A home equity line of credit, or HELOC, is when a lender provides a borrower with a certain maximum amount they can spend if needed, and the borrower’s home equity acts as collateral.
What is a HELOC and How Does it Work?
During the second quarter of 2018, homeowners took out 361,845 home equity lines of credit (HELOCs), the highest level since the third quarter of 2008. This increase is likely due to rising home equity in recent years.
A HELOC is a revolving line of credit that you get based on the equity of your home. Here’s an in-depth explanation of what it is and how it works.
You’ll be able to qualify for this home equity line of credit if you have available equity in your home. This means that the value of your home should be higher than any amount you owe on it.
Lenders will typically give you a HELOC worth 85% of your home’s value minus any amount you owe on the home.
The HELOC has some similarities to a mortgage since lenders will also be looking at factors such as:
- Your credit score and history
- Monthly income
- Employment history
- Monthly debts
Since a HELOC is much like borrowing against the equity in your home, your home will serve as collateral.
Three factors make a HELOC different from conventional home equity loans:
- Although you’ll have access to the entire amount offered to you, you do not have to take it as a lump sum.
- The available credit is renewed when you repay loan balances after taking any amount from the available credit.
- You only pay interest on the amount you take from the available credit, not the entire available amount.
You’ll likely have a 10-year draw period during which you can borrow as little or as much as you need, up to your set credit limit. After the draw period ends, lenders typically give a 20-year repayment period.
When considering a HELOC, always check the specific terms from the lender, including:
- Minimum and maximum withdrawal requirements
- Whether you’ll use checks, credit cards, or both for the credit line
HELOCs provide a convenient method of paying for large expenses or consolidating higher-interest-rate debt from credit cards or other loans. This is because HELOCs often have lower interest rates compared to other loans.
However, not all HELOCs are the same. There exist two varieties: variable and fixed rate.
Variable-Rate HELOC
In a variable-rate HELOC, the interest rate may change from one month to the next. Here, you may get lower monthly payments in the beginning, but those payments may go up as the interest rate increases over the rest of the repayment period. Fortunately, lenders don’t change interest rates randomly. Instead, an index and margin are used to determine the variable rate.
An index is basically a financial indicator that’s used to set rates on many consumer loan products. As the index moves up or down, so does the variable-rate HELOC.
A margin is the second component that determines the variable interest rate. The margin remains constant throughout the life of the HELOC, and it is simply added to the index. Based on this general understanding, always check these two aspects when considering a variable-rate HELOC:
- the periodic cap, which is a limit on rate changes during a particular period
- the lifetime cap, which is the lifetime limit on interest rate changes
As you may expect, payments for your HELOC can change based on interest rate fluctuations as well as your balance.
Take note that lenders may offer temporarily discounted interest rates. This rate will often be unusually low and last only for an introductory period, like six months. When the introductory period ends, your rate will increase to the market level (based on the index plus margin).
Therefore, always confirm whether the lender is offering you a “discounted” rate and what rate will apply at the end of the discount period.
Fixed-Rate HELOC
You may find that interest rates on fixed-rate HELOCs are slightly higher than variable-rate HELOCs. However, as the interest rate in a variable-rate HELOC may increase, the fixed-rate HELOC will remain constant over the life of the credit line.
A fixed interest rate makes it easy to predict payments you’ll make on your HELOC. It will also protect you from rising interest rates.
Some lenders may offer the option to convert a variable-rate HELOC to a fixed rate.
Additional Fees
Apart from the interest rate, HELOCs can have various other fees, which affect the total cost of this line of credit.
When taking out a HELOC, you’ll receive similar expenses as financing your mortgage, including:
- An application fee
- An annual membership or participation fee
- Transaction fees
- A cancellation/ early closure fee
- Title search
- Appraisal
- Points (a percentage of what you borrow)
- Attorneys’ fees
You should consider these fees, especially if you’ll only be borrowing a little from your credit line. The extra costs can make your loan significantly more expensive. You can also try to negotiate with lenders to avoid paying for some of these expenses.
Additionally, check for any penalties for late payments. Where they apply, find out the specific conditions that determine if you are in default and whether the lender will demand immediate full payment.
Based on the protections provided by the Federal Truth in Lending Act, you shouldn’t have to worry about hidden costs. The law forces lenders to tell you about all applicable terms and costs when applying.
The act also protects you from changes in your HELOC terms (other than variable-rates) before the plan is opened. Following the applicable guidelines, if you choose not to enter into the plan due to a change in terms, you’ll get back all the fees you paid.
Is the Interest on a HELOC Tax Deductible?
Since tax rules may change, you should consult your tax advisor regarding interest deductibility on a HELOC. That being said, here are some useful insights into the issue.
The IRS recently set up restrictions on home mortgage interest deductions. Fortunately, certain conditions allow taxpayers to still receive tax deductions on interest for:
- Home equity loans
- Home equity lines of credit
- Second mortgages
The exemption that allows deductions on interest requires borrowers to use the HELOC to build, buy, or substantially improve the home used to secure a loan. As an example, you’ll get an interest deduction if you use the HELOC to build an addition to your home, but you won’t get an interest deduction if you use the HELOC to pay off your credit card debt or other personal living expenses.
Moreover, the new law on interest deduction imposes a lower dollar limit on mortgages or HELOCs that qualify, specifically:
- Taxpayers can only deduct interest on $750,000, down from prior limits of $1 million
- For a married taxpayer filing a separate return, it’s $375,000, down from $500,000
You should consider these factors if you wish to benefit from the tax deduction.
Conclusion
Clearly, HELOCs offer valuable flexibility through their revolving line of credit. This helps you turn the equity in your home into ready cash for your needs without having to remortgage your home.