What is a Home Equity Line of Credit (HELOC)?
HELOCs are a secured loan through your bank, which leverages the equity in your home. Before you go off and search for the definition of “equity,” essentially, it’s the difference between the value of your home and the mortgage balance. For example, if your home is worth $250,000 and your home loan or mortgage is $150,000, you have $100,000 of equity, which you could potentially borrow against in the form of a cash-out refinance, second mortgage, or of course, a HELOC. Let’s look at a real-world example of how a HELOC works. Recently a friend of mine, let’s call him Joe, decided to do a substantial renovation on his home. The project included replacing the carpeting with hardwood floors as well as new appliances in the kitchen. The materials, as well as labor costs, were considerable and totaled approximately $25,000. Joe didn’t want to max out his credit cards as the interest rates would be astronomical, and his FICO Score would likely take a serious hit as well. The contractor offered to finance, but the interest rate was over 15%. Fortunately for Joe, he owned his home with plenty of equity, so he called his bank to check on getting a HELOC. Good news for Joe, he had plenty of cash to work with for his HELOC being that he bought the house several years early, owing just $300,000 on the current mortgage while the home value had increased to $400,000 — giving him $100,000 of equity.
How Much Can you Borrow using HELOC?
All banks and lending institutions have their own rules and fees, but generally, you can get a HELOC for 85 percent of the value of your home minus what you owe on it. So, using Joe’s example: Home value of $400,000 x 85% = $340,000. We subtract the amount owed on the original mortgage from the 85 percent number: $340,000 – $300,000 = $40,000. Joe was able to qualify for a HELOC of $40,000. As with other loans, each month, the bank will send a statement showing the principal and interest due. There is a draw period, which is usually 10 years, during which time you can withdraw any amount up to the agreed-upon limit. There is usually a 20-year repayment period that follows the draw period. You cannot withdraw any funds during the repayment period and must pay back the remaining balance and interest.
How does the Interest Rate of a HELOC Compare to Other Types of Loans?
A HELOC generally has a variable interest rate (some lenders offer fixed rates) tied to the prime rate. There is also a margin, typically around 1 percent, that stays consistent throughout the loan’s life. Generally speaking, a HELOC interest rate will always be lower than a credit card or personal loan rate. However, your interest rate will primarily depend on the loan amount and your FICO score.
Is the Interest from a HELOC Tax Deductible?
In most cases, if you will be spending the funds from your HELOC on home renovations, the interest you pay on the HELOC will be tax-deductible. That said, tax law is complex, and no two tax returns are the same. Please be sure to check with your tax adviser to find out what deductions are available to you.
One of the advantages to the HELOC is you can withdraw any amount up to the agreed-upon limit; in Joe’s case, this limit was $40,000. Joe started work on his house by withdrawing $25,000. As time went on, the project expanded a bit, and he took another $8,000. When the work was completed, Joe started paying back the interest and principal. The beauty of the HELOC is that you can continue to withdraw up to the credit limit during the draw period and if you’ve paid back some principal, that counts towards the total funds available. A HELOC is like a credit card with one huge advantage; the interest rate is significantly lower on the HELOC compared to a credit card. Some people will take out a HELOC to consolidate their other higher interest debts, such as credit cards. Why pay 28 percent interest on a credit card when you can pay 6 percent on a HELOC? Generally, to qualify for a HELOC, a lender will look at your credit score, history of payments, and your monthly income, monthly debts, and employment history. The process is very similar to applying for a mortgage. The numbers I’ve used are all examples and will differ from what you’ll find in the current marketplace. All lenders have different terms and conditions for their HELOCs, and the fees can vary as well. It makes sense to shop around to find the HELOC that makes sense for your needs.
