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As property prices continue to rise, homeowners are looking for ways to take advantage the equity in their home benefit from low-interest financing. A home equity line of credit, or HELOC, is a great way to access a line of credit based on a percentage of the value of your home, minus the amount you still owe on your mortgage.
The downside is that if you find yourself in a situation where you can’t pay off your HELOC, the lender may force you to sell your home in order to settle the debt.
How a HELOC Works
Let’s say your home has an appraised value of $400,000 and you have a remaining balance of $200,000 on your home’s mortgage. A lender typically allows access to up to 85% of the total equity in your home.
(Value X lender access) – Amount owed = Line of credit
$400,000 X 0.85 = $340,000
$340,000 – $200,000 = $140,000
Unlike home equity loans, your home equity line of credit will have a variable rate, meaning your interest rate can go up and down over time. Your lender will determine your rate by taking the indexed rate and adding a markup, based on the health of your credit profile.
When a HELOC makes sense
Your home equity line of credit is best used for wealth-building uses like home improvements and repairs, but can also be used for things like debt consolidation or the cost of sending your child to the university. While it may be tempting to use your HELOC for all kinds of things, like a new car, vacation, or other splurges, these do nothing to improve the value of your home. To ensure that you will be able to repay your loan, it is important to focus on wealth-building attributes when you can.
Home Equity Line of Credit and Home Equity Loan
If you’re exploring various loan options, you’ve probably come across two different home loan terms: the home equity line of credit and the home equity loan.
While home equity loans give you all the flexibility and benefits to leverage your home’s value when you need it, a home equity loan offers a lump sum payment.
Depending on your situation, a lump sum withdrawal may be better suited to your needs. Understanding the differences is the first step to making the loan decision that’s best for you.
• Home Equity Loan (HEL) – A home equity loan allows you to borrow a fixed amount at one time, secured by the equity in your home. The loan amount you qualify for will depend on your loan-to-value ratio, credit history, verifiable income and payment terms. These types of loans have a fixed interest rate, often 100% deductible from your taxes.
• Home Equity Line of Credit (HELOC) – A home equity line of credit is not a loan, but a revolving line of credit that allows you to borrow money as needed with your home as collateral. Applicants are typically approved based on a percentage of their home’s appraised value and then subtracting the balance owed on their existing mortgage. Things like credit history, debts and income are also taken into account. Plans may or may not have regulations on withdrawals and minimum balances, as well as a variable interest rate.
Before tapping into the equity in your home, it’s important to weigh the pros and cons of each type of loan depending on your situation. Since your line of credit and home equity loan relate to your most important asset – your home – the decision should be carefully considered. Is a second mortgage better than a credit card or secured loan? If you’re not 100% sure, talk to a financial professional before putting your home at risk.