One of the greatest benefits of being a homeowner is that you’re building equity in your property over time. Equity is important because you can use it to secure a loan with a low interest rate. Known as a home equity line of credit (HELOC), this type of loan can be incredibly useful since you can use the funds for any reason including renovations or buying another home. Before you start borrowing from your home, it’s important to understand how a HELOC works.
How a HELOC works
A HELOC requires you to have home equity. Essentially, home equity is the difference between the market value of your home and the amount you owe on your mortgage. For example, if your home is worth $500,000 and you owe $200,000 on your mortgage, you have $300,000 in home equity.
Generally speaking, there are three major things to understand if you’re considering getting a mortgage with a home equity line of credit.
You can access only up to 65% of your home’s value
If you’re getting a mortgage combined with a home equity line of credit, you can access a maximum of 65% of the property’s market value. That said, your outstanding mortgage balance + your HELOC can’t exceed 80% of the value of your home.
While these limits may sound complicated, it’s actually easy to figure out. First, take your home’s market value and multiply it by 0.80 (80%). Now, subtract the outstanding balance on your mortgage. The remaining amount is how much you can access through a HELOC. As long as that amount doesn’t exceed 65% of the value of your home, you’re good.
For example, let’s say your home is worth $500,000 and you still have $200,000 to pay off. Your formula would be as follows:
$500,000 X 0.80 = $400,000
$400,000 – $200,000 = $200,000
$200,000 / $500,000 = 40%
A HELOC is a revolving line of credit
With HELOCs, you’re not borrowing a lump sum upfront. Instead, you’re getting a revolving line of credit. When you decide to access it and how much you decide to use is up to you. When you do make a withdrawal, you pay interest only on the amount borrowed, calculated daily at a variable rate.
HELOC rates are typically a touch higher than variable-rate mortgages and are tied to the lender’s prime rate. For example, your HELOC interest rate could be prime + 2%. Keep in mind that your lender could technically change your HELOC interest rate at any time.
You make interest payments only
Once you access your HELOC, you’ll need to make monthly payments. You may not realize that the minimum payment covers only interest. In other words, you could be paying your balance for years without actually repaying the amount you borrowed. For you to pay off the balance, you would need to make additional payments on your own.
» MORE: What is a home equity loan?
Types of home equity lines of credit
There are two types of home equity lines of credit: one is combined with a mortgage, and the other is a stand-alone product. Although similar, they work in different ways.
Home equity line of credit combined with a mortgage
A home equity line of credit combined with a mortgage is what we’ve been describing so far since it’s the most common HELOC. Most financial institutions offer this type of HELOC, but sometimes under a different name, such as a Homeline Plan.
The mortgage portion of this HELOC is just a standard mortgage that has a term and amortization period, and you make regular payments that go toward both the principal and interest. The HELOC portion is a revolving line of credit, where you pay interest only on the amounts you withdraw. As you pay off your mortgage, you’ll have more equity available. In turn, the amount you can borrow with your HELOC increases.
Stand-alone home equity line of credit
As the name implies, a stand-alone home equity line of credit doesn’t involve your mortgage. It’s still a revolving line of credit that’s guaranteed by your home, and the maximum you can borrow is still 65% of your home’s market value. Since this HELOC is not tied to your mortgage, you won’t be able to borrow more as you pay down your mortgage principal.
How to qualify for a HELOC
The nice thing about HELOCs is that you need to be approved only once. To get approved, you must meet a few conditions:
- Provide proof you own your home
- Have home equity of 20%; or
- Have equity of 35% when using a stand-alone HELOC as a substitute for a mortgage
- Acceptable credit score
- Stable income
- Acceptable total debt service ratio
- Pass the mortgage stress test
- Supply mortgage details
- Updated home appraisal
Although that sounds like a lot of steps, it’s actually a pretty straightforward process that your lender can walk you through. You also need to consider any fees when setting up a HELOC. Some fees you may need to pay include, a home appraisal, legal fees, title search and administration fees.
Pros and cons a home equity line of credit
There’s no denying that a HELOC can be useful. Assuming you have the equity, you can get instant access to a low-interest loan with favourable repayment options. That said, HELOCs can also be abused to a point where some people treat their homes like automated teller machines. Always consider the advantages and disadvantages of a HELOC before applying.
Home equity line of credit pros
- Easy access to credit. Use the funds for anything you want such as buying a rental property, consolidating debt or retirement savings.
- Low interest rate. HELOC interest rates are typically low, especially compared to credit cards.
- Interest-only payments. Since you need to pay back interest only, you can better manage your cash flow.
- Easy additional payments. There are no penalties when making prepayments.
- Borrow as needed. This is not a lump-sum loan. You can borrow whenever you need the funds.
Home equity line of credit cons
- Requires discipline to repay. Interest-only minimum payments mean you need to purposefully make additional payments to pay off the loan.
- Easy access to large amounts of cash. The amount you are approved for can be huge, which may encourage you to spend more.
- Switching lenders can be difficult. If you have a HELOC, you may need to pay it off in full before switching to a different lender.
- You could lose your home. Missing payments could result in your lender taking possession of your home.
Applying for a HELOC can help you manage your finances, but you need to have a plan. Only borrow when you need to, and try to repay more than the minimum interest payments. Alternatively, you could ask for a lower limit when applying, so you’re not tempted to spend more. Regardless of what you decide, be sure to read the terms and conditions before you apply.