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Understanding the basics of HELOCs

Whether it is fresh homeowners or even those who already have HELOCs, every one of them is asking—so, what is a HELOC anyway? According to a survey conducted by TD Bank, many borrowers do not fully understand the details of their HELOC or comprehend the terms of their lines of credit. This article gives a reasonably detailed insight of HELOC.

What is a HELOC?
Pronounced “he-lock,” HELOC translates to Home Equity Line of Credit, or simply Home Equity Line. It is a loan that allows a person to borrow up to a certain dollar amount using one’s home as collateral. It can be used to make purchases, and one can pay for those purchases later. A HELOC essentially acts as a credit card with one difference—it is secured because it is backed up by an asset with considerable value—one’s house. A credit limit is set, and the interest rate varies with the prime rate. So, when one makes mortgage payments every month and the house’s market value goes up, a person is essentially building equity. One can borrow a HELOC against that equity. This is where a HELOC differs from a home equity loan—in the latter, the bank provides a lumpsum loan. While in the former, one doesn’t borrow it until he/she needs it.

How does a HELOC work?
If one has a home valued at $500,000 with a balance of $200,000 on the first mortgage that you took, and let’s say the lender allows you to access up to 80% of the home equity. Therefore, your line of credit will be $200,000.

$500,000 x 80% = $400,000

$400,000 – $200,000 = $200,000

However, one must keep in mind that most HELOCs have flexible interest rates—this essentially means that as the base interest rates change, so will your interest rate.

The rate is set for every individual will begin off with the lender setting an index rate, such as LIBOR or prime rate, and then adding a markup depending on the credit profile of the individual.

Once people have been approved for a HELOC, they can begin using their line of credit. The first 5–10 years (different periods by different lenders) of a HELOC are called the draw period. During this time, people can borrow from the HELOC with interest-only minimum monthly payments. After the draw period is up, the repayment period starts, which generally lasts around 20 years. During this time, people have to pay both the principle and the interest, with the entire loan amount being repaid by the end of the repayment period.

When to use a HELOC?
Homeowners usually employ the use of HELOCs for renovations, home repairs, and even upgrades such as renovating the basement or upgrading the back garden. However, people also use HELOCs for myriad other reasons and uses such as making down payments on vacation homes, paying off credit cards, buying cars, paying for college, and the likes. While it’s easy to use the convenient HELOCs for other uses, they won’t add to the equity of one’s home. Moreover, one must remember that the interest on the HELOC could be tax-deductible.

Advantages of HELOCs
Using a HELOC has many advantages.

  • HELOCs are fitting for funding any urgent intermittent requirements, such as paying for college tuition, making improvements on one’s home, or even paying off credit cards.
  • HELOCs allow people to withdraw and pay interest on only the amount that they actually need.
  • Upfront costs of a HELOC are also comparatively low. For instance, on a standard loan of $150,000, unless the borrower pays a high-interest rate for the lender to pay off the amount, the settlement costs may run to the tune of $ 2,000–5,000. However, for a HELOC to the tune of $150,000, costs rarely surpass $1,000. What’s more, in many cases, they are paid by the lender sans rate adjustments.
  • Certain HELOCs can even be converted to fixed-rate loans at the time of any withdrawal. This is an extremely beneficial option for those borrowers who withdraw a large sum of money in a single go.

The Risks of a HELOC
A HELOC also has many disadvantages. They are listed below:

  • One of the major drawbacks of a HELOC is its exposure to interest rate risk. While all HELOCs are essentially ARMs (adjustable rate mortgages), they are much riskier than the typical ARM, primarily because market variations have a very speedy effect on a HELOC. For instance, if April 30th is when the prime rate changes, May 1st is when the HELOC rate will be effective.
  • Some people argue that the prime rate, to which HELOC rates are tied, are more stable than the indexes that the standard ARMs use. However, this is an illusion that arises because prime rates don’t change every day. For instance, in the year 1980, the prime rate ranged between 11.25% and 20%, changing a record-breaking 38 times. Again, in the year 2003, the prime rate changed but once on June 27th to a 4% low. Over the next 3 years, however, the rate changed a whopping 17 times (by 0.25% every time) hitting a high of 8.25% on 29th June 2006.
  • Most of the ARMs typically have caps on rate adjustment, which limit the rate change size, as well as maximum rates, which are capped at around 5-6% over the initial rates. HELOCs, on the other hand, have no rate adjustment caps, with the maximum rate being 18% (16% in North Carolina).
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