Home equity line of credit

A “HELOC”, or Home Equity Line of Credit is a home loan that allows a borrower to open up a line of credit using their home as collateral. It differs from a conventional home loan for several different reasons. The main difference is that a HELOC is simply a line of credit that allows a homeowner to borrow a pre-determined amount set by the lender, whereas in a conventional home loan, the amount borrowed is the total amount financed.

In other words, a HELOC is a lot like a credit card because of its revolving nature. When you open a credit card, the bank sets a certain limit, such as $10,000. You don’t need to pay interest on the total amount, or even withdraw or spend any of the $10,000, but it is available if and when you need it.

This is also how a HELOC works. Your bank or lender will give you a line of credit for a certain amount, say $100,000. And you can draw upon it as much as you’d like, up to that $100,000 if and when you want. It’s a good choice for homeowners because it allows them to use the line of credit if they need to, without having to pay interest if they don’t.

With a conventional home equity loan, you pay interest on the total amount borrowed. The HELOC not only gives the borrower the freedom to decide when and if to use the money, but also how much they need to pay back and when.

A HELOC normally has a 25 year term, with a draw period and a repayment period. The draw is typically the first 5 to 10 years, followed by the repayment period of 10 to 20 years. During the draw period, the homeowner can borrow as much as they’d like within the line amount, and can make interest-only payments on the amount drawn upon.

The HELOC interest rate is determined by the average daily balance and the prime rate plus the margin designated by the bank or lender. Most banks and lenders give borrowers prime rate with zero margin, or even less than prime. You’ll often see bank ads that say “prime -1%” or something to that effect. This is usually an introductory rate, and will often go up after the first few months.

If your loan scenario is a bit more high-risk, it could carry a margin up to 4% or more, which when combined with the prime rate, can be quite hefty. Prime is currently 7.75%, so adding a margin of 4% would make the interest rate 11.75%, which isn’t a very desirable rate.

After the draw period, the borrower must pay off the principal of the HELOC as well as the interest. This period is known as the repayment period. Usually the loan balance is broken down into monthly payments, but there could also be a balloon payment because of the way the loan amortizes. Also note that some HELOCs don’t have a repayment period, so full payment is due at the end of the draw period.

Many borrowers steer away from HELOCs for a number of reasons. The main reason being that a HELOC is an adjustable-rate mortgage, tied to prime. Whenever the fed moves the prime rate, the rate on your HELOC will change. Usually it’s only .25% at a time, but the fed has raised the prime rate about 20 times in a row since 2004, raising the prime rate from 4% to 8.25%. So your interest rate can fluctuate greatly, even if the fed moves prime in so-called “measured” amounts.

On top of that, HELOCs don’t have periodic interest rate caps like standard adjustable-rate mortgages, just lifetime caps, so the rate can fluctuate as much as the fed allows it to, up to 18% in California (it varies by state). HELOCs also come with early closure fees of around $300, although they don’t usually carry a prepayment penalty.

Most HELOCs are set up as a line of credit behind an existing first mortgage. They are opened behind the existing mortgage as a source of cash to pay down credit cards or other revolving debt, or for home improvements and other household costs. A HELOC provides flexibility at a relatively low interest-rate as compared to a standard credit card.

They can also be used as purchase-money second mortgages, meaning the full line amount is drawn upon at the time of closing. A purchase-money HELOC uses the entire draw of the credit line as a down payment on their home, and the borrower must pay interest on it from day one. For example, if a borrower wanted a zero-down loan on a $100,000 property, they would likely do an 80% first mortgage for $80,000 and a $20% second mortgage for $20,000. The first mortgage would likely be a fixed-rate mortgage or an adjustable-rate mortgage, while the second mortgage would be a HELOC.

The reason a borrower would choose a HELOC as a purchase-money second is usually because the interest rate is lower than the fixed seconds that are available. And a HELOC has an interest-only option which many fixed-end seconds don’t offer. HELOCs also don’t carry a prepayment penalty, whereas many fixed-end seconds will.

Some borrowers will even utilize a HELOC for their first mortgage, although it is less common and can be fairly risky for a homeowner.

HELOC advantages:

- lower rate than a fixed loan

- interest-only option

- no prepay

- ability to choose draw you want, when you want

- low fees

HELOC disadvantages:

- adjustable rate

- no periodic caps on interest rate

- early closure fee

- minimum draw amounts