HELOCs: Home Equity Line of Credit

David Blaylock, CFP®
24 Jun

You may have heard of the term "HELOC", and wondered what that series of letters means. HELOC stands for “home equity line of credit” and while it is similar to a second mortgage it actually functions more like a credit card that is tied to the equity in your home. This revolving type of debt uses your home as collateral for a lender to extend a credit line which can be used at any time by the borrower.


What is this line of credit used for?

For those that want to access the equity in their home on flexible terms, this can be a great solution. You may not want to go through the expense or hassle of refinancing to unlock this equity so a HELOC can be a great alternative. This line of credit can be accessed as part of an emergency savings plan or to finance short to medium term purchases. It’s also a good alternative to your credit card, which usually carries a higher interest rate  because your credit card is unsecured. A HELOC, however, is secured by your home. This provides collateral to the bank if you don’t pay back your loan, minimizing the down-side risk for the lender. Though the HELOC is tied to the equity in your home, the amount you borrow can be used for almost anything.


How it works

In order to set up a HELOC, you would need to contact your current mortgage lender or another bank that offers this type of loan. There will be an application process that is similar to applying for a mortgage in that it requires a bit of documentation. You will likely need documents such as pay stubs and tax returns as well as bank and other financial statements. Lenders will also perform a credit check and will verify your income just like any extension of credit.  

While the fees to set up a HELOC are not as high as the closing cost for a typical mortgage there are various administrative fees such as an application fee and appraisal fee (they need to know how much your home is valued at for the collateral). Many lenders also charge an origination fee on the amount borrowed, which is usually around 1%.

The lender will use a formula to determine the amount of your available line of credit. This typically depends on your credit profile and likely will be a maximum of around 80% of the equity in your home. Let’s look at an example: 


Once you have been approved, your lender will provide the terms and conditions for repayment.  

HELOC’s typically have a variable interest rate that can adjust with market conditions over time. The risk is that interest rates go up and therefore your payments could go up. In addition, there are a variety of terms related to the length of time you have to repay the loan. Most options aim to have you repay the loan in 10 years or less (while mortgages are usually 30 year loans). You will have a minimum payment each month like a credit card, but if you want to get the loan paid off in a reasonable amount of time you will need to make a larger payment each month (beyond the minimum required).


Comparing HELOC to Home Equity Loan

Another popular way to access your home equity is through a home equity loan. HELOCs and home equity loans share a similarity in that both allow you to borrow against the equity in your home and charge interest on the amount borrowed.  However, the way you borrow, how you repay, and the way interest is charged are all different.

First, with a home equity loan, the loan proceeds are paid in a lump-sum. With a HELOC you can access the funds against your credit line as you need them. For the loan, you would be required to know exactly how much you need to borrow, say for a credit card payoff. This would not be as useful for home renovations because the cost of these projects aren't exact and can change. 

Repayments are also different.  A home equity loan requires you to start repaying the loan with fixed-monthly installments immediately (similar to a car or home loan).  On the other hand, with a HELOC you can make smaller minimum payments early on before having to increase your payments to ultimately pay down the debt.  Finally, the interest rate on HELOCs is typically variable while home equity loans are usually fixed. 

Here is a quick chart describing these differences:

 

Downsides to HELOCs

When you choose to borrow from a HELOC you have to keep in mind that your home is the collateral for repaying this loan.  If you find yourself unable to pay, your lender may foreclose and you could lose your home.  If you are taking out a HELOC to pay off consumer debt, be sure to address the underlying concerns related to how you amassed the debt in the first place.  A HELOC can quickly add to your debt if you continue to rack up more consumer debt after you have taken out money from your home. 

Variable rates associated with HELOCs can be unpredictable.  You need to make sure that even if rates rise you are still able to pay off the debt.  This means, ensuring that you aren't borrowing against the maximum payment you can afford. Also, your home value could change, causing you to owe more on the home than it is worth because of the balance on the HELOC.  This could be problematic if you need to sell your home unexpectedly.  

A HELOC can be a great tool that you can use to access the equity in your home.  Its flexible terms make it a preferred option over the high rates associated with credit cards.  If you can safely repay the borrowed amount over time then a HELOC may be the right choice for your borrowing needs.

If you have any questions about using a HELOC reach out to your Origin Planner.