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Home Equity Line of Credit

By Kirk Haverkamp
Updated and reviewed: Jul 10, 2013

There are infinite scenarios that may leave you in need of a quick infusion of cash. You may be seeking funds to buy a car or send your child to college, or you may be longing to renovate an aging kitchen or bathroom, or adapt new green technologies to your home. Ideally, you could fund these purchases with some type of emergency cash fund or savings account that you’ve been accumulating for this very occasion. But if you’re like most Americans, you don’t have that kind of cash sitting around in your account just waiting for you to need it.

If you’re a homeowner who has accumulated equity in your property, you may be able to tap into it for the cash you need with a home equity line of credit, which is also known as a HELOC. By doing this, you can take advantage of borrowing money at a relatively low interest rate, and get some tax benefits to boot that are not available with other kinds of loans.

HELOCS - The Basics

A HELOC is a second mortgage against your property. Unlike its sister, the home equity loan, which offers a fixed rate and a fixed term, a HELOC is akin to a giant credit card account that’s secured by your property. Once the HELOC is opened, you can withdraw as much cash as you need, up to your approved credit limit, and you’ll only pay interest on the amount you withdraw.

Lenders will generally extend a credit line up to 80 percent of your home’s available equity. To determine that amount for your individual situation, you’ll need to know the following numbers: the appraised value of your home, and the amount remaining on your mortgage, if there is one.

If your home is worth $200,000, for example, and you owe $100,000 on your mortgage, the equity in your home is 100,000. Since most banks will generally allow you to borrow up to 80 percent of your outstanding equity, the maximum amount you could borrow in this scenario is $80,000. There are many other factors that will determine whether you will be approved for a HELOC, including your credit history, income, how much debt you have, and your other financial obligations. If you don’t pay your HELOC back in a timely manner, however, you could lose your home.

Paying it back

HELOCs come in two parts: the draw period, and the repayment period. During the former, which is generally around 10 years, you can pull out the funds you need, up to your credit limit. The bank will provide you with separate checks or a credit card to facilitate your withdrawals. However, when that period ends, you could be required to pay back the entire indebtedness in full. Some banks may allow you to renew the credit line, or convert the loan into an amortizing adjustable-rate loan, which will be required to be paid back during a specified number of years. It’s important that you understand the terms of your loan before you agree to it, or you could be in for a big shock when the draw period is over, especially when the total amount of the borrowing is due and payable.

With a HELOC, the interest rate is adjustable. Therefore, the amount that you’ll pay each month will vary based on prevailing interest rates. The rate will be based on an index, generally the prime rate, that’s set by the Federal Reserve. When your lender gives you the HELOC rate, it will generally be quoted as this index, plus or minus a margin. If the prime rate is seven, for example, and the rate that your bank gives you is prime minus 1, you’ll be paying an interest rate of 6 percent for that month. The good news with a HELOC is that you’ll pay interest only on the amount you borrow, not on the entire line of credit.

In many HELOCs, the amount of principal that you’ll be required to pay each month is up to you, although there will always be some minimum payment of around $50 if there is an outstanding balance. You could choose not to pay any principal back until the end. But beware – if you choose this path, you may be hit with a huge payment that you won’t have when the time comes.

HELOCs are very desirable when interest rates are low or dropping, but they can be very unappealing in periods when interest rates are high.

Shopping for a HELOC

The process of looking for a HELOC is similar to shopping for a mortgage. You’ll be required to pay an application fee, which may or may not be refundable, depending on your particular lender -- so don’t forget to ask. You’ll also have to fork over funds for an appraisal, so the bank can determine the value of your home in the current real estate market.  You may want to check with a local realtor, or with a website like Zillow.com, to get an estimate of the value of your property. If prices have dropped, you may not have enough required equity to make a HELOC worthwhile.

There may be other costs the bank can ask for, including closing costs, attorney fees, mortgage preparation, and filing expenses. Some banks charge annual membership and/or maintenance fees, or even a fee every time you make a transaction. But not all banks do, which is why it’s imperative that you shop around and make sure you’re getting the best deal available for you.

Begin your HELOC search with a bank that you’re currently doing business with, because many lenders give discounts to existing customers. In addition, if you have outstanding credit, many banks will waive all the closing costs altogether. And don’t forget to ask if your loan can be renewed or converted to a fixed-rate loan once the draw period is over. How your HELOC ends is just as important as how it begins.

Advantages of HELOCs

There are many other ways to borrow money from your home other than by using a HELOC, but they may not offer the same advantages. You could try a home equity loan, for example. In this case, you’d withdraw all the funds at once, and pay it back on a fixed schedule with a fixed interest rate, which means it wouldn’t have the same flexibility. You could also consider a mortgage refinance, but closing costs will be a lot more expensive.

