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There are many different kinds of mortgages that homeowners can use to tap into the equity in their properties. If you want to borrow against your home's value, a home equity line of credit (HELOC) is one option. But what is a HELOC? This guide will help you understand, and can assist you in deciding if a HELOC is right for you.
A HELOC is a loan you take against your home. When you apply for a HELOC, the lender evaluates your financial credentials and the value of your home. You're given access to a line of credit with a maximum borrowing limit determined based on those factors.
You are allowed to borrow up to the credit limit your lender allows, just like with a credit card. But the interest rate on a HELOC is much lower than on a credit card or other types of debt. Your home serves as collateral for the loan and if you don't make your monthly payment then your lender can foreclose. Your line of credit is usually available for a set time, such as 20 years.
If you are approved, the lender will tell you the maximum you can borrow. For example, you may be extended a $40,000 line of credit. You do not have to borrow that amount up front. You can access your line of credit as often as you'd like, up to your credit line. As you pay back what you've borrowed, you can draw from your credit line again.
Your payments on your HELOC loan will be based on the amount you have borrowed and your interest rate. Usually, the line of credit is extended for a set period of time, such as 20 years. At the end of your repayment period, you'll no longer be able to access your credit line.
When answering the question "what is a HELOC?" you need to understand how much you are allowed to borrow. The specific amount varies based on lender rules, the balance on other home loans, and the value of your home.
Many HELOC lenders cap your total loan balances at 75% of what your home is worth. This includes your current loan and your home equity line of credit. For example, if your house was worth $100,000, you would be allowed total mortgage loans of no greater than $75,000. If you already owed $50,000 on your existing mortgage, you'd be allowed at most a $25,000 credit limit on your HELOC.
Some lenders have more relaxed borrowing rules and may allow you to take a HELOC valued at up to 90% of what your home is worth.
It is important to understand different mortgage types when answering the question "what is a HELOC?"
Most HELOCs are variable-rate loans, which means the interest rate is tied to a financial index and can change over time. This could make your loan more expensive if rates go up. There are some lenders that offer fixed-rate loans though. You should check current mortgage interest rates to compare fixed- and adjustable-rate loan options.
While variable-rate loans typically have lower starting rates than fixed-rate loan options, you should be aware that rates could go up. Be sure you understand the risks of a variable-rate loan.
You can generally access the funds from your home equity line of credit to be used for any purpose.
Debt consolidation is one common use for HELOC funds because you may be able to substantially reduce the interest rate on your current debt. That's because a HELOC often comes with a lower interest rate than other loans.
HELOC money is also used frequently for home improvement costs and interest can be tax deductible provided that the money is used to substantially improve, buy, or build the home that's guaranteeing the HELOC.
Under the law, you have three days to change your mind and rescind your credit agreement after you sign for a HELOC and receive your Truth in Lending disclosure detailing total costs. You will need to request this in writing. Your lender cannot allow you to access the funds in your line of credit until after the three days have passed.
When you research "what is a HELOC?" you need to understand there are closing costs with this loan, just like when you received your mortgage. These are usually around 2% to 5% of your home's value and include fees for an appraisal; credit report; a loan origination fee; and title insurance. Some lenders also charge an annual fee, so be sure to check.
Some lenders offer "no-fee HELOCs." But, fees are typically paid for in other ways with these loans, such as in the form of a higher interest rate.
There are advantages and disadvantages to HELOCs you must consider when answering the question "what is a HELOC?" and determining whether one is right for you.
These are the biggest advantages of HELOCs:
If you want access to a line of credit at a low rate that you can draw from as needed, a HELOC may be a good option for you.
There are also some downsides to HELOCs including the following:
If you'd prefer a fixed-rate loan with a steady repayment schedule, a home equity loan may be a better option than a HELOC.
When you are looking into the question of "what is a HELOC?" you should compare home equity lines of credit to common alternatives.
Is a home equity line or a home equity line of credit right for you when you want to borrow against your home? It depends on your goals.
Home equity loans allow you to borrow a fixed amount and you have a choice of fixed- or variable-rate loans. You can't just borrow again after getting your initial lump-sum distribution of funds. But you'll have a predictable payoff timeline and repayment schedule.
HELOCs provide more flexibility, but less certainty, especially if you choose a variable-rate loan.
Is a HELOC or cash-out refinance the best choice? They are very different so you need to understand both options.
A HELOC, as mentioned, often has a variable rate. HELOC rates are usually higher than the rate on a cash-out refinance. And the amount you can borrow is determined based on how much equity is in your home and your current loan value.
A cash-out refinance, on the other hand, could be a fixed- or variable-rate loan. You will borrow enough with a cash-out refinance to repay your current home loan and give you cash left over. For example, if you owed $50,000 on a home valued at $100,000, you could take a $75,000 cash-out refinance loan. You'd repay the $50,000 and get $25,000 cash to use as you please.
Cash-out refis don't provide the flexibility that HELOCs do since you borrow a fixed amount up front and can't take any more money out. But you may be able to lower the rate on your current home loan, making payoff cheaper. Interest on your cash-out refi should also be tax deductible regardless of what you use the extra cash for, as long as you itemize on your tax return.
Most of the best mortgage lenders offer home equity lines of credit. When choosing a mortgage lender, get quotes from several loan providers. This could include banks, a credit union, and online lenders. Be sure you're comparing only fixed-rate loans with other fixed-rate loans and variable-rate loans with other variable-rate loans.
You should consider how much the lender allows you to borrow, the timeline your line of credit will be available, qualifying requirements, and interest rate when selecting a HELOC lender.
To learn more and determine if a home equity line of credit is right for you, check out our picks for the best HELOC lenders.
Here are some other questions we've answered:
Typically, a home equity line of credit is available for a set period of time that you determine with your lender. The timeline for how long the credit line lasts varies, but it could be as long as 20 years with some loan providers.
The amount you can borrow with a HELOC is determined based on your home's value and current loan balances. Some lenders also allow you to borrow more than others, relative to the value of your loan. For example, while many lenders cap your total loan amounts at 75% of home value, others go up to 90%.
If a lender allows you to borrow up to 75% of total home value, you'll need to subtract the amount of your current home loan when determining how large your line of credit will be. If you owe $50,000 on a $100,000 home, you might be given a $25,000 line of credit.
Your credit score, other financial credentials, and choice of lender determine the starting rate on your HELOC. On a fixed-rate loan, this rate will remain the same for the life of the loan. However, many HELOCs are variable-rate loans. This means they are tied to a financial index and can move along with that index. If the index shows rising rates, your loan could become more expensive.
You should improve your finances as much as possible to get the best HELOC rates. This means taking steps to improve your credit score, such as debt repayment. You should also shop around and get several quotes as borrowing costs can vary by lender.
HELOCs do have closing costs. They are often between 2% and 5% of the amount borrowed although they can vary by lender.
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