What is a Home Equity Line of Credit?
A home equity line of credit, known in short as a HELOC, is simply a line of credit secured by the applicant putting their home up as collateral. Like all lines of credit, it is a revolving loan wherein funds are withdrawn, to a limit, and paid down cyclically, interest being charged only on funds withdrawn.
Interest rates, which are typically lower than those found with credit cards, as well as credit limits are determined by the applicant’s perceived creditworthiness – the degree to which their income, credit score, credit history and the like imply that they are a safe bet for the lending institution in question. One special feature of HELOCs is that the interest paid on withdrawn funds is, in most cases, tax deductible.
Table of Contents
- Rates (%)
- Credit Requirements
- For Bad Credit
- Advantages and Disadvantages
- Line of Credit vs Loan
- Home Equity vs Personal
- Line of Credit vs. Refinance
- Interest Only
- Fixed Rate
- Tax Deductibility
Due to the fact that HELOCs are secured by property as substantial as a private home, interest rates tend to be quite low, compared not only with credit cards but also with other types of lines of credit.
Interest rates are calculated by lending institutions in the following manner: each lending institution has a prime rate, the lowest rate that money could hypothetically be lent by the institution, a value that fluctuates over time. For a HELOC, a margin is added to the prime rate, the margin being a unique, fixed amount determined by an applicant’s income, credit score, etc. Given that prime rates fluctuate over time, interest rates given on HELOCs fluctuate as well.
Every lending institution has their own set of criteria for HELOC eligibility, but generally speaking, credit scores and the like, while still important, are secondary to concerns about home equity, as the credit line will be secured by the equity in the home. Having equity available in your home, in that what you owe on the property (mortgage, etc.) is less than the value of the home, is a must. Typically, upwards of 80% of the loan-to-value ratio (LTV), the total value of your home over what is currently owed on it, can be borrowed in the form of a HELOC.
For Bad Credit
Applicants with poor credit will face more hurdles than others in applying for a HELOC, but there are a few ways by which one can help their chances. Firstly, having a co-signer on the application, ideally, someone with strong credit, will greatly increase the perceived legitimacy of your creditworthiness. A second option is to apply for a HELOC via a credit union, a cooperative, not-for-profit financial institution. Typically, credit unions, being community-focused, are a bit more understanding of the life circumstances that lead to bad credit and may be willing to lend on the strength of your character.
There is also an alternative to a HELOC, refinancing. A refinance, wherein your existing home loan is replaced by a new loan, with new terms (including access to funds), ensures that your desired cash loan is backed by a lien on your property, a step that should make credit scores less relevant to the lending institution, but more on that below.
Advantages and Disadvantages
There are several advantages to taking out a HELOC. Like all credit lines, funds from a HELOC can be withdrawn when needed by the lender for non-discriminatory use. Interest rates will be lower than those seen with credit cards, and the interest to be paid is owed solely on funds withdrawn. HELOCs are secured, meaning that interest rates ought to be low, and in some cases, interest paid can be written off your taxes. Unlike other types of lines of credit, HELOCs are frequently offered with fixed interest rates which, although sometimes higher than a variable rate, offer stability unavailable elsewhere in the world of credit lines.
There are a few disadvantages specific to HELOCs that are important to consider before applying. First, obviously, your house will be used as collateral, which makes the line of credit high stakes for a lender. Second, closing costs, lenders fees, appraisal fees, and, sometimes, legal fees all have the potential to be levied throughout the application process. There’s also the risk that, though initiated with the best intentions, a lender may begin spending funds from their HELOC wantonly, their home may lose value, interest rates may rise, etc., and the lender will be stuck with a towering loan that will be difficult to pay down. Some of this is avoidable if the lender shows prudence in spending HELOC funds, but some is just up to fluctuations in the market.
Line of Credit vs Loan
Both HELOCs and home equity loans are kinds of “second mortgages,” in that they are specialized loans dependent on the available equity of your home, and can be held concurrently with a traditional mortgage. While HELOCs are, like all lines of credit, revolving loans where funds can be withdrawn & repaid cyclically, home equity loans are more akin to an auto-loan, where a one-time lump sum is lent out. A home equity loan, being more traditional in structure, has a rigid repayment schedule and a fixed interest rate, two things HELOCs eschew in favor of flexibility.
If you’re in need of financing for a specific project or other one-time use, a home equity loan might be the better option. If instead, you’re in need of a line of credit to stabilize your finances or consolidate debt, a HELOC might be the perfect option for you.
Home Equity vs Personal
There are a few key differences between a HELOC and a personal line of credit, the primary one being that a HELOC is secured by the applicant’s home being put up as collateral.
Although interest rates can be variable with a HELOC, traditionally HELOC offers include a fixed interest rate, something you will never see with a personal line of credit. Also, the interest paid on HELOCs is tax-deductible, unlike interest paid on a personal line of credit. Finally, interest rates on HELOCs are, generally, lower than what you’d find on a personal line of credit, due to their being secured.
Line of Credit vs. Refinance
A good alternative to a HELOC, especially for individuals with poor credit, is to simply refinance your home. A refinance, where your existing mortgage is replaced by a new, larger mortgage, ideally with a lower interest rate, will grant the lender an up-front lump sum and may also make monthly payments less burdensome. Also, Interest rates on refinanced mortgages tend to be lower not only than the pre-existing mortgage but lower even than those of HELOCs.
When deciding on one option vs another, it’s less about one being better and more about one being better for your circumstances. If you need funds on a revolving basis, and slowly wading your way through red tape isn’t an option, a HELOC might be the perfect fit. If you’re put-off by high, variable interest rates and flexible monthly payments, which are more tempting to abuse, a refinance could be the ideal financing scheme for your particular circumstances.
An “interest only” HELOC is one wherein, for a set period of time, minimum payments are on interest accrued only, effectively making them as small as possible. This can beneficial for anyone who’s planning on putting their HELOC to use in funding a venture or project that will pay dividends, so that, when the capital repayment period comes about, their income will be able to sustain it. That being said, it’s often presented as a freebie offer, and frequently leaves lenders in a position, when the capital repayment period comes around, in which they need a second HELOC to fund payments on the first.
As mentioned above, many lending institutions offer HELOCs with a fixed interest rate. The downside is that this rate typically hovers above what the going interest rate is at the time of application. The upside is that should interest rates rise, your HELOC payments will remain stable. This is a good option not just for people who appreciate the peace of mind, but also for folks whose finances couldn’t sustain variable monthly payments.
Because the interest paid on a HELOC is essentially an investment in home equity, the payments are, in most cases, tax-deductible, which can be of extreme value to lenders. HELOCs are the only lines of credit where this is true, aside from business lines, and they are a major selling point of this lending medium.
If you’re thinking about using a HELOC, make sure to check out all your options, and even speak with an expert before committing to anything. These loans can be a great resource under the right circumstance, but since your home is on the line you’ll want to make sure it’s the right option for your situation.