The Essential Steps to Follow When Getting and Using a HELOC
Reading time: 6 Minutes
By James Charisma
October 10th, 2019
If you're a homeowner looking to improve your property, consolidate high-interest debt, or fund an investment property, a home equity line of credit (HELOC, for short) may be a great way to secure funds at a reasonable interest rate.
A HELOC is a line of credit, backed by your home as collateral. To qualify for one, you'll need to meet the lender's minimum requirements for credit score, debt-to-income ratio, home value and other factors.
If you meet those qualifications, you can generally borrow up to 85 percent of your home's value, minus the amount you still owe on the mortgage loan. For example, if your property is appraised at $400,000 and you owe $150,000, you would calculate 85 percent of the total value, which comes to $340,000. Then subtract $150,000, giving you a maximum line of credit of $190,000.
HELOCs function much like a credit card: You can withdraw as many times as you like, within your credit limit. (Some lenders also have a minimum draw amount) As any outstanding balances are paid, the amount of credit available is also replenished. However, this feature exists for a limited amount of time, called the draw period, which varies in length depending on the term set by the lender. During the draw period, you may only be required to make interest payments, but can make additional payments toward the principal if you wish. After the draw period, you either enter into the repayment period, during which you can no longer draw and your required payments increase to include interest and principal, or you reach the deadline for the balloon payment, at which point the remaining balance of the loan is due.
What makes HELOCs attractive to most homeowners is that typically they come with a low introductory promotional interest rate, which generally lasts for one to four years. After the promotional rate ends, the interest rate typically increases to a variable rate (aka the market rate) and fluctuates as the prime index to which the rate is tied is adjusted. Typically your variable rate will include both the floating index portion and an additional "spread" above the index. Over the years, the interest rate on your loan may change many times—and not always in the direction you want. For example, between December 2016 and December 2018, the Prime Rate (an index rate often used for HELOCs) rose from 3.75 percent to 5.50 percent.
As with any kind of credit, HELOCs can involve risk and complications. Fortunately, with a little research and planning, you'll be able to avoid some of the most common mistakes and make the best use of your line of credit.
Here's What You Need to Know:
1. Research for the Best HELOC Deal
You'll want to shop around to find the best deal. Some lenders may offer a low introductory rate for the first 12 to 48 months of a HELOC, making it tempting to jump into a bargain, but make sure you take into account the rate which will be active after that promotional period, since it will be higher and most likely variable, meaning your payments could increase significantly over the life of the loan. Also factor in the fees and closing costs required by any particular lender—as well as the larger-than-normal balloon payments that can be built into the end of some HELOCs.
Compare the features offered by different lenders. Interest-only payments may be available, but, if you're looking to pay down balances sooner rather than later, features such as fixed-rate loan options may be more important to look for. Some lenders may also offer rate discounts for using their automatic payment feature. This may help save on interest, especially if you have a large balance.
Decide your priorities. If you need the largest amount of cash right away, and can repay it within the introductory period, you might choose a different HELOC than if you'd rather keep your monthly payments low over a longer period of time. Get different estimates, and see what rates, terms and conditions are best for your unique situation.
2. Budget and Plan Your HELOC, from Beginning to End
When applying for a HELOC, it's smart to plan, and then plan some more. For starters, you should think carefully about how much you really need to borrow. Just because you may be able to tap into, for example, $300,000 of your home equity, it doesn't mean you should necessarily max out your credit capability. Being tied to a variable interest rate means that your monthly payments could climb higher than you originally thought you'd have to pay, which might leave you in a tight spot. Think carefully about how much you really need to borrow and for what purpose—in many cases, a smaller line of credit is more prudent—but it all depends.
It's also important to think ahead of time about how you'll pay off a HELOC. The required monthly payments at the beginning of your HELOC's term will likely be relatively small, because you generally are only required to repay the interest on the loan, but that monthly payment will grow larger once you reach the repayment period of the loan and are paying off the principal as well. If you're relying on funding that increase with a future windfall, such as a raise at work, landing a commission, or receiving a bonus, what happens if that windfall doesn't pan out? Make sure you've got a contingency plan in place.
And, if you're planning on selling the home at some point, will the cost of the sale cover the HELOC, as well as closing costs? Also think about the life stages you may be entering during the term of the HELOC, and the financial impact that might have (children going to private school/college, changes in income, retirement, etc.)
Whenever borrowing money, HELOC or otherwise, it's crucial to have realistic plans in place to avoid serious financial trouble. Consult an expert loan officer, know your options, and set a plan in place before borrowing from your home's equity.
3. Spend Your HELOC on the Right Things
Once you've secured your HELOC, remember to use the funds on projects that will build value, such as home renovations. HELOCs aren't intended to help you live above your means and shouldn't be spent on anything risky. Think carefully about using your HELOC on depreciating assets such as vehicles, vacations or luxury goods, and avoid speculative gambles such as investing money in the stock market. When it comes to your child's college tuition, there are certain cases in which a HELOC makes sense (if, for example, you're able to pay off the loan while interest rates are still low), but there will usually be other loan vehicles, including financial aid and structured student loans, that make for better options.
Keep in mind that a HELOC is different from other common forms of debt, such as credit cards. A credit card balance is considered “unsecured” debt because there's no collateral. Failing to pay may hurt your credit score, and the lender may attempt to collect the debt by taking you to court and garnishing your salary, but credit card companies cannot simply repossess your assets to satisfy outstanding loan balances. With a HELOC or any other real-estate-secured loan, however, your house is collateral. If you don't repay the loan, the lender can take your house.
Use your HELOC responsibly—you literally owe it to yourself.
James Charisma is the editor of Abstract Magazine, and contributing editor of HONOLULU Magazine.
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