*Cue the trumpets* It’s time we introduced you to the royally awesome, incredibly useful financial solution known as a home equity line of credit, often referred to as a HELOC.
If you felt a little disappointed by the end of that sentence, trust me, HELOCs are worth the hype! There’s more to these powerful loans than what meets the eye.
What is a HELOC?
Home Equity Line of Credit (HELOC) Key Points
- Revolving line of credit that leverages home equity
- Borrow what you need up to the fixed amount
- Borrowers repay only the money they used in addition to a variable/floating interest rate (payment totals may change)
- Two stages within it’s lifespan: a draw period and a repayment period
- The draw period requires interest-only payments on what you withdraw
- The repayment period requires interest and principal payments
- May have application or repayment fees
- Typically lower interest rates than personal loans and credit cards.
- Good for higher-cost projects that require flexible access to funds over a longer period of time (home improvement, financial emergencies, debt consolidation)
- Interest may be tax-deductible on home improvement projects
- Expect access to funds in two to six weeks
HELOCs are similar to a financial resource you probably have in your wallet right now…a credit card!
A credit card is basically a renewable short-term loan. You borrow money from a lender up to a pre-established amount (your credit limit) and repay all of the money you used within a specific time period (your billing cycle). Paying off that borrowed balance replenishes your available funds so you can pull from them again in the future. This borrowing and repaying process repeats itself as you continue to use the card, keeping those funds available over time, hence why it’s called a revolving line of credit.
Similarly, HELOCs are loans with a revolving line of credit. However, the amount you can borrow with a HELOC is determined by your home equity; your home’s current market value (determined by an appraiser) minus the amount you owe on a mortgage.
Home equity line of credit makes a lot more sense now, right?
Typically, lenders will let you borrow 80-90 percent of your home equity minus any outstanding mortgages you have. The amount remaining is what you are approved to borrow with a HELOC, similar to a credit limit on a credit card.
To summarize, a HELOC is a revolving line of credit secured by your home equity. Let’s look at an example:
- The current market value of your home: $150,000
- The amount you owe on your mortgage: $50,000
- Home equity: $150,000 - $50,000 = $100,000 80% of home equity: $100,000 x 80% = $80,000
- The total amount you can borrow with a HELOC: $80,000 - $50,000 = $30,000
You now have a $30,000 HELOC that you can draw from and use as you wish! Remember, since it is a line of credit, you don’t HAVE to use the full $30,000 like you would with a lump sum home equity loan. You can draw what you need when you need it, up to the $30,000 limit.
However, since HELOCs are loans, you must pay interest, and lenders require weekly, bi-weekly, or monthly payments.
Interest Rates
The unique appeal of a HELOC is that it provides flexible access to funds, typically at a lower interest rate than that of other borrowing options, such as personal loans or credit cards.
However, in most cases, HELOCs have floating or variable interest rates, which can increase or decrease over time, affecting how much you pay in interest each month. Keep this in mind when we cover your repayment options.
Now, you may be thinking, “Who sets these rates, anyway? Am I getting the best rate option available?”
Eight times a year, the Federal Reserve evaluates interest rates and decides whether an increase or decrease is necessary to improve the economy, establishing what’s referred to as the federal funds rate.
Financial institutions use the federal funds rate to determine their prime rate, which is often considered the best available rate option for customers with good credit. When your HELOC is approved at the prime rate, it’s like getting a gold star sticker from the teacher for a job well done.
Depending on the financial institution, the prime rate is typically about 3% higher than the Fed’s. Currently, the federal fund rate is around 5.25%-5.50%, and 1166 FCU’s HELOC prime rate is 8.50%. The math checks out! However, lenders may raise interest rates for clients with bad credit since more risk is involved.
How Long Do HELOCs Last?
Unfortunately, your HELOC can’t stick around to use for the rest of your life. Instead, a HELOC has two stages in its lifespan, the draw and repayment periods, impacting how long you can tap into the available funds and the sum of each payment.
Depending on your lender, the draw period usually lasts 5 to 15 years. During this time, you have the green light to pull money from your HELOC (up to the approved credit limit) and use it how you wish. You’ve got two options for payments during the draw period.
Option One: Make interest-only payments on the amount you use. This option doesn’t help to pay down your balance. IMPORTANT NOTE: Federally Regulated Credit Unions are not legally able to provide interest-only loans.
Option Two: Make payments on both the principal (the amount you owe) and interest simultaneously. This can help you pay down your balance before the repayment period.
After the draw period comes the repayment period, during which borrowers…you guessed it…have to repay the lenders. But now, unlike the draw period, borrowers are required to pay back both interest and principal; and they must pay off their balance by the end of the repayment period, which usually ranges from 10 to 20 years.
