Is a Home Equity Line of Credit (HELOC) the best solution for your financial needs? These guidelines will help you decide.
What is it?
A HELOC is a line of credit, usually with an adjustable rate, that is secured by the equity in your home. It typically has a draw period between five and ten years, during which you can withdraw funds as needed up to the loan limit. As with a credit card, paying back the equity makes funds available for later use. At the end of the five-year term, you can no longer withdraw funds. The HELOC then becomes a regular 10, 15, or 20-year loan, which allows for lower payments.
Who qualifies and for how much?
A homeowner with a sufficient amount of equity is eligible for this type of loan. Typically, a borrower can borrow up to 90% of the home’s combined loan-to-value (CLTV), including a first lien loan, if there is one. Therefore, the amount owed on the first mortgage is a determining factor in the size of the loan. A HELOC is often easier to obtain than a second mortgage or a new first mortgage.
What is the tax impact?
While individuals should check with their tax advisors to ensure that they meet the IRS criteria, interest on HELOCs on a primary residence may be tax-deductible if you are using the money for home improvement or refinancing your existing mortgage (consult your tax advisor).
What is the biggest advantage of a HELOC?
Flexibility is the most attractive benefit of this type of loan. A HELOC allows for repeat use of your equity, with interest charged against the amount you borrow. This provides you with an easy way to access the cash you have invested in your home, along with the flexibility of a lower payment than other forms of credit. Funds sourced can be used for many purposes, not just home improvement.
If your cash needs are large and spread out over time, such as paying college tuition by semester or proceeding with stages of a major renovation, a HELOC can be a viable option. You don’t have to pay interest on money that you are not yet using. Also, a HELOC may be less expensive because it is a secured loan, as compared to some other sources, such as credit cards.
If your first mortgage is at a good rate, you might want to leverage a HELOC to access your equity without interfering with your first loan.
When should you choose a different type of loan?
Start by discussing your needs with your mortgage lender.
If you want to consolidate debt, a HELOC may not be a good choice, particularly because the rate is often variable. A closed-end loan, such as a second mortgage or even a refinanced first mortgage, is generally a better solution as it is usually a fixed rate over the repayment term of the loan.
If you only need a small amount of money and for a short time, the origination fees and other costs of a HELOC may offset its advantages, as compared to a credit card or another short-term loan.
Since a HELOC may be a variable-rate loan, you should compare the value of its flexibility to the costs of obtaining a fixed-rate second or even a new first mortgage.
Are HELOCs popular?
Following the downturn of the housing market, many borrowers lacked sufficient equity to utilize these loans. As the market recovers, more large institutions may offer them.
What should I watch for?
If you decide a HELOC is right for you, consider these key points:
- Look for a reputable lender
- Shop around for rates and terms
- Watch out for early termination or prepayment fees
- Determine the details of the adjustable rate, if applicable
- Find out what caps and adjustment times apply to the interest rate
- Make sure the loan is set up to be paid off by the end of the term (i.e. no balloon payment required)
If you are faced with major expenditures that will be spread out over time, a HELOC may provide just the flexibility you need.