In previous weeks, we have broken down the most popular mortgage loans, and shown you how ARM loans work. For Part 3 of our “Mortgage Loans EXPLAINED” series, we dive into the Home Equity Line of Credit (HELOC).
What is a home equity line of credit?
A home equity line of credit, or HELOC, is a second mortgage that gives you access to cash based on the value of your home. You can draw from a home equity line of credit and repay all or some of it monthly.
With a HELOC, you borrow against your equity, which is the home’s value minus the amount you owe on the primary mortgage. You can also get a HELOC if you own your home outright, in which case the HELOC is the primary mortgage rather than a second one.
In either case, you could lose the home to foreclosure if you don’t make the payments.
How does it work?
Much like a credit card that allows you to borrow against your spending limit as often as needed, a HELOC gives you the flexibility to borrow against your home equity, repay, and repeat.
Most HELOCs have adjustable interest rates: this means that as baseline interest rates go up or down, the interest rate on your HELOC will adjust too. For more information on adjustable-rate loans, click here.
As with a credit card, you only pay interest on the amount of money you use, not the total amount available to borrow.
How do you qualify for a home equity line of credit?
Exact requirements will vary depending on your lender, but here are the general requirements to qualify for a HELOC:
- A debt-to-income ratio of 40% or less.
- A credit score of 620 or higher.
- A home value of at least 15% more than you owe.
How to get a home equity line of credit
The process of getting a HELOC is similar to that of a purchase or a refinance on a mortgage. Here are the steps you’ll follow:
- Determine whether you have sufficient equity using a HELOC calculator.
- Once you have an idea of what you can borrow, call Sharp Loan.
- Gather the necessary documentation as advised by your lender.
- Once you have completed these steps, apply for the HELOC.
At this point you will receive disclosure documents. Read them carefully and make sure the HELOC will fit your needs. For example, does it require you to borrow thousands of dollars upfront (often called an initial draw)? Do you have to open a separate bank account to get the best rate on the HELOC? Consult with your lender if you are unsure.
The underwriting process can take anywhere from several hours to a few weeks, and may involve getting an appraisal to confirm the home’s value.
The final step is the loan closing, at which point the paperwork is signed and the line of credit becomes available.
How much can you borrow with a HELOC?
The maximum amount of your home equity line of credit will vary based on the value of your home, what percentage of that value the lender will allow you to borrow against, and how much you still owe on your mortgage. Two quick calculations can give you an idea of what you might be able to borrow with a HELOC.
Say you have a $500,000 home with a balance of $300,000 on your first mortgage and your lender will allow you to access up to 85% of your home’s value. Multiplying the home’s value ($500,000) by the percentage the lender will allow you to borrow (85%, or .85) gives you a maximum amount of $425,000 in equity that could be borrowed. Subtract the amount you still owe on your mortgage ($300,000) to get the total amount you can borrow with a HELOC — $125,000.
How do you pay back a home equity line of credit?
A HELOC has two phases: the draw period and the repayment period.
During the draw period you can borrow from the credit line by check, transfer, or a credit card linked to the account. The length of the draw period varies but is commonly set at 10 years.
During the repayment period you can no longer borrow against the credit line. Instead, you pay it back in monthly installments that include principal and interest. With the addition of principal, the monthly payments can rise sharply compared with the draw period. The length of the repayment period varies but is commonly set at 20 years.
At the end of the loan, you could owe a large lump sum — or balloon payment — that covers any principal not paid during the life of the loan. Before you close on a HELOC, consider negotiating a term extension or refinance option so that you’re covered if you can’t afford the lump sum payment.
Is a HELOC Right for You?
Do you think a HELOC could be the right choice for you? Do you still have questions? Contact us below to learn more!