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

Do you have substantial equity in your home and in need of cash? A Home Equity Line of Credit (HELOC) may just be for you.

Are you a homeowner? Do you have substantial equity in your home? Are you in need of cash? A Home Equity Line of Credit (HELOC) may just be an excellent way for you to borrow money at an attractive interest rate.

A HELOC is just one of many ways to borrow money for things like a home remodeling project, paying for college, consolidating debt, or any other needs you may have for a substantial amount of money. A HELOC has some considerable advantages over using a credit card, taking out an unsecured loan, or using financing that may be available from another source or service provider.

Let’s look at a real-world example of how a HELOC works.

Recently a friend of mine, let’s call him Joe, decided that he would like to do a substantial renovation on his home. The project included replacing all carpeting with real wood floors as well as painting and other structural modifications. The materials, as well as labor costs, were considerable and totaled approximately $25,000.

different carpenter tools (rubber hammer, electrofret, joiner angle) on the laminated floor

Joe didn’t want to load up or max out his credit cards, which certainly wouldn’t help his FICO Score, and the interest would be astronomical. The contractor also offered to provide financing, but the interest rate was very high, so it wasn’t the way he wanted to go. That left Joe with, in his mind, two choices. He could go to his bank or credit union for a conventional loan, or he could get a HELOC.

Joe bought his house several years ago, and its current market value is roughly $400,000. He owes about $300,000 on his mortgage, which means he has $100,000 of equity in his home. Joe could save a bundle in interest if he took advantage of that equity by setting up a HELOC to finance his home remodeling.

All banks and lending institutions have their own rules and fees, but generally, you can get a HELOC for 85 percent of the value of your home minus what you owe on it. So, using Joe’s example: Home value of $400,000 x 85% = $340,000. We subtract the amount owed on the original mortgage from the 85 percent number: $340,000 – $300,000 = $40,000. Joe was able to qualify for a HELOC of $40,000.

A HELOC generally has a variable interest rate (some lenders offer fixed rates too) that is tied to the prime rate. There is also a margin, typically around 1 percent, that stays consistent throughout the life of the loan. You’ll get a bill each month showing the principal and interest due. There is a draw period, which is usually 10 years, during which time you can withdraw any amount up to the agreed-upon limit. There is usually a 20-year repayment period that follows the draw period. During the repayment period, you cannot withdraw any funds and must pay back the remaining balance and interest.

One of the advantages to the HELOC is you can withdraw any amount up to the agreed-upon limit; in Joe’s case, this limit was $40,000. Joe started work on his house by withdrawing $25,000. As time went on, the project expanded a bit, and he took another $8,000. When the work was completed, Joe started paying back the interest and principal. The beauty of the HELOC is that you can continue to withdraw up to the credit limit during the draw period and if you’ve paid back some principal that counts towards the total funds available. A HELOC is like a credit card with one huge advantage; the interest rate is significantly lower on the HELOC compared to a credit card. Some people will take out a HELOC to consolidate their other higher interest debts, such as credit cards. Why pay 28 percent interest on a credit card when you can pay 6 percent on a HELOC?

Generally, to qualify for a HELOC, a lender will look at your credit score and history, your monthly income, monthly debts, and employment history. The process is very similar to applying for a mortgage.

The numbers I’ve used are all examples and will differ from what you’ll find in the current marketplace. All lenders have different terms and conditions for their HELOCs, and the fees can vary as well. It makes sense to shop around to find the HELOC that makes sense for your needs.

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