A home equity line of credit (HELOC) is an excellent option for people seeking cash to cover significant expenses. HELOCs let you borrow money against the equity in your home and are considered a type of second mortgage intended for large purchases.
A home equity line of credit is one of the best options for homeowners who need financial aid quickly. However, this method does not come without its fair share of risks, and without proper knowledge of your HELOC, you might struggle with hefty repayments and stringent terms.
So what is a HELOC, how do they work, and how can you get started with a HELOC? Our HELOC guide has everything you need to know about home equity lines of credit so you can embark on a fulfilling financial journey and access the funds you need to succeed. Let’s get started!
What is a HELOC?
A HELOC, short for a home equity line of credit, is a money source where you borrow funds against your home’s equity. With HELOCs, your home is used as collateral to secure the loan. This secondary mortgage typically lets you borrow up to 85% of your home’s equity or a percentage of your home’s appraised value minus the amount owed on your mortgage. The amount you can borrow might vary depending on your lender.
HELOCs are a type of revolving credit account similar to your credit card. Homeowners can withdraw funds from their HELOC and repay the funds withdrawn in monthly installments. HELOCs usually have a variable interest rate; however, some lenders offer homeowners a fixed-rate option. Your HELOC is intended for larger expenses like education, significant home improvements, or emergencies.
How Does a HELOC Work?
So, how does a HELOC work for homeowners? HELOCs are similar to credit cards in that you can withdraw and reuse funds from your account while repaying that amount with interest. With HELOCs, your lender must approve a maximum amount available to withdraw based on your home’s equity and how financially capable you are of repaying your loan. You can access your HELOC funds in several ways, such as online transfers or with your debit or credit card.
Before entering the phases of a HELOC, you might have to pay some upfront costs. While many lenders waive upfront costs for HELOCs, some will charge initial fees; for instance, you might need to pay a fee for your home appraisal, an application fee, and closing costs like attorney fees, mortgage preparation and filing, property and title insurance, taxes, and other expenses.
HELOCs have two primary phases: the draw period and the repayment period. Below is a breakdown of each.
Home equity lines of credit begin with a draw period, typically about 10 years. During the draw phase, you can access funds whenever necessary to cover large expenses. Most borrowers do not have a limit on the amount they can draw at a specific time or how often they withdraw, provided that it doesn’t exceed the line’s maximum credit limit. You can expect to be charged a variable interest rate during this time, though certain banks and credit unions will charge a fixed rate instead for clearer repayment costs.
While in the draw period, you’ll still need to make interest-only payments on the amount you withdraw from your equity funds. You don’t need to make interest payments on your untapped funds. Consider your lender’s terms before agreeing to a HELOC, as some lenders might have restrictions on minimum withdrawal amounts, different interest rates, and other unique factors that impact your decision.
When the draw period concludes, you might consider requesting an extension to your loan – if you don’t, you’ll move into the second phase of HELOCs, the repayment period.
If you don’t request an extension on your HELOC, you enter the second phase: the repayment period. You can not access or withdraw money from your home equity line of credit during the repayment period. Once you’re cut off from your funds, you must repay your outstanding withdrawal balance with added interest at a contracted rate. Repayments occur every month.
Lenders typically provide a 20-year repayment phase for a standard 10-year draw phase. While this might seem feasible, many homeowners are unprepared for the stark jump in payment amounts between the draw and repayment periods. Because of your interest-only payments during the draw phase, your payments in the repayment period can nearly double.
If you can’t meet these repayment requirements, you are at risk of defaulting on your loan and losing your collateral – in this situation, your home. These strict terms make it vital for you to be financially prepared to handle the responsibilities of a HELOC.
HELOC: Pros and Cons
While home equity lines of credit are extremely useful in many situations, there are some risks and downsides to consider before deciding whether a HELOC is right for you.
There are several reasons to consider a HELOC. While repayment terms can be stringent, HELOCs are still available at a lower cost than other types of loans you might consider for emergency funds. HELOCs are relatively flexible because they give you access to large amounts of cash when needed in important situations like funding your or your child’s education or covering emergency expenses. Additionally, your interest payments might be tax-deductible if you use the funds for home improvement projects.
HELOCs do not require a down payment or incur any interest payments until you start withdrawing money. Unlike other funding options, HELOCs only require you to pay interest on the amount withdrawn and used rather than the entire amount of your HELOC.
Despite the benefits of choosing a HELOC for funding, there are downsides to this option that many homeowners don’t consider. The biggest potential issue with a HELOC is that you risk losing your home if you fail to repay the amount due and default on the loan. Since your home is collateral, you take a significant risk when you choose a HELOC.
While this is the most notable risk, additional factors can make HELOCs a poor choice for some homeowners. If you miss your payments, some lenders will freeze your line of credit or reduce the amount available.
Since HELOCs usually have variable interest rates, you also risk hefty payments and rate increases during the term of your loan. If you aren’t prepared for these increases, you’re in for an unpleasant surprise come repayment time.
How to Get Started With a HELOC
If you feel like a home equity line of credit is right for you, there are a few steps you’ll need to take to get the process started. Set a monthly budget for your HELOC based on the amount you can realistically afford to repay during the draw period before you start looking for a suitable lender, as this can save you much stress in the future. Once you have a clear monthly budget for your HELOC, you can take the following steps to get started with your HELOC.
Choosing a Lender
After setting your monthly budget, you can look for a suitable lender. Focus on the rates available from individual lenders and inquire about annual fees, upfront costs, interest rate caps, minimum withdrawals, inactivity fees, and other costs or factors that will impact your loan and whether the lender fits your financial needs.
Once you’ve chosen the right lender, you can start the HELOC application process. You might be charged a nonrefundable application fee during this period, so check with your lender and prepare for the cost before you apply.
When applying for a HELOC, you must provide personal information about yourself and your property. This information includes your personal details, income, assets, and liabilities. Lenders often request documents like your most recent W2s, driver’s license, pay stubs, mortgage statements, homeowner’s insurance declaration, and credit authorization.
The next step in the HELOC process is getting a home appraisal, which allows your lender to determine your home’s current market value and loan-to-value ratio. A higher home appraisal means a higher borrowing allowance once your draw period begins.
Underwriting and Closing
An underwriter will review your documents and application to verify the information provided and determine whether or not to approve your HELOC. Underwriters might request additional information from you to ensure you can repay your loan without defaulting.
If an underwriter approves your application, you move into the closing process. You’ll receive a notification to set a closing appointment and sign all relevant loan documents to seal the deal. After you sign your documents, you have a three-day period where you can cancel the loan based on your right of recession – if you do not cancel within this period, the loan goes through.
How iTHINK Financial Can Help
Navigating the world of HELOCs can be tricky, even with an informative HELOC guide. The credit union experts at iTHINK Financial can help you out by getting you started with a home equity line of credit for all of your financial needs.
iTHINK Financial provides the best financial services available for homeowners looking to access funds for large expenses. Whether you’re seeking a HELOC, a savings account, loans, or other financial services, iTHINK Financial is here to help.
Become a member of iTHINK Financial today and get started on your new financial journey!