What Is A Home Equity Line Of Credit And How Does It Work?

By: Kate Samano January 5, 2021

A home equity line of credit, also known as HELOC, is a type of credit secured by your home, which gives you a revolving credit line to use for more considerable expenses. The home equity line of credit has comparatively lower interest rates than other types of loans, where the interest may be tax-deductible.

Some people confuse the home equity line of credit with mortgages, but they are not the same. A mortgage is used to direct finances to purchase a house or renovating it. Unlike mortgages, home equity is not the primary thing to finance when getting a HELOC. Of course, you may consider using HELOC to pay off mortgage, but mostly there are no specific requirements for using the funds. The only role of home equity is that it serves as a collateral when you apply for HELOC.

This type of loan lets typically borrowers get approved for a credit of up to 85% of their home equity value. So, the size of the loan will not be too big for those who do not have collateral with a considerable amount.

HELOC interest rates are lower because the credit line is secured by home equity. The credit lines which are not guaranteed by any collateral tend to have higher interest rates. The home equity line of credits offers various advantages to those who use the finances wisely. Let’s now take a closer look at how you can get qualified on HELOC and what are the benefits of it.

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How does HELOC work?

The process for applying for a home equity line of credit is similar to that of the mortgage lending process. Lenders will request the appraisal of your home equity, your monthly income, whether or not you have outstanding debts, and your credit score.

Once the bank or financial institution reviews your appraisal and other documents, it will contact you with an offer. Home equity lines of credits vary in terms and conditions, but the typical HELOC will have a 30-year repayment period with a corresponding schedule. Before applying, do detailed budgeting of your finances to understand how long you want the credit line to remain active. Surely, you cannot anticipate financial emergencies, but do not apply for a 30 year HELOC if you are unsure the money will be needed.

Once you are approved for the home equity line of credit, the lender will give you a HELOC account card or cheques to manage your finances conveniently. As already said, terms may be different from loan to loan. It is essential to understand what your contract terms are not to miss any payment. Some lenders might require to repay all the money owed at the end of the draw period, and some may extend the repayment over decades.

There is also another critical detail to consider while applying for a home equity line of credit. If you choose to sell your house while having an active HELOC account, the bank may require to pay off the outstanding limit immediately. Before selling your home, consider that the sold amount may not cover the whole outstanding amount, and you will be required to use your other savings.

The historical evidence

The historical evidence of 2008 leading to housing market collapse was due to financial institutions deciding to allow homeowners to borrow as much as 100% of their home equity value. This led to the subprime crisis, which improved laws and regulations of mortgage lending. As for now, a home equity line of credits provide loans not more than 80% of the amount of your home equity, alongside with other documents such as monthly income statements, tax returns, etc.

There are upfront lender fees such as application and processing fees, origination, appraisal, and legal costs. Application and processing fees may start from $100 or more depending on the complexity of the deal. However, some banks and financial institutions refund the money in case the application is denied.

When your application is approved, and the HELOC account is opened, the lender will usually charge 1% of the total loan amount as an origination fee. Hiring a professional and getting appraisal for home equity does not have a fixed rate; instead, a professional will charge based on the collateral’s complexity.

Pros of a Home equity line of credit

Interest may be tax-deductible

One of the most notable benefits of HELOC is that the interest may be tax-deductible. According to the Internal Revenue Services, the interest payments on home equity products are not deductible unless used to build, improve, or renovate the home equity, which is collateralized. So, if you are applying for HELOC for such purposes, you may also have an opportunity to save money.

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Qualify for a low annual percentage rate

Some of the best home equity loans offer yearly percentage rates below 5%. Like other types of credit, home equity loans also give favorable conditions to those who have higher credit scores. Even though the collateral mitigates some risks, banks still choose the best interest to go to those with better credit scores.

One thing you may do if you are unaware of your credit standing is to get the free annual credit reports from one of the three bureaus. If you are somewhere between good and excellent credit score, you may want to wait for a while to pay off current debts, increase your score and get more favorable terms for a home equity line of credit.

Wrapping up

All in all, HELOC is an excellent source of financing if you use them wisely. In case you are unsure whether this is a good option for financing your expenses, head over to online consulting platforms like Lendzi, to find out more about home equity line of credits.

Indeed, HELOCs can be a backup when emergency funds are not available, and you have outstanding debts to pay off. The good thing about this type of loan is that you are not limited in directing them to individual spheres like the home renovation or home buying. This may be an excellent method to improve your financial well-being and improve your credit score.

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