Contributing Writer at Tally
July 28, 2020
Homeownership comes with many responsibilities but also has its fair share of perks. One such perk is that a home is an asset that tends to appreciate in value, resulting in equity you can tap into when a financial need arises.
You can tap into this equity using a home equity line of credit (HELOC), which gives you access to cash for a wide range of needs.
Before you can take advantage of this perk of homeownership, you need to understand all the nuances surrounding this line of credit, including:
The two HELOC phases
HELOC balloon payments
The tax benefits of a HELOC
How a HELOC compares to a home equity loan
Below, we'll cover all this and more to help you decide if a HELOC is right for you.
A home equity line of credit is a revolving credit line, like a credit card, that converts the equity of your home into accessible cash you can use to pay for goods or services. The lender will generally issue you a debit card and checks attached to the HELOC that give you quick access to the cash in the line of credit.
The primary difference between a HELOC and other lines of credit is the collateral securing the loan, which is what the lender will seize and liquidate if you default on the loan. Your home and its equity serve as the collateral securing a HELOC, so the lender will foreclose on your home If you default on your HELOC payments.
To further mitigate against losses, lenders will place a loan-to-value (LTV) limit — the maximum loan amount relative to the home's value — on a HELOC. The LTV limit will vary by lender, but it's typically up to 85% of your home's equity.
Like many home loans, if you default on your HELOC, the lender can foreclose on your home, sell it and use the equity to recoup some or all of the HELOC.
Some of the key components that make a HELOC stand out compared to traditional loans include its phased structure, its handling of interest rates, and the potential for a balloon payment at the end.
The typical HELOC has a 25-year term. The term is broken into two phases: draw period and repayment period.
The first phase is the draw period. This is the time when you can use the HELOC to pay for goods and services. Each lender will have a policy on the draw period, but most are 5-10 years.
During the draw period, you still make payments, but you have the option to make interest-only payments or payments on the principal and interest. Your monthly payment will vary, depending on the balance and interest rate each month.
If you have no loan balance at the end of the draw period, the HELOC closes.
If your draw period ends with a balance, you enter the repayment period for the duration of the HELOC’s term.
At this point, you can no longer use the HELOC as a source of additional funds. You must begin to repay your debt by making principal and interest payments.
The terms will vary with each lender, but most HELOCs come with a variable interest rate. With variable-rate interest, you'll get an initial interest rate when you open the HELOC, but it'll have rate-change periods built into its terms that allow the lender to adjust the rate.
During each rate-change period, HELOC lenders generally tie their interest rate changes to the prime rate, which The Wall Street Journal publishes based on the federal funds rate and a 30-bank survey.
Lenders can't change their interest rates to whatever they please. Instead, you have some insight into potential interest rate changes through the lifetime adjustment cap and periodic adjustment cap.
The lifetime adjustment cap is expressed in percentage points and represents the maximum number of percentage points that the interest rate can rise above the initial rate. For example, if a HELOC has a 5% initial interest rate and a 5% lifetime adjustment cap, the interest can never exceed 10% over the life of the loan.
The periodic adjustment cap, also expressed in percentage points, limits the number of percentage points your interest rate can increase during each rate-change period. For example, if a HELOC has a 2% periodic adjustment cap, the lender can’t increase the interest rate by more than 2 percentage points during any single adjustment period.
These interest rate changes apply only to the loan balance at the time of the rate change and don’t apply retroactively. Even with these caps, an increase of 2 percentage points during a rate-change period can make a significant impact on your monthly payments.
Because lenders may offer a significantly lower interest rate than most fixed-rate loans, HELOCs often look like great options initially. Unfortunately, this can change quickly once a rate-change period hits.
You can get all the details on the interest rate and a lender's rate-change schedule and caps in the terms of the loan. Examine these carefully and consider your potential payment if the interest rate reaches its maximum.
Some lenders now offer a fixed-rate option on their variable-rate HELOCs. This gives you the option of converting any portion of your variable-rate HELOC balance into a fixed-rate loan during the draw period. The fixed rate will likely be higher than the variable rate, but it allows you to avoid the potential future interest rate increases.
The HELOC terms will outline the fixed-rate option and its interest rate.
In the past, interest charges on a HELOC worth up to $100,000 were tax-deductible regardless of its use, helping you save money on taxes.
New tax laws now allow you to deduct only interest charges on a HELOC used for capital improvements, which are permanent improvements to a home that increases its value. Plus, you're only eligible for tax deductions on the interest for up to $750,000 of home-related debt.
For example, if you have a $500,000 mortgage balance on a home and took out a $250,000 HELOC to renovate an outdated kitchen, repair the plumbing and fix the roof, you could deduct the interest charges on the full $750,000 in loans on the home.
However, if you took out a $300,000 HELOC, the interest charges on the extra $50,000 wouldn't be tax-deductible.
