If you own your own home, you may be able to take advantage of its current market value and obtain a home equity line of credit, or a HELOC. The market is especially favorable right now, as property values have skyrocketed and interest rates on loans and lines of credit are particularly low. For this reason, it may be an optimal time to see if you qualify for a HELOC. In our short guide, you can find out everything you need to know about HELOCs and if it is the right choice for you.
What Is a HELOC and How Does It Work?
A home equity line of credit is a type of line of credit or a borrowing limit you can tap into at any time and payback. The difference between a HELOC and a regular line of credit is that the bank secures your line of credit with your home. Since this is the case, you can obtain a higher limit. It may be particularly helpful in situations where you wish to consolidate debt, perform expensive renovations, or make large, personal purchases.
If you acquire a HELOC, the amount is based on the current equity of your home. You may have high home equity if the demand for homes in your area is high, you performed renovations, or you paid off a significant amount of your primary mortgage already. As a quick guide to determine how much you could receive for your HELOC, simply take 80% of your current home value and subtract the balance of your mortgage. If the result is less than 65% of your current home value, you may qualify for up to this amount.
You can take out any amount from your home equity line of credit at any time during your draw period. You may choose to pay off the parts you use during your draw period or pay only the interest during this time. After the draw period is closed, you begin a repayment period where you need to pay principal and interest. If you fail to repay your balance during a specified amount of time, your bank can seize your home to repay the line of credit.
What Is an Example of a HELOC?
It may be easier to understand exactly how a HELOC works by viewing a clear example. Let’s suppose a homeowner has a current home value of $300,000 and their mortgage balance is $150,000. They would be eligible for up to $90,000 for their home equity line of credit. With their $90,000, they decide to do major renovations on their home and pay for their daughter’s wedding.
They decide to only pay the interest during the draw period and pay back the principal after the draw period has closed. Since their interest rate is only 3.45%, they only need to pay $258.80 per month.
At the end of their draw period, they realize they have significantly increased their home value by performing these renovations, paying down their mortgage further, and from the shifting market. Their home’s value is now worth $500,000 and their mortgage is only $40,000. Their home equity is now $360,000 however this is more than 65% of their home value, therefore they can only take out $325,000 on their home equity line of credit. They use this line of credit to pay off their mortgage and their previous HELOC. Now, they decide to make payments on the principle and pay their monthly interest from this point forward. They make a payment of $787.80 per month on their outstanding balance of $130,000, including the monthly interest of $433.30 (their new interest rate is 4%).
Is a HELOC a Good Thing?
A HELOC can be advantageous for many individuals. Noteworthy benefits include:
- Higher credit limits than other types of loans
- Lower interest rates than other types of loans
- Only borrowing the amount you need, when you need it
- Only paying interest on the amount you borrow
- Ability to pay back your outstanding balance at any time
- Only need to pay back the outstanding balance after the draw period
- No restrictions on what you can use the line of credit for
- You can take advantage of tax deductions at the end of the year
However, some individuals prefer not to take out a HELOC and opt for other options, such as a second mortgage, also known as a home equity loan. The disadvantages of a HELOC may include:
- Variable interest rates, meaning interest changes at any time
- Fixed-rate interest options are generally higher than a variable rate
- Your home is at risk if you do not pay back your line of credit balance
- You need good credit and an excellent debt-to-income ratio to qualify
- Easy to fall into a cycle of HELOCs
How Is a HELOC Paid Back?
When you have a home equity line of credit, you obtain a draw period and a repayment phase. In the first phase, the draw period, you typically have ten years to use your line of credit. You can borrow and repay any amount under your limit. You also only need to pay monthly interest on the amount you used during this time. Generally, these monthly payments are relatively low which is part of the appeal of a HELOC.
After your draw period, you will enter into a repayment period, typically lasting between 10-20 years. During this period, you will need to pay back your outstanding balance. Your monthly payments will convert to equal amounts of principal and interest. However, if your balance is already at zero, your account will simply close.
Can You Pay Off Your HELOC Early?
Since a line of credit stays open during your draw period, working similarly to a credit card with lower interest rates, you can pay off your HELOC early with no pre-payment penalties. In many situations, it may be the most advantageous option, especially if you have a variable-rate interest. Since the interest is subject to change, you may wish to pay off the balance early before you pay a potentially high-interest rate and the principal together.
How Do Tax Deductions Work with a HELOC?
One of the advantages of obtaining a home equity line of credit is the possibility of obtaining tax deductions. If you are using your HELOC to make valuable home renovations, you can write off a portion of the interest payments on your taxes at the end of the year. Naturally, the improvements must be made to the home the line of credit was taken out under. The improvements must also be itemized on your tax forms, so it is important to keep a list of your expenses, note what they were used for, and keep any receipts. Currently, the IRS states that you can deduct interest on up to $750,000 on a HELOC if you are a homeowning couple, or up to $375,000 if you are a single homeowner.