A HELOC offers the following advantages when compared to other types of borrowing

  1. Low closing costs. As mentioned earlier, closing costs are low, relative to a mortgage refinance. And if you have outstanding credit, the bank may waive them altogether.
  2. Caps on rate increases. Your HELOC will have a maximum cap on how high it can climb, so even if interest rates rise, you have some protection. Check the lifetime cap before you agree to the loan, and make sure that you’ll be able to handle the monthly payment if it jumps to the maximum.
  3. No usage fees.  Most banks will not charge you each time you draw from your HELOC. However, check with your bank, because some banks do, and you wouldn’t want to get stuck with a bank that charges fees for their HELOC, when you could have one that’s free of such costs.
  4. Pay back freedom. You can pay back the principal whenever you like. If you need a short-term loan, for example, to pay your taxes while you’re waiting for some money to come in, you could take a draw on your HELOC, pay interest for a short term, and then pay off the balance in full once you receive your funds.
  5. Tax advantages. You may be allowed to take a mortgage interest deduction for your HELOC of up to $100,000 of your borrowing. However, there are restrictions on how these funds are used, so it’s important that you consult your tax advisor to make sure that it’s appropriate for your particular situation.

Using your HELOC creatively

There are situations where using a HELOC makes obvious sense. If you have short-term financial needs, or you want to fund a renovation, or even if you need money for a vacation where you’re a few thousand dollars short, it makes sense to use a HELOC. But savvy homeowners have used their HELOCs in a variety of other ways that you may not have thought of, especially in times when the credit markets are tight, and it’s hard for people to borrow from banks.

If you’re considering funding a small start-up business, for example, a HELOC is an easy way to get access to money. Borrowing for a business that’s not established comes with a catch 22 – you need to show that your business is established in order for a bank to consider you a worthy candidate for a loan, but you can’t build your business without funds! But if you’re a homeowner with equity, a HELOC could help you solve this problem until the point when your business is successful, and the bank will deem you a worthy candidate for a loan.

Another way you can think outside the box when it comes to a HELOC is to use it for a bridge loan if you’re buying a house, but the sale of your current house hasn’t closed. A HELOC is a great candidate for a situation that demands temporary liquidity, because closing costs are low, paperwork is minimal, and it usually doesn’t take too long to get approval. You’ll also save money over a traditional bridge loan, because you only pay interest on the amount you borrow, as opposed to the entire sum that you’ve applied for.  The big trick here is to apply for your HELOC before you list your property with a broker. Once the property is up for sale, most banks won’t give you a HELOC.

HELOC lockdown

If you have a HELOC during a period where home prices are going in a downward spiral, your bank may freeze your credit line.  This can occur if the value of your home significantly declines, or if there is a change in your financial circumstances. If this happens to you, you can take the following steps:

  1. Try an appeal. Your first step would be to contact your bank, and learn the specific reason that they decided to freeze your credit line. They will also tell you what steps you need to take to get it reinstated. You may be able to get a new appraisal on your home, in order to show the bank that your home is retaining its value. If you decide to take this route, discuss it first with your bank, to ensure that they’ll accept the appraisal before you go out-of-pocket to pay for it. One problem with this path is that it can take a long time before you get all your paperwork to the bank, and it may be too late.
  2. Contact other banks. Just because your bank is tightening their purse strings doesn’t mean that other banks are. If you can get a new HELOC with another lender, you can pay off the old one and move forward. It may, however, mean another round of closing fees.
  3. If you get wind that your bank is beginning to freeze HELOCs, and you have more credit left on your line, you can withdraw the maximum amount or as much as you need. The only problem with this strategy is that you have to pay interest on the amount you withdraw.

Tips for finding your HELOC

If you’ve determined that a HELOC is right for you, here are some hints for making sure you find the one that’s the best deal.

  1. Shop carefully. Your first step is to call a variety of different lenders, and check online sites, to get information. Make a list so that you can compare what each bank offers side-by-side. Take a piece of paper, and get ready to compare. The first section should include the basic features of each loan. Make columns for the annual percentage rate, the index used (and current value), the amount of the margin, the frequency that the rate adjusts, and the interest-rate cap. You’ll also want to compare the draw period and the repayment period, and the initial fees, including ones for the appraisal, application, and closing costs. Finally, list all the possible repayment terms, including when the period ends, if there’s a balloon payment, and if a renewal or refinancing will be made available by the lender.
  2. Don’t be afraid to haggle. If one lender offers a good rate with closing fees, but another offers no closing fees, don’t be afraid to ask your preferred lender for a better deal. They may say no, but if you don’t ask, you don’t even give yourself a chance.
  3. Watch out for teaser rates. Some lenders will advertise HELOCs with very low rates, or fixed rates, just to draw you in, or “tease” you to become a customer. However, after a certain period of time, those rates will revert back to their higher counterparts. Make sure that the rates you are being quoted are for the entire term of the loan.
  4. Get the draw information. Since each bank has its own policy, make sure that you fully understand how each bank operates. If you need money quickly, you might want to withdraw funds during the closing, since it may be a few weeks before you get your checks or the credit card that’s connected to your account.
  5. Stay conscious. Make sure that you can handle the payments, even if the interest rate hits its cap. Discipline is essential when you have a HELOC. If you withdraw the total amount, you won’t have any more credit available. And worse, if you have a huge outstanding balance when the draw period ends, you may need to pay it all at once. If you don’t have the funds on hand – and it’s likely you don’t if you’re applying for a HELOC – you may need to do a mortgage refinance or take out another HELOC. If you’re in a tough lending environment, this may not be possible, and you run the risk of losing your home.