Some HELOCs seem affordable initially, but there may be a balloon payment lurking at the end. These balloon payments occur when the monthly minimum payments weren't enough to pay off the loan at the end of the repayment period. This lump-sum is usually at least twice the monthly payment, but they can also reach into the tens of thousands of dollars in extreme cases.
If you can't afford this lump-sum payment, you have two choices: risk foreclosure by not paying it or take out a new loan to pay it. Neither option is favorable, which is why it's key to read the full HELOC terms to ensure there's no balloon payment or the balloon payment will be affordable.
A HELOC and a home equity loan are similar, as both tap into the equity of your home. Beyond that similarity, there are distinct differences between a HELOC and a home equity loan.
A HELOC is a revolving credit that works like a credit card. You can use the line of credit many times within the draw period if there's available credit remaining and make payments only on the amount you draw from the HELOC.
Many HELOCs also offer flexible minimum payment options in their early years. You can choose to make interest-only payments or principal and interest payments during the HELOC's draw period.
One key difference between a HELOC and a home equity loan is the phasing structure. A HELOC has two separate phases, draw and repayment, which allow the borrower to use the line of credit it for a period of time while opting for lower interest-only payments.
A home equity loan is a traditional loan that goes immediately into the repayment phase.
Another way HELOC and home equity loans may differ is in the interest rate each offers. Each lender will vary, but HELOCs generally come with variable interest rates and home equity loans offer fixed rates.
With a variable-rate loan, you may get a lower interest rate initially, but you agree to periodic rate changes.
With a fixed interest rate loan, you and the lender agree to an interest rate that remains the same throughout the loan. This interest rate may be higher than a variable-rate loan initially, but the benefit is its consistency.
When comparing HELOCs and home equity loans, remember to consider the fixed-rate lock option some HELOC lenders offer.
Like most loans, HELOCs and home equity loans come with fees, but their fees differ.
A home equity loan generally sticks you with many of the same closing costs you had when you bought the home. These may include:
Title search fees
Home equity lines of credit tend to have fewer closing costs, and some have none at all. This helps keep the overall cost of financing down, but some HELOC providers charge an annual fee on your line of credit.
A home equity loan is based on the equity you have in your home. Once you have all the data you need, determining your home’s equity is straightforward.
A home equity calculation starts with the amount you owe on your home. You must consider all liens on your home, including a first and second mortgage and other home equity loans. Add these balances together to determine your total home debt.
Next, determine your home’s market value. You can get estimates of your home’s value using various real estate websites like Zillow or Redfin. If you want a more precise valuation, you can hire an appraiser. Keep in mind, though, an appraisal can cost upward of $450 and you may have to pay for it again during the HELOC process.
Subtract your total home debt from the market value of your home to get its equity. For example, if you have a $150,000 mortgage balance and your home has a $300,000 market value, you have $150,000 in equity.
HELOCs generally have few limitations on use, making them very flexible. This flexibility may be troublesome for some borrowers.
Many borrowers use HELOCs for home-related costs, including:
The great thing is most HELOC lenders don't require you to use the line of credit on home-related costs. So you can also use it for:
HELOCs are also helpful in times of financial uncertainty, like during the current COVID-19 pandemic. If you fear your job may be in jeopardy due to a financial crisis, a HELOC will give you access to extra funds if you lose your job. As long as you don't use any of the available credit in the HELOC, this backup funding costs you only the lender fees.
The downside to this flexibility is it requires willpower not to use the line of credit on frivolous purchases. Like a credit card, frivolous spending on a HELOC can seriously strain your finances. And unlike a credit card, a HELOC lender can foreclose on your home with relative ease if you fail to repay your debt.
When used correctly, there are plenty of pros to taking out a HELOC, including:
The option of interest-only minimum payments during the draw period
The flexibility of using it like a credit card
Low initial interest rates
Interest applies only to the amount of the HELOC you use
Long repayment periods result in lower minimum payments
Tax-deductible interest is used for home improvement
There is a lot of good in HELOCs, but there are some downsides to them, including:
Variable interest rates can rise quickly and cause higher minimum payments
Flexibility can get some borrowers in financial trouble
Annual fees can add up over the years
Long draw period can result in more interest charges
Your home is at risk as collateral
Approval is subject to an appraiser's valuation of your home
There are many loan options available, and with a firm understanding of what a home equity line of credit is and how it works, you're ready to see if this is the right tool for you.
If you've been in your home for a few years, got a great deal on a home or improved your home's value through renovations, there's a chance you have equity in your home. This line of credit will allow you to tap into your home's equity while offering the flexibility to use it as you please over an extended period.
If you need a loan with some flexibility and believe you have equity in your home, now's the time to apply for a HELOC and see if the terms meet your needs. You can apply at a wide range of lenders, including your bank or credit union, other banks and even various online lenders.