The inability to repay your HELOC in either the draw or repayment period could lead to high interest rates, penalties, a damaged credit score, and foreclosure.
Should You Make Interest-Only Payments on Your HELOC?
The fluctuating interest rates of HELOCs come with some risk when using this financial resource. Remember, within the repayment period, you must pay off both your interest and the principal. This can be a bumpy transition for those who are used to making interest-only payments, increasing the possibility you may fall into more debt if you
aren’t prepared. Additionally, if you enter into the repayment period and rates have increased, you now have to pay even more than you may have expected.
To make the transition easier and less risky in terms of losing control of your debt, we recommend paying more than the interest-only payments each month to diminish your balance quicker and avoid paying more in the future.
Some lenders will also charge repayment fees if you pay off your HELOC in the draw period. Financial institutions do this because lenders make money from interest, and they anticipate receiving that revenue throughout the lifespan of your HELOC. We’re different at 1166 FCU; our priority is our member's financial well-being. We let you pay back your HELOC as early as you’d like, meaning you can avoid prolonged interest charges and paying more than necessary.
What Should I Use a HELOC for?
Technically, you could use a HELOC for most things, but that DOES NOT MEAN YOU SHOULD. Think of it like this; I COULD eat a whole family-sized bag of Cheetos, but just because the Cheetos are there doesn’t mean that I should. Too much of a good thing is a bad thing…even with Cheetos, much to my disappointment.
“What’s the big deal, though? I was approved for that money, so shouldn’t I use it for whatever I want?”
You’re using your home equity as collateral, meaning high stakes are involved. You want to be as wise as possible with the use of HELOC funds, as it is putting you into debt. As a rule of thumb, HELOCs should be used for large expenses that build your wealth in the long run. Consider using a HELOC for the following options:
Home improvements/repairs
- This is one of the most popular uses of a HELOC. Essentially, this uses your home's value to increase it even more, so it’s a good return on investment. Home improvement projects often require flexibility with money and time, something a HELOC can provide. Additionally, the interest you pay may be tax deductible if you meet the right criteria.
Educational expenses
- Tuition or student loan bills swiftly approaching? A HELOC can help cover those school expenses. Borrow and pay for school fees on time, and repay on a schedule that works for you. However, check out your student loan options first, as they may have better terms and protections than a HELOC.
Consolidating high-interest debt
- The lower interest rates of a HELOC may make it easier to pay down debt than other options like a credit card. HOWEVER, be realistic about your dedication to eliminating debt using this method to avoid getting stuck with even more debt than before. If you know that you struggle with debt repayment, getting a HELOC could be a risk you don't want to take.
Starting a business
- Instead of viewing finances as a reason to refrain from chasing your dreams, use a HELOC to help your new business hit the ground running. However, if your business isn’t as successful as you hoped, it can make loan repayment and business expenses difficult to manage.
Financial emergencies
- Unexpected medical expenses? Car issues? Broken HVAC system? A HELOC can help back your emergency fund in the midst of financial
strain. Get the financial support you need when you need it so you can focus on the issues at hand.
What Should I Not Use a HELOC for?
Just because you have a HELOC doesn’t mean you should go out and buy a luxury sports car or pay for your vacation to Aruba. The money has to be paid back monthly, so use your home's hidden value to grow your and your family’s future.
You’ll find people who say NOT to use a HELOC for educational purposes, new business ventures, or any of the scenarios in the previous section. That’s because life circumstances and the state of the economy greatly impact what financial solution is currently best for you.
For example, using a HELOC instead of an auto loan may not be the best move because HELOCs may have higher rates and more risk involved. Or, you could invest in
property with a HELOC, but the volatile nature of the real estate market could cause issues with payments down the line.
The rules aren’t set in stone, but best practices and advice from professionals (like 1166 FCU’s certified financial counselors) can help you make the right decision.
What are the Requirements for a HELOC?
The application process for a HELOC convinces lenders of an applicant's financial responsibility. Lenders evaluate an applicant's credit score, equity percentage, debt-to-income ratio, income levels, payment history, and more.
Do HELOCs Have Fees?
HELOCs often have initial application fees in addition to closing fees to pay for the behind-the-scenes tasks financial institutions must complete to get you your HELOC. These tasks involve things like filing with the county, documenting the lien, the appraisal
process, the title search, etc. Basically, it’s all the paperwork that makes most people shrivel and cry.
Be aware that your lender may also charge inactivity fees if you don’t pull from your HELOC within a set amount of time.
HELOC vs Home Equity Loan
Last month, we took a deep dive into home equity loans (check out that blog if you haven’t already). While home equity loans and HELOCs appear to be cut from the same cloth, each has specific nuances that may satisfy your needs better than the other.
