There are a few ways in which a homeowner can tap into their property’s equity to cover a big expense or finance an emergency repair. Here we’ll take a look at home equity lines of credit, or HELOCS, a revolving credit account (like a credit card) that could enable you to borrow up to 80% — or even 90% of your home’s value. Of course, you — or, perhaps, more pointedly, your home — will be on the hook for those charges. To help you decide if tapping your home’s equity is the right move, here’s a primer of home equity lines of credit.
What Is a Home Equity Line of Credit?
An equity line, or HELOC as it is commonly known, is a line of credit secured by a lien on your home. As with commercial lines of credit, you are allowed to draw on your line at any time just by writing a check. HELOCs can be an excellent source of instant cash for homeowners and can have significant benefits if used to finance worthwhile purchases (more on this is a minute).
How Does a Home Equity Line of Credit Work?
The interest rate on HELOCs is adjustable, typically tied to the prime rate and occasionally to T-Bills or CD rates. With the prime rate at 3.75% as of December 2016, equity line loans are in the 4% to 8% range depending on the borrower’s creditworthiness and other factors — most notably how much equity you actually have in your home. (Note: You generally need at least 20% equity to qualify for the lowest HELOC rates.)
To get a better idea of what HELOC rates you may qualify for, you can check two of your credit scores, updated every 14 days, for free on Credit.com. You can figure out how much equity you have in your home by subtracting the amount of money you still owe on it from the home’s current value. (You should be able to get an estimate by looking at what similar properties are listed for online.)
HELOCs are revolving lines of credit and the payment you make each month is based only on the outstanding balance. The line of credit is typically interest-only for the first ten years, at which time the loan balance is frozen and converts to an amortizing loan, still with a variable rate.
The Downsides of HELOCs
Let’s get one thing straight about HELOCs: These are equity-destroying loans. You’ll have less equity after you use one. Moreover, if you default on a HELOC, you could wind up losing your home to foreclosure — no matter what standing your original mortgage is in.
Remember, too, that walking around with that equity line checkbook can be a temptation to buy something just because you can. People who can’t say “no!” to their impulses should not get an equity line. It will just get them in trouble. Be careful not to use the equity line for frivolous purposes.
Other potential drawbacks of HELOCs? If you get a “no closing cost” loan, you can almost always count on an early-termination fee if you terminate the loan before, typically, three years.
If your line provides for only interest payments, you have to be diligent about paying the balance down on a regular basis so as to regain your equity. Before financing a purchase, be sure to budget your monthly payment to retire your loan balance. If you’ve used it to pay off credit cards, aim to pay the balance off in two or three years. If you use it to buy a car, be sure the loan is paid off by the time you wish to replace the vehicle, say in four years.
The Benefits of HELOCs
The major benefit of a HELOC is that you can draw on the equity line any number of times. For example, you can start out by paying off high interest rate credit cards, lowering the interest rate perhaps from 18% to 8%. When that balance is paid off, you may wish to finance a car with your equity line instead of taking out a car loan. Finally, while they are not a good substitute for true education loans, HELOCs can be used to meet short-term needs, as when the tuition bill comes around when you are a little short on cash.
The interest on an equity line is, within limits, tax-deductible, a benefit that lowers the effective interest rate compared with consumer loans and credit cards.
An innovation from the late 1990s is the “piggyback” loan, where an equity line is used to finance the purchase of a home. The homebuyer takes out a first mortgage for 80% plus another loan, an equity line, for the next 10%, 15%, or even all 20% of the purchase price. That way, the homebuyer avoids Private Mortgage Insurance, or PMI. If this interests you, find a competent loan officer who can make the calculations for your situation. In 2017, PMI payments are tax-deductible.
Banks love equity line loans because the loans they used to make on an unsecured basis are now secured by equity in homes, thereby reducing their risk. The combination of a good yield and low risk is something bankers dream about.
Equity line loans are very competitively priced and frequently the lender will pay the appraisal and title costs so they are offered with no or only nominal upfront costs to the borrower. Be sure to check the local banks and credit unions in your area to see if someone is having a “special.” Some lenders charge annual fees, but they are modest, perhaps $25 per year.
Here’s quick recap of a HELOCs’ pros and cons:
- Equity line loans are attractive because they can be used over and over as the need arises.
- You pay interest only on the amount you use.
- They are usually available for free or with only nominal upfront costs.
- They are not a good loan for those who have trouble controlling their spending.
HELOCs vs. a Home Equity Loan
While they both utilize your home as collateral, a HELOC is not the same as a home equity loan. A home equity loan is an installment loan, like a mortgage or car loan — you borrow a certain amount of money, then make a fixed payment for a set period of time to pay it back. That means, unlike with a HELOC, you know exactly how long you’ll be paying back your debt and you won’t be faced with the same temptation to overspend. (You will, however, be locking yourself into a monthly payment.)
The rates on home equity loans, as with HELOCS, are influenced by your credit score and amount of equity you actually have in your home. Home equity loans are also tax-deductible.
Another big important similarity: If you default on a home equity loan, you could lose your house to foreclosure. That’s why it’s important to read the fine print of any financing you’re considering carefully — and to weigh all your options before deciding what move is right for you.