If you’re a homeowner—or a hopeful homeowner-to-be—you may have heard the obscure-sounding term “HELOC work.” Pronounced “hee-lock,” it stands for “home equity line of credit” and is a popular method for American homeowners to obtain credit for major purchases. But what is a HELOC, how does it work, and when should you—or shouldn’t you—use it? In this blog post, we’ll answer some of your questions about HELOCs.
What Is a HELOC?
As previously mentioned, HELOC stands for “home equity line of credit.” In other words, this means it’s a home equity loan, similar to a standard double mortgage. However, unlike a traditional double mortgage, where you’re loaned the full amount right from the start, this is a line of credit, which means you can borrow as much, or as little, as you need against the loan’s collateral, which is the equity of your home.
In other words, if your home has available equity of $250,000, a second mortgage would give you a full sum of $250,000 to use at once, while a HELOC would give you a new line of credit worth $250,000 for you to use as and when you need.
How Does a HELOC Work?
Typically, a bank or credit union offering a HELOC requires you to have equity available in your home. In other words, this means that the amount you owe on your home must be less than the home is worth.
You can usually only borrow a portion of your equity: that is, the home’s value minus what you still owe. This is usually anywhere from 75 to 90 percent of the value, depending on which organization is offering you the HELOC work. So, if your home is worth $500,000, and you have $200,000 left to pay on your initial mortgage, your available line of credit will usually be somewhere between $225,000 and $270,000.
The life cycle of a HELOC work is divided into two phases. In the first phase, the “draw period,” which tends to last around 10 years, you can draw as much money from the line of credit as you need, up to the maximum. Similar to a credit card, if you pay off your balance, that funding becomes available for you to borrow against once more. If you borrow $200,000 on our hypothetical example, you might have only $25,000 left, but if you pay off $50,000, you can borrow $75,000 more.
After the draw period is over, the “repayment period” will begin. Repayment can last up to 20 years. During this time, the homeowner is expected to repay the outstanding balance on their HELOC work, as they would any outstanding bill, like a mortgage or credit card debt.
A HELOC contains one other major difference from a traditional mortgage. While the interest rate on most traditional mortgages is typically fixed, either for the entire length of the repayment period or for long periods measured in years if not decades, a HELOC is an adjustable-rate mortgage, which means its interest rate is calculated daily and can fluctuate as often as month to month.
Most banks and credit unions use the US Prime Rate as the index for their HELOC rates. As the Prime Rate moves up and down, so too will a HELOC’s interest rate increase or decrease. While this can be good for homeowners who have HELOCs—after the financial crisis in the late 2000s, the Prime Rate lowered significantly so HELOC interest rates plummeted with it—it can be a double-edged sword. If the Prime Rate goes up, so can your interest rates, and you’ll already be locked in.
Some HELOCs may offer fixed rates, but these tend to only be introductory terms for a short period of time, typically a few months or half a year at most.
Why Get a HELOC?
Why would you get a HELOC, as opposed to a traditional home equity loan?
As mentioned, HELOCs are more flexible than traditional mortgages, and the fact that you can “free up” space in your line of credit means that you technically can borrow more money than the theoretical maximum, provided you pay off your balance.
For this reason, HELOCs are perfect for recurring major expenses whose maximum limit isn’t known, like home improvements or medical bills. HELOCs are also very good for other intermittent expenses, like paying for a child’s college tuition. Due to their typically low interest rates, HELOCs are also excellent for consolidating higher-interest loans, like credit cards.
The fact that you only borrow what you need on a HELOC can make it very appealing since, unlike a home equity loan, where you know you’ll be on the hook for the full amount, a HELOC only costs you what you need.
A potential downside, however, is that because a HELOC is an ongoing line of credit, it can potentially be terminated by the lending institution if they determine the credit line isn’t being used. When HELOC rates plummeted, as previously mentioned, in the aftermath of the financial crisis, many major lenders did just this, meaning that homeowners suddenly found themselves without the available loans they believed they had.
What Questions Should You Ask Before Getting a HELOC?
HELOCs, as we’ve seen, have many upsides in terms of flexibility and affordability. However, as with any major loan, there are inherent risks. For this reason, you should ask your lender—and yourself—some questions before you embark on the HELOC journey.
- Do I have the equity? As with a mortgage, a HELOC is based on the equity of your home as collateral. Defaulting on a HELOC, therefore, can lead to foreclosure in worst-case scenarios. Make sure your finances and equity are in shape to avoid this situation.
- What is the margin? The rate of a HELOC is tied to the Prime Rate, but with an extra margin for the lender. If the margin is 2 percent and the Prime Rate is 4 percent, then your interest rate will be 6 percent.
- How long will the start rate last? As mentioned, lenders will typically offer a fixed-rate period of a couple of months to begin the draw period. You want to be certain of this in advance.
- Is there a minimum draw amount or any other fees? You want to know for sure how much you’ll be expected to pay at the minimum. Some HELOCs require you to draw a minimum from your line of credit or to maintain a minimum average balance. You don’t want to have to pay more than you need, so keep an eye out for these.