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Understanding Home Equity Lines of Credit

Understanding Home Equity Lines of Credit
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What is a home equity line of credit?
How a HELOC works
When a home equity line of credit makes sense
Home equity loan vs. HELOC
Getting the best HELOC rate
When should you avoid a HELOC?

The home equity line of credit, or HELOC, is also known as a “second mortgage.” Because your home is often your most valuable asset, you use it as collateral for another loan.

The downside is that if you can’t pay back the HELOC, the lender may force you to sell your home.

What is a home equity line of credit?

A home equity line of credit gives you access to a sizable pool of cash, usually up to about 85% of your home’s value, less the balance remaining on your mortgage and adjusted based on your creditwortthiness and ability to pay.

How a HELOC works

Say you have a $500,000 home with a balance of $300,000 on your first mortgage and your lender is allowing you to access up to 85% of your home’s equity:

  • $500,000 x 85% = $425,000
  • $425,000 – $300,000 = $125,000, your maximum line of credit limit

Keep in mind that most HELOCs have variable interest rates. This means that as baseline interest rates go up or down, so too will your interest rate.

To set your rate, the lender will start with an index rate, like the prime rate or LIBOR (a benchmark rate used by many banks), then add a markup depending on your credit profile. Variable rates leave you vulnerable to rising interest rates, so be sure to take this into account.

» MORE: Check your credit score for free

When a home equity line of credit makes sense

A HELOC is best used for home repairs and upgrades. While it’s tempting to tap the easy-as-using-a-debit-card convenience of a HELOC for all sorts of things — a vacation, a new car, whatever — those splurges won’t be wealth-building uses of your home’s value.

A bonus: The interest on your HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home, according to the IRS.

» MORE: How much is my house worth?

Home equity loan vs. HELOC

While a HELOC gives you the flexibility of tapping your home’s value in just the amount you need as you need it, a home equity loan provides a lump-sum withdrawal. That may be more suitable for your situation.

Home equity loans also usually are issued with a fixed-rate interest charge. That can save you future payment shocks if interest rates are on the rise.

» MORE: Calculate how much home equity financing you can qualify for

Getting the best HELOC rate

This one’s on you: The more you research, the bigger your reward. As you look for the best deal on a home equity line of credit interest rate, check out various financial institutions.

First, check your primary bank; it might offer discounts to existing customers. Get a quote and compare its rates with those of other lenders. As you shop around, take note of introductory offers: initial rates that will expire at the end of a given term.

Look into the caps on your interest rate, both the lifetime cap and a periodic cap if it applies. Caps are the maximum limits on interest rate increases. Remember, the annual percentage rate on your HELOC is variable; it fluctuates with the market. Make sure you know — and can afford — the maximum rate you’ll pay.

» MORE: Best HELOC lenders

What else to know about HELOCs

Under federal law, you have three business days to cancel a signed HELOC agreement without any penalty. You can cancel for any reason, as long as your primary residence, rather than a second home or investment property, is used as collateral.

Under this law, Day One begins after you receive all of the necessary disclosure documents, as well as your notice of the right to cancel, or sign the loan contract — whichever comes last. Your lender will provide you a “right of rescission” document notifying you of your ability to cancel the contract.

Keep this in mind as you’re shopping around: You have the legal right to cancel even after the agreement’s been inked.

When should you avoid a HELOC?

Your income is unstable. If it’s possible that your income will change for the worse at any point during the loan, a HELOC may be a bad idea. If you can’t keep up with your monthly payments, a lender might force you out of your home, although foreclosure laws concerning timing and procedures vary by state.

Your bank also may decide to freeze your HELOC if your home dramatically loses value or the bank reasonably believes you won’t be able to repay the loan. Freezing a HELOC cuts off the line of credit. This doesn’t mean the bank will evict you just because it feels like it; only foreclosure will lead to that misfortune. Rather, if a bank thinks you’re a greater risk than it did previously, you may no longer be eligible to make draws from your HELOC.

You can’t afford the upfront costs. Taking out a HELOC can be expensive. You have to pay many of the same fees that you did when you took out your first mortgage. These include an application fee, title search, appraisal, attorney’s fees and points. In total, these charges can set you back hundreds of dollars.

You aren’t looking to borrow much money. Those heavy upfront costs mentioned above may not be worth it if you only need a small line of credit. If that case, you may be better off with a low-interest credit card, perhaps one with an introductory interest-free period.

You can’t afford an interest rate increase. Unless you can get a fixed-rate HELOC — and those are rare — you need to prepare for interest rates rising over the course of the loan. All adjustable-rate loans have lifetime caps; those indicate the highest the interest rate could ever be. Can you pay that rate? If not, think twice about getting the loan. Also, see if your loan will have a periodic cap. This is the maximum amount your interest rate can rise in a given time period. How quickly could your interest rate, and the monthly payment, rise? Make sure your budget can manage it.

You’re using it for basic needs. If you need extra money for day-to-day purchases, and you’re having trouble just making ends meet, a HELOC isn’t worth the risk. Get your finances in shape before taking on additional debts.

Getting a HELOC for the right reasons — and if you have the financial resources to weather the possibility of rising interest rates — can make a lot of sense. But study your situation and compare loans carefully before diving in.

OK, what’s next?

Now that you’re up to speed on HELOCs, you can confidently choose a lender that offers loan terms that are best suited for your needs.

Compare HELOC lenders»

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Updated Jan. 10, 2017.