What is a HELOC?

When it comes to taking equity out of your home a home equity line of credit, or HELOC may be an option. Here’s a look at what is a HELOC.

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After you’ve paid down your mortgage for a few years, you may be able to take advantage of the equity you’ve gained through a home equity line or credit, or HELOC. A HELOC is a revolving credit line that you can draw against, typically for major purchases like home improvement or higher education expenses. Your home serves as security for the HELOC. Defaulting on payments could lead to foreclosure.

How HELOCs Work

A HELOC is different from a second mortgage because the balance is revolving – purchases deduct from your credit line, but you can borrow the money again after you make a payment.

With a HELOC, you have a draw period, which may be 10 or 15 years. During the draw period, you can make purchases up to your credit line, similar to the way you would with a credit card. You may have minimum monthly payments during the draw period. Minimum payments may be interest-only or interest plus a percentage of the principle balance, depending on the terms of your HELOC.

After the draw period is over, you’ll be required to repay the balance, either all at once or in installments over a certain number of months. If the HELOC balance will be due all at once, you should have a plan for how you’re going to pay it. You may have to refinance the HELOC or ask your lender about converting it to a fixed installment loan.

The limit of your HELOC is based on the current appraised value of your home and the amount owed on your mortgage. Lenders often allow homeowners to borrow a maximum of 80% of their home’s appraised value minus the balance owed on the mortgage. For example, if your home is appraised for $150,000, you can borrow up to 80% ($120,000) of the appraised value, and you owed $70,000 on your mortgage, you could get a HELOC up to $50,000. HELOC approval and credit line is also based on your income, expenses, other outstanding debt, and credit rating.

Fixed & Variable Interest Rate vs. ARM

HELOC interest rate may be fixed or variable, but variable interest rates are more common. Variable interest rates can change daily based on another interest rate like the prime rate. A HELOC with a variable APR is more risky than an adjustable rate mortgage because interest rate increases take effect quicker. With an ARM, the interest rate only adjusts every few months or years. ARMs can also have stipulations that keep your interest rate or monthly payment from rising over a certain amount. The HELOC doesn’t have this feature.

If you’re deciding whether to take an HELOC or a second mortgage, note that you can’t compare the two options based on APR. The mortgage APR includes interest rate plus other fees, while the HELOC APR is a periodic interest rate that doesn’t consider any other fees you’ll have to pay.

Drawbacks of the HELOC

You may have to pay closing costs and other fees, e.g. application and appraisal fee, at the time you get your HELOC. Make sure you know these costs before you commit to taking the line of credit.

In the event that your home value decreases, the lender may lower your HELOC, sometimes taking away the entire unused amount. If this happens, you’ll be unable to draw against the HELOC. Making payments may not necessarily free up additional credit line, because the lender may continue reducing your HELOC down to the true equity in your home based on the decreased home value.

Tax Benefit

You may receive a tax benefit from interest paid on an HELOC on balances up to $100,000, but you have to itemize your tax deductions to get the benefit. If the total of your itemized mortgage tax deductions is less than the standard deduction, then it makes more sense to take the standard deduction.