Versatility of HELOCs

Your home's equity can be one of the best ways to find capital when funds are scarce. And the best way to tap into this equity is with a home equity line of credit (HELOC), which gives you the flexibility of a credit card and the tax-deductions of a mortgage. Since a HELOC allows you to draw funds for myriad reasons, it has become the Swiss Army Knife of financial instruments.

One credit line, many uses

Popular reasons to tap a home's equity include home improvement, debt consolidation, a second home purchase, vacations, and college tuition. Many small business owners will opt to use a HELOC instead of applying for business loans, because the process is easier and less expensive.

In recent years, debt consolidation has proven to be an extremely popular use for the HELOC. It can drastically reduce a borrower's monthly payment by offering lower interest rates than credit cards. On the flip side of the coin, people who are debt-free often use the HELOC to buy a car, taking advantage of the tax-deductibility of the interest payments.

Rainy day fund

It's a basic rule of thumb to keep three to six months of living expenses stowed away in a liquid account as a rainy day fund. Even though it's a great savings habit, consumers are forsaking savings, and using a HELOC as a source for emergency funds. If you choose this route, make sure the lender you select doesn't charge a fee just to keep the line of credit open. Just because you have a rainy day fund doesn't mean the institution should rain on your parade.

Fee Free

HELOCs can be fee-free. Avoid a lender who wants to charge you for writing checks or proposes exorbitant closing costs. Some lenders might require an appraisal; but there are plenty of lenders who will waive the appraisal fee. The cost of writing checks should also be free of charge.

Convert to a fixed-rate loan whenever you want

Since HELOCs are tied to short-term interest rates, they may rise suddenly. If they do, you may find that a fixed-rate home equity loan can save you money in interest payments over the long-term. If you choose to convert, expect a higher monthly payment. There may also be additional closing costs, so do the math to see if this move is right for you.

These features, as well as caps on interest rate increases and no prepayment fees, are all versatile benefits that underscore the HELOC's Swiss Army Knife reputation. About the only thing you can't do with it is whittle, or use it to spoon up beans by the campfire. Short of those tangible benefits, the HELOC could be the versatile borrowing tool for just about anything you need.

HELOCs: Find The Hidden Fees

Life is all about taking the good with the bad. With a home equity line of credit (HELOC), just make sure that your mortgage has more good than bad when you're comparing potential lenders.

The devil is in the details. For mortgage lenders, so is the profit. With the home equity line of credit (HELOC), there are a number of ways a lender can make money that may not be immediately apparent to a borrower. These details are generally woven into a loan's fine print, so you'll need to watch out for them when you're HELOC shopping.

Margin call

The primary way a lender makes money on a HELOC is by charging a margin. The margin is the amount that's added to the prime rate to determine your mortgage rate. The lender may offer a HELOC with an introductory rate that's much lower than the prime rate plus the margin. But after the initial period-generally six months to a year-a lender will adjust the rate upward, even if the prime rate hasn't changed. They may continue to base the interest on the prime, but they'll likely have built in a margin, and you may not know exactly what the margin will be unless you inquire directly about it.

When you're shopping for a HELOC, always ask about the margin. Factor this in as you collect quotes from a number of different parties.

To TIL the truth

With every mortgage, a lender is required to disclose a Truth in Lending (TIL) statement. The TIL discloses the exact cost of the loan. For many homeowners, this is an excellent way to determine precisely how much your mortgage will cost you. For HELOC borrowers, the issue is slightly cloudy. The TIL makes no disclosure of margins. You can't rely on the document for an apples-to-apples comparison, so don't trust it. You'll need to ask the lender directly about it.

See no evil

Lenders are notorious for sliding in a few fees here and there, with many of them occurring the year after you've closed the loan. For example, a lender may entice you into closing on a loan by not including any closing or appraisal costs. However, the next year, you may discover on a statement that you've been charged an annual fee. Be sure that you know all the fees before you make a move.

These types of devilish details tend to leave a bad taste in borrowers' mouths. To be fair, this is how lenders make their money. You can expect to pay some sort of costs during the course of the loan. Just be sure to check in all the known places where fees and hidden costs tend to hide. Find them, and you'll find a way to get yourself a more affordable HELOC.

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