A HELOC, Home Equity Line of Credit, is a line of credit that uses your primary residence as collateral. Since it is a revolving line of credit, it can be utilized often and without a new application each time you withdraw money, similar to a credit card. You can pay down your balance at any time and it frees up available funds each time you pay down your principal.
What is it used for?
The most common reasons for obtaining a HELOC include: home improvements, debt consolidation, and major purchases. However, you can use a HELOC for just about anything you want, as long as you qualify for it. Qualifying involves your creditworthiness as a borrower, your income, and the equity available in your home to use.
How much can I get?
Most people don’t understand the formula to determine how much you can obtain in a HELOC. It isn’t a simple matter of: Home Value – Mortgage Balance = Available HELOC. The lender will typically multiply your home value by a number at or around 80% before subtracting your mortgage balance. That means the formula is actually: (Home Value x 80%) – (Mortgage balance) = Available HELOC. The reason most lenders won’t use 100% of your home value is for the same reason most lenders won’t let you borrow 100% of your mortgage—it overextends the borrower. There is a greater risk of default if every penny is borrowed. In addition to the aforementioned formula, the borrower will also need to qualify based on credit score and income. In calculating income, the lender will assume the borrower will max out the HELOC and then use that monthly payment in your total debt-to-income ratio. Most lenders don’t want people to be over 40% on a debt-to-income ratio, so they assume the HELOC is maxed out up front to approve the loan. That way, the borrower will never go above 40%(or whatever percentage the lender uses), even if the HELOC is maxed. You can also expect the minimum FICO requirement to be around 640.
Are there costs associated with it?
There are costs to get a HELOC, which include: appraisal, title work, loan processing fee, etc. Many lenders offer a way to cover these costs 100% if you meet certain criteria. An example would be: HELOC must be a minimum of $30,000 and you must withdraw at least $10,000 within 30 days and keep the balance for 6 months. There are a wide range of examples of how to bypass closing costs, so check with your lender to see if they offer one. If you qualify for the cost waiver, then you can get the HELOC for no cost! You may also want to ask about an annual fee. Some lenders don’t charge a fee, while others charge between $100-$200 to keep it open, even if you never use it.
What is the interest rate?
The rate is based on the prime rate, and it is expressed as a formula. For example, the rate may be: Prime + 1%. That means that whatever the current prime rate is you add 1% and that’s your rate. If prime goes up, so does your loan rate. If prime goes down, so does your loan rate. The point is that it’s always variable and always based on prime. Some lenders have teaser rates. For example, your first 6 months are at 4.99% before you default to your approval rate. Check with your lender for teaser rates(also called Introductory Rates).
Some lenders have an option to take an existing HELOC balance and convert it into a fixed rate/term loan inside the HELOC. Let’s say you have a $50,000 HELOC with a current balance of $20,000. The lender may let you convert that $20,000 balance into a 7 year, fixed rate of 8% with set monthly payments. The remaining $30,000 is still available to withdraw the same way your original contract was done.
What are the payment options?
I’ve seen payment plans fall into two categories: Interest-only or fixed percentage. If it’s a fixed percentage, you simply pay that percentage amount each month. For example, if the percentage is 3% of the balance of $10,000, then you would pay either $300/mo or $25/mo, depending on if the 3% is an annual or monthly number. The payment would trickle down slightly each month since you would be reducing your balance after each payment, and your new payment would be 3% of the new balance. If you have interest-only payments, then you would have a very small monthly payment due, but you would never pay down your balance if that’s all you paid. For example, if your balance is $10,000 and your rate is 10%, you would pay $83.33/mo($10,000 x 10% / 12 months).
How do I access the funds?
Most lenders offer the following options: checkbook, debit card, transfer to checking account, or direct withdrawal at the bank. If you have a HELOC at a bank where you also have a checking account, you can usually do a transfer on the mobile banking app and pay for something out of the checking with the funds. This is what most of my customers like to do.
How long do they last?
Usually between 5-20 years. Most people simply renew it if it matures and there is still a balance.
What else can they be used for besides the most common reasons?
I’ve seen some get used to fund college. Others use them to start a business. I have some landlords who like to use the HELOC to purchase a rental property, and when they start getting rent or flip the house, the money goes back into the HELOC to start the cycle over again. HELOCs are much easier options for this instead of getting a new loan with each property purchase. Another reason I recommend them is for an emergency/retirement fund. Use this as a back-up option. For example, if a couple is about to retire and they are worried about what the financial situation will look like, I encourage them to take out a HELOC before they retire(so they can qualify for it) and then keep it during the first years of retirement. That way, if an emergency arises, you have a backup source of funds outside of retirement accounts. Retirement accounts should be the last option to fund an emergency, and a HELOC provides a great alternative. It’s best to find a lender who doesn’t charge an annual fee if you want to go this route. HELOCs also serve as emergency funds whether a person is retired or not. Emergencies happen, and HELOCs that are already in place can provide instant funds without the waiting time if you need to buy a car, replace an A/C, fund a surgery, etc. You don’t get asked why you are withdrawing from a HELOC. Once you have it, you have it.
