So, what exactly is a HELOC? A Home Equity Line of Credit (HELOC) allows you to tap into your home’s equity (the difference between your home’s value and how much you owe on it).
Here’s how it works:
A HELOC is similar to a credit card. It’s a revolving line of credit that allows you to borrow up to a specific limit, pay it off, and then borrow it again. A percentage determines the limitation that the lender sets for you called the loan-to-value (LTV). The LTV the ratio of how much you owe versus how much your home is worth.
The amount of money the lender will allow you to borrow for your HELOC will depend on the lender’s maximum acceptable LTV.
HELOC vs. Credit Card
While a HELOC is similar to a credit card, it works slightly differently. One of the most significant differences is that HELOCs have a time limit. With a HELOC, an initial draw period is generally a 10-year period where you can withdraw and use the money. A typical HELOC will require you to make payments during the draw period. Those payments go towards the interest that accrues.
Another big difference is the repayment period. Once you reach this period, you will start repaying the principal and interest you’ve accumulated and will no longer be able to borrow money. Repayment periods typically last between 10-20 years. If you decide to move before the repayment period is over or you’ve paid everything back, the remainder of the balance will be due before you close.
Qualifying for a HELOC
You’ll need to prove to your potential lender that you’ll be able to pay back any money you borrow. Your lender will consider several factors when determining if you qualify: your debt-to-income ratio (DTI), your credit score, and more. Your HELOC lender does not need to be the same as your mortgage provider.
Taking the Risk
Let’s pump the brakes for just a minute before you rush out and apply for a HELOC. It’s essential to be aware of the risks associated with HELOCs. First and foremost, a HELOC requires you to put your home up as collateral in exchange for the credit line. In other words, if your situation changes drastically and you’re unable to make your payments, you risk losing your home. You are also reducing your equity in your home when you use a HELOC, as you’re increasing the debt that you owe against it.
A HELOC is not free money. There are fees for opening and maintaining a HELOC. Similarly, HELOCs can have variable credit rates. That means the rates can change with market factors. You might start with a low rate initially, but it could rise to something that is much less affordable.
You can also run the risk of overborrowing with a HELOC. HELOCs can have a high limit, and it can be easy to slip into using more than you can afford to pay back, thus getting yourself into unnecessary debt.
Lowering & Freezing
Lenders can lower or freeze a HELOC. If something happens that significantly changes things from when you first opened the HELOC, the terms of the HELOC could change as well. The lender may lower your approved amount or even refuse to allow you to borrow any more. Your home dropping in value or the lender having reason to believe that you will no longer be able to make your payments are just a couple of examples of situations that could result in term changes.
Is a HELOC Right for You?
You are the only one that can decide if a HELOC is right for your situation. You must consider all of your debt, risk tolerance, and for what you want to use the money. Home renovations or home improvements are one of the most common uses for a HELOC. For these purposes, the interest on HELOC payments can be tax-deductible and may have a lower interest rate than a credit card or other loan options. However, that rate is not guaranteed to remain throughout the term.
If you need extra funds and are comfortable with the idea of borrowing against the equity of your home, a Home Equity Loan could be another option for you. This loan works similarly to a HELOC, but rather than being a credit line, it is a lump sum that you borrow and repay. If the risks of tapping into your home equity are too significant, it might be a better idea to seek funds elsewhere.
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