What Are Heloc Loans & How Do They Work?

heloc

A home equity line of credit (HELOC) is a type of loan that utilizes the equity you have in your property as collateral. Home equity refers to the value of your interest in your residence (i.e. its current market value, minus any liens on the property). A down payment on a house represents a form of home equity. The amount of credit you can use depends not only on your home equity but also on your debt-to-income (DTI) ratio and credit score. Much like with credit cards, most lenders will likely not approve your application for a HELOC if you have any late or missed payments.

hand holding heloc paperwork and a penGiven that HELOCs are asset-backed securities, they typically carry more favorable interest rates and higher credit limits than other types of loans or credit cards. HELOCs also generally have variable interest rates. If you can’t repay your HELOC loan, your home can go into foreclosure, which means you can lose it. One of the most common reasons homeowners take out HELOCs is to perform home improvements such as bathroom or kitchen remodels or renovations of exterior structures such as patios. However, HELOCs can also be used to finance things such as cars, trips, or weddings.

How Do HELOC Loans Work?

Much like a credit card, a HELOC allows you to borrow money up to a defined maximum. Most HELOCs have a withdrawal period between 5 and 10 years and the repayment period lasts between 10 and 20 years. After the loan has closed, your lender can offer you a credit card or special checks. Lenders often have minimum or maximum withdrawal amounts.

To determine your credit limit, most lenders will typically take a percentage of your property’s appraised value and subtract the balance you owe on your mortgage. Many lenders require a DTI ratio of 50% or lower or a FICO credit score of 675 or higher.

With some HELOCs, you can make fixed monthly payments during the reimbursement period. In this case, you may be obligated to make a “balloon” payment once this period ends if you can’t cover the entire principal plus interest with this fixed monthly amount.

It’s important to note that the risk of debt reloading associated with HELOCs is substantially high. Debt reloading occurs when you take out a new loan to repay an existing one as a means to benefit from a lower interest rate (or as a debt consolidation tactic). If you have a large amount of credit card debt with interest that is accruing rapidly, reloading may be a sound financial option to pursue.

Interest Rates On HELOCs

bank professional going over heloc rates with clientVariable interest rates on HELOCs are in part determined by public indexes such as the U.S. prime rate. This is a rate that banks and other major lending institutions across the country use as a benchmark for pricing several short and medium-term loans and other debt instruments. The federal funds rate (which is the rate banks charge each other for short-term loans) influences the prime rate.

Certain lenders offer you the option of having a HELOC with a fixed interest rate, which means part of this line of credit becomes a home equity loan. Locking in part of your HELOC can ultimately benefit you financially during times of economic uncertainty such as the current market, which is marked by high volatility for many equities coupled with inflation (especially high gas and food prices). One notable benefit of a fixed interest rate is a lower borrowing cost. Many HELOCs also have introductory rates (adjustable rates during the initial withdrawal period) and rate limits, so be sure to understand these before making your final decision. If you have previously taken out loans with a given bank or credit institution, you may also qualify for special discounts, so be sure to take advantage of these as well when applying for a HELOC.

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