Is a HELOC Right For You?

If you’re a homeowner looking to finance a home-remodeling project, consolidate credit card debt, and/or pay for big-ticket purchases, you may want to weigh the benefits offered by a Home Equity Line of Credit, or HELOC. A HELOC is a unique type of loan which allows you to borrow money from a lender based on your home’s equity, or the value of your home compared to the dollar amount of your existing mortgage. Below, we’ll explore HELOCs and how to determine if they are right for you.

What Is a HELOC?

A HELOC is a line of credit, or amount of money a financial institution agrees to lend you, based on the equity you have in your home. This equity, or the difference between the fair market value of your home and the remaining balance you owe on your mortgage, serves as the collateral, or asset you offer the lender as security, in exchange for the HELOC.

Unlike a first mortgage, which provides a fixed-dollar amount to fund the initial purchase of a home, a HELOC, or second mortgage, helps current homeowners use the equity they have built in their home to fund other purchases via a flexible line of credit. When using a HELOC, you are under no obligation to take the maximum allowable loan amount.

For example, if you qualify for a $50,000 HELOC, but decide only to use $20,000 of these funds, you only pay interest on the borrowed amount, not the total. As you repay the balance of the HELOC, you replenish the amount of available credit you may access.

The way you spend the HELOC funds (accessed through specially-issued checks tied to your HELOC account) is entirely up to you. However, if used to finance home improvements, the interest you pay on the loan may be tax deductible (consult your tax advisor).

Factors to Consider When Determining If a HELOC Is Right for You

While a HELOC offers a flexible way to unlock funds from the equity in your home, it’s important to do your homework to determine if it is the right choice for your financial circumstances. When considering a HELOC, and shopping for a lender, understand features including:

• Draw periods: During this term, also known as the borrowing period, you may spend, or “draw” funds from a HELOC to pay for expenses as you see fit. This period may range from five to 10 years, based on the lender. Once it concludes, you may no longer spend funds from the HELOC.
• Repayment periods: At the conclusion of the draw period, the repayment period—or period where you pay back both the funds you used and accumulated interest—begins.
• Interest rates: Interest rates for a HELOC vary among lenders but are generally lower than you would pay on a credit card. Many lenders offer either a fixed interest rate (which remains the same throughout the loan) or a variable interest rate (fluctuates based on changes initiated by the Federal Reserve).
• Credit line amounts: This total loan amount is determined based on the equity in your home as well as your current financial health according to your credit score, income, debts, assets and other factors. Most lenders limit maximum HELOC lines of credit to around 80 percent of your home equity.

Costs Associated with HELOCs

Before starting the application process, it is important to understand the costs and fees often associated with a HELOC. These vary widely based on your financial institution, but may include items such as:

• Transaction fees: Each time you use the funds in a HELOC to pay for expenses, you may incur a small transaction fee.
• Inactivity fees: Some lenders charge if you do not access the funds in your HELOC for a given period of time, typically in excess of one year or more.
• Minimum withdrawals: Some lenders also apply minimum dollar amounts for draws against your HELOC. 
• Annual fees: Financial institutions may also charge a small annual fee to cover the administrative costs associated with maintaining your line of credit. 

HELOC Repayment Variations

Lenders may present you with choices on how you wish to repay the funds used in a HELOC. These include:

• Interest-only draw period: This option allows you to make monthly payments during the draw period to repay the accumulated interest on the draw amount. By using this method, you can keep your initial payments lower during the draw period. Once the draw period is over and you transition to the repayment period, you will make payments covering the amount you borrowed (the principle), as well as the interest which accumulated.
• Draw period with interest and principal: Choosing this option will help you repay the HELOC at an accelerated pace. Similar to a first mortgage, your monthly payment is a combination of both the principal and interest. 

Applying for a HELOC

The process of applying for a HELOC is similar to what you likely experienced when applying for your home mortgage. Initially, you will complete and submit an application online. Then, for verification purposes, you may also need to provide documents including:

• Most recent tax returns
• Recent pay statement from your employer
• Mortgage documentation
• Financial institution statements for your checking and savings accounts
• Credit card bills
• Lists of money market accounts

You’ll also need to factor in a range of closing costs for your HELOC such as appraisal fees, attorney fees, origination fees, and application fees.

Overall, HELOCs can offer homeowners a flexible option to help pay for big-ticket items or consolidate high-interest debt. Be sure to understand the features, as well as any associated costs and fees, before finding the one right for you.