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The equity in your home is an important part of your portfolio, but it also offers you a way to get cash for a variety of purposes from buying a car to funding a small business. A home equity line of credit can free up the value you have in your home without needing to sell the property.
A home equity line or credit, or HELOC, also lets you access the equity you’ve built up in your home without going through a lengthy application process for a term loan from a bank or other lender. To help you decide if this is the right financing option to meet your needs, here’s what you need to know about HELOCs:
A HELOC is a line of credit that uses your home equity as security. For example, if your home is worth $200,000 and you've paid $100,000 on your mortgage, you have $100,000 in equity that could be available as a line of credit.
A line of credit isn't like a term loan with set monthly payments for a specific period of time. Instead, a line of credit works more like a credit card: it has a maximum credit limit that you borrow against and pay back each month. When the balance is paid off, the full credit limit is available to use again. If you don't use the credit line, there's no need to make payments. The flexibility of this type of revolving credit is a great option for homeowners who don't want to be tied to making monthly payments over the long-term.
Most business and personal loans are unsecured, so they have higher interest rates and stricter approval processes. A HELOC uses your home as security, which means that if you don't make payments and default on the line of credit, your home could be at risk. Because this risk is so significant, it can be easier to get approved for a HELOC compared to other loans and lines of credit. Lenders know that if you don't pay, foreclosure is a possibility, and that gives them more confidence that you won’t default on the loan.
Loans are typically calculated using a fixed rate of interest, but HELOCs usually have a variable interest rate that can go up and down depending on the prime rate. If you have a balance on your HELOC and the rate goes up, the amount you need to pay each month increases too.
HELOCs function differently than most other lines of credit that are either unsecured or backed by a cash deposit. Because HELOCs are secured by your home equity, the amount of money you can access depends on how much equity you have in your home. If you have strong credit history, you may be able to get a higher limit through a standard, unsecured line of credit.
HELOCs also have an expiration date. While most other lines of credit can be borrowed on and repaid indefinitely, HELOCs can only be used as a line of credit for a certain period before converting to a home equity loan.
HELOCs aren't the only way to access the value you've built up in your home. A home equity loan and mortgage refinancing are two other options.
A home equity loan is a type of term loan that's secured by the value you have in your home. As with any term loan, it needs to be paid back on a fixed monthly schedule over a set time frame.
A mortgage refinance involves applying for a new loan at a higher dollar amount. For instance, if your home is worth $200,000 and you have $100,000 left on the mortgage, you could apply for a new loan for $120,000. This would let you pay off the original mortgage and have $20,000 left to use for business expenses, to finance home repairs or to for other related purposes.
Getting approved for a HELOC can be a little easier than qualifying for a traditional line of credit or term loan, but it's not just a matter of having some equity in your home. With most lenders, HELOC applicants need to meet a few requirements such as:
Most lenders approve HELOCs for up to 85% of a home's value, but this percentage can vary between lenders. Banks can also limit the amount they'll approve regardless of the value of your home and how much equity you have. For example, PenFed Credit Union only approves HELOCs up to $400,000. This means if your home is worth $800,000 and you own it free and clear, you'd only be able to borrow 50% of your equity instead of 85%.
Lenders require certain documentation from an applicant to approve a home line of credit. While the requirements can vary from lender to lender, generally, you'll need to provide:
Some banks require extra documentation. U.S. Bank, for example, also wants to see a completed mortgage loan application. Be sure you understand the requirements before applying with a particular lender.
You may be wondering why your personal credit information matters if you have equity in your home to borrow against, but your financial history is extremely important when you're applying for any type of loan, including a HELOC. This is because your credit history can shed light on how likely you are to repay the money you borrow. If you have bankruptcies or delinquent debt in your recent history, banks may be hesitant to lend to you for any reason.
When using a HELOC to fund a small business, your lender may ask for financial details on the company such as cash flow, tax returns and length of time in operation. Ultimately, since a HELOC is a personal loan, your own debt, income and financial history carry far more weight.
While fees can vary between banks, most charge an origination fee that's a set amount or a percentage of the HELOC credit limit. Sun Trust Bank, for example, charges $65. PenFed Credit Union, on the other hand, charges a variable fee based on the loan amount, while U.S. Bank doesn't have any origination fee. These fees can be a cost you have to pay upfront, or they may increase the total amount you owe if they're added on to the loan.
Home equity line of credit interest rates can vary based on the lender as well as market fluctuations. It's not uncommon for rates to change every few months, and this affects how much interest is due on a HELOC balance, making it important to compare interest rates offered by different lenders before applying for this line of credit. As an example of how lender rates can differ, PenFed Credit Union rates range between 3.75% and 18%, while U.S. Bank's APR range is more affordable at 4.6% to 8.1%.
To what extent the interest rate affects a borrower really depends on how a HELOC is used. If you pay off the balance every month, you won't be charged any interest. If you max out your credit limit and pay it back in small monthly amounts, a higher interest rate can make a significant difference in your total cost over the long term.
As with other lines of credit, HELOCs need to be repaid on a regular basis, usually monthly. Borrowers get a statement with a minimum payment and a total balance. Paying the minimum is all it takes to continue using the line of credit without penalty, but interest will be charged on the remaining amount owed.
HELOCs do have payback terms or a specific length of time that the line of credit can be used. Again, this depends on the lender. Some banks offer longer terms while others prefer HELOCs to be paid back in full over a shorter period of time.
They also differ from most other home financing methods because they work as a line of credit for a certain length of time before converting to a standard home equity loan. During the LOC period that typically ranges from five to 10 years, you can draw out money up to the credit limit, repay it and then borrow it again.
Once this draw period ends and the HELOC transitions to a regular loan, you have 10 to 20 years to repay the outstanding balance via monthly payments. The variable interest rate charged on most HELOCs is easy to manage during the draw period, but it can be more difficult to budget for once the repayment phase begins. At that time, you have the option of refinancing to a conventional mortgage or reapplying for a new HELOC.
Some HELOCs also have additional fees for paying the balance in full before the line of credit converts to a standard loan. Sun Trust, for example, requires a borrower to pay closing costs if their loan is paid off early.
Like all kinds of financing, HELOCs have a lot of advantages, but this kind of home credit line is not right for everyone. Keep these pros and cons in mind when deciding whether to tap into your home equity with a HELOC:
Unlike some other forms of business or personal loans, HELOCs are secured loans, which can make them easier to get approved. Though interest rates are variable, they tend to be lower than other lines of credit, which can save the borrower money over the loan's term. Home equity lines of credit can also be cheaper to obtain, since there are rarely closing costs. Since a HELOC is a line of credit, you can pay back the balance and borrow it again, which isn't possible with a standard term loan.
Additionally, the biggest advantage of a HELOC is often the flexibility it offers. HELOC funds can be used for just about anything without getting approval from your lender. If you originally planned to finance your small business but later decide to use part of your credit line for a kitchen renovation, for example, it's completely acceptable.
HELOCs have a lot to offer, but they also have a few drawbacks. Loan caps tend to be lower because the amount you can borrow is directly tied to the amount of equity you have in your home. Most lenders will only lend a maximum of 85% of the equity you've built up, so even if your home is paid off, it's not usually possible to borrow the full amount. Any balance on your line of credit also needs to be repaid if your home is sold, which can reduce the amount you end up getting from the sale.
If you’re considering a HELOC, choosing the right lender is a must. If you’re looking for transparent terms, low cost and affordable interest rates, lendzi can help you find your perfect fit. Contact us to get started on a loan application.
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