The first thing to know about a HELOC is that it’s not the same as a Home Equity Loan. This is important because many people confuse the two and, in certain aspects, they’re at opposite ends of the lending spectrum.
A Home Equity Loan is similar to your primary mortgage in the sense that it’s set for a specific loan amount to be repaid with fixed monthly payments. (This type of loan is sometimes called a “second mortgage”.) Typically, Home Equity Loan interest rates are fixed and fully amortized.
A Home Equity Line of Credit (HELOC) is a credit line from which you can draw funds up to your maximum credit line on an “as needed” basis. Your monthly payments can be interest-only (if that’s your preference), however, that can only last for a specified period of time. Once the repayment period had ended, any balance due on the line of credit must be paid. A HELOC is a revolving line of credit, similar to credit cards from which you draw money as needed and repay the funds.
Why would you need a HELOC?
A HELOC is often used to pay for items such as:
- Home improvements
- Medical bills
- College education
- Auto purchase
There are other reasons to use a HELOC, but it’s important to run the numbers first and look ahead to future scenarios that might turn into more trouble than they’re worth. For instance, some people use a HELOC to pay off credit card debt. The problem with that is there was a cause of the original credit card debt that cause must be resolved before using one’s home as collateral. If the debt problem continues and the credit card balances rise again, the security of keeping one’s home could be at risk.
How much of a HELOC can you get?
Typically, lenders will allow borrowers 80% – 85% of their home’s equity, although income, credit history and the home’s market value will also be taken into consideration. As an example: let’s say your home is appraised at $200,000 and the lender will give you 80% of that value. That’s a credit line of $160,000. But wait! You still owe $100,000 on your primary mortgage. So the bank will only allow a HELOC based on $100,000 (your equity in the home), which comes to $80,000.
HELOC rates can be fixed or adjustable. Many people choose the adjustable rate because it’s less expensive than the fixed rates. If you select an adjustable rate HELOC, know that rates are based on prime lending rates and if the bank prime lending rate increases, so will your HELOC interest rate. The current rate is in the 3.25% zone, which is low compared to decades ago. However, if the rate rises to historic norms (i.e. 5%), the minimum payment you’ll owe on that loan will also rise.
Is a HELOC right for you?
Like every other life decision, it’s imperative to compare the pros and cons. When it comes to a HELOC, these are some of the issues you might want to consider:
Flexibility in the sense that you can borrow up to your limit, or less, depending on your needs and circumstances. Your monthly payments will vary depending on the amount you’re using.
Inexpensive as compared to other interest rates such as those of a credit card. Sometimes lenders offer “special” introductory rates to entice you into choosing them for your HELOC.
Home Values can decrease and if you’ve used more cash from your HELOC than your home is worth, this could lead to trouble.
Income loss can also become a problem. In the event of a job loss or poor investment returns, it’s important to have a backup plan to help pay off a HELOC.
When it comes to taking out a loan, research is crucial. In the end, you want peace of mind, knowing that no matter what type of loan you have, you’ll be able to sleep every night without wondering if you’ve bitten off more than you can chew.
If you’d like to see what kind of loan might work best for you, check out this myFICO comparison chart. We’ve even provided calculators to help you make the best decision.
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