate on the loan changes depending on how the loan is calculated, but most likely based on the U.S. prime rate. The loan rate changes as the prime rate goes up or down. The payment is also not fixed. Much like a credit card, the payment is based on the interest rate plus the balance. As your loan gets bigger, your payments increase.
What are the costs associated with a HELOC?
There is no set length of time for a HELOC. Lenders offer 5-, 10-, 15- and even 30-year loans. The interest rate is often based on the length of the loan. Shorter loans generally have a higher interest rate, and sometimes you only pay interest for the first part of the loan’s terms.
While the interest for some HELOC can be quite low, others are rather expensive. Rates vary from low single digits all the way up into the teens. The rate is based on your credit history and the perceived risk to the lender. You only want to take out a HELOC if it makes financial sense. If the interest rate is getting close to a typical credit card rate in the twenties, it is not a good idea to put your home at risk.
There are often other fees associated with a HELOC. These can include an application fee, documentary stamp fees, the cost of appraisals and credit checks, annual fees, and cancelation fees. You need to take these into account when making your decision to get a HELOC and ask your lender to present all of the associated fees.
How much equity do you need to get a HELOC?
It used to be quite easy to get a HELOC. Prior to the 2008 real estate crash, many lenders had loose standards on these types of loans, and often loaned up to 100% of the equity in the home. That is not the case anymore. Most lenders restrict lending to 80% of the equity in the home, and the borrower must have a good credit rating, usually 620 or higher.
When is a HELOC the right choice?
Most financial advisors would suggest that you only get a HELOC for improvements to the home. While a loan for a trip or a new car seems like a good idea, because the interest you could get is low, you are taking on enormous risk. If you fail to repay the loan, the bank can foreclose on your house. That is not the case with a credit card. It’s an unsecured loan.
If you make reasonable improvements to the home, you will likely recoup the expense when you sell it. If the HVAC system breaks or the roof leaks, you need to make those repairs whether you have budgeted for them or not.
How do I apply for a HELOC?
The process of applying for a HELOC is very similar to when you get your primary mortgage. The lender will need to know the equity in your home, your debt-to-income ratio, credit score, and employment history. They will want to determine how much of a credit risk you are, and they will set an interest rate based on that risk.
Like a mortgage, you can shop around for the best deal on a HELOC. You do not have to get the loan from your mortgage company. There are a variety of lenders who offer HELOC products, and you can find one that presents you with the best terms.