If you’ve been paying on your mortgage for a few years, or even a few decades, you most likely have some equity built up in your home. That equity is the market value of your home minus the balance left on your mortgage. If you have enough equity built up, you may be eligible to borrow from a home equity line of credit, or HELOC, to use for other financial needs, such as debt consolidation, tuition payments or paying for a dream vacation. As great as that sounds, though, it’s important to understand how a HELOC works to decide if it’s the right move for you.
What is a home equity line of credit?
When you have a home and are paying a mortgage, you build equity every time you pay down your principal balance. When you’ve built up enough equity, you may be eligible to borrow funds against that equity with a home equity line of credit.
It is important to note that a HELOC is basically a second mortgage, meaning your home is considered collateral and if you default on the payments, you may face foreclosure on your home. However, these funds are available to homeowners to use for whatever financial needs they may have, within reason. A HELOC will typically have a lower rate than a personal loan or a credit card, which makes it a great option for more substantial financial needs.
Keep in mind that HELOC usually comes with a variable rate, meaning that the interest rate you get when you open the line of credit may not be the rate you have for the life of the credit line. It is subject to change based on the index, which can lead to unpredictable monthly payments.
What can a home equity line of credit be used for?
There are a number of ways that you can use the funds from a HELOC. The most popular uses are debt consolidation, home improvement and tuition payments. The interest rates are typically lower than other financing options, so a HELOC is often used to address bigger financial needs that may take a longer period of time to pay off because it saves money on interest paid to the lender.
When can I apply for a HELOC?
If you’re considering a HELOC, make sure you have built up at least 15% to 20% of your home’s value in equity. That is typically the minimum amount of equity a lender will want before you are considered eligible to apply. This will be determined by a property appraisal, which is usually a drive-by appraisal, done during the application process.
An important stipulation of a HELOC is you can only borrow up to 80% of the available equity. For example, if you have $50,000 of home equity available, you may be able to borrow a maximum of $40,000 from the lender. You’re not required to borrow the entire 80%, though. That’s just the maximum available if you qualify for it.
What fees are associated with HELOCs
Since a HELOC is a second mortgage, there are closing costs associated with it. You should expect to pay anywhere between 2-5% of the loan value in closing costs, which can include the appraisal fee, origination fees and document fees.
Be sure to ask your lender if there are any annual fees or fees for prepayment on the HELOC. Most lenders will tack on an annual fee between $50 and $100, plus a fee if you pay off the HELOC before the term is up. You should also check for any dormancy fees that could be associated with not using your HELOC for an amount of time.
How is a home equity line of credit repaid?
A HELOC is a revolving line of credit, much like a credit card. If you use funds and pay them back, the money becomes available to you again. You won’t have access to the funds forever, though. A HELOC will come with a draw period, which is a set amount of time you have to use the funds, and a repayment period, which is the amount of time after the draw period you have to pay off any remaining balance.
A standard HELOC will come with a 10-year draw period and a 20-year repayment period. During the draw period, you’re often required to make monthly payments based on the balance you’ve used, though some HELOCs will allow you to pay on the interest only during that period. Once the draw period is up, the HELOC immediately goes into the repayment period, during which you will make monthly payments on the remaining balance and interest but can no longer use funds from the HELOC.
Pros and cons of a HELOC
Flexibility: You can use the funds when you want and how you want. You can also borrow as much or as little at a time from it as you need.
Lower interest rates: The national average for a HELOC is around 6% compared to a personal loan at 10% and a credit card at 17%.
Variable rates: The rate will fluctuate with the index. This can make unpredictable monthly payments and make it hard to budget.
Equity is required: This option may not be available to those who haven’t been a homeowner for long. It can take years or decades to build up substantial equity in order to be eligible. Also, if your home has lost value, you may not be eligible at all.
Alternatives to HELOCs
Home equity loan
Similar to a HELOC, a Home Equity Loan is based on the equity built up in your home. However, it is typically a fixed-rate and you will receive the funds in one lump sum instead of a revolving line of credit.
If you’re in the market to refinance your home loan for a lower rate or lower monthly payment, you can also consider a cash-out refinance. It’s similar to combining a home equity loan with a refinance but having one monthly payment. You can take out the amount of your mortgage refinance, plus up to 80% of your available home equity, all in one loan. You will receive the funds from the home equity in one lump sum to use however you need.
This option should only be considered if you are only needing to finance smaller financial needs, such as appliances or school books. If you believe you may be able to either pay off the balance in full at the end of the billing cycle, or you have considered the interest that will accrue. However, this revolving line of credit will provide flexibility in using funds when needed.
Banks with the best HELOC rates
Chase offers HELOCS that will have a rate between 5.0% and 7.64%. It also only charges a $50 origination fee and a $50 annual fee. Typically, Chase will not charge any closing costs beyond this. You may borrow up to 80% of the equity available in your home.
HELOC rates at US Bank range from 3.80% to 8.20%. It charges no origination fees or closing costs. It does charge a $90 annual fee; however, this bank offers ways to waive that fee through having a US Bank Platinum Checking Package. In some cases, you may be able to borrow up to 90% of equity available.
Bank of America
This bank has a pretty sweet deal when it comes to HELOC fees: it charges almost nothing. You pay nothing to apply, plus zero closing costs, and it doesn’t charge an annual fee. Rates start at 3.24% and there are potential rate discounts that you may qualify for.
You can get a promotional rate as low as 4.74% with Citizens Bank. It also charges zero closing costs, application or appraisal fees. It does charge a $50 annual fee that will be waived the first year and a $350 fee if you close the HELOC within three years of opening. It also offers rate discounts for automatic payments. Citizens Bank only services East Coast states, so make sure your property is in one of the qualifying areas.
Flagstar Bank offers a promotional rate of 3.49% for HELOC borrowers. It does not charge any closing, application or origination fees as long as the line remains open for at least 36 months. Otherwise, the borrowing party is responsible for paying those fees upon closing. However, tit does charge a $75 annual fee that is waived during the first year.
The bottom line
A HELOC can be a great way to relieve some financial hardships or consolidate debt. However, it’s important to understand the costs that may come along with it, such as fees or putting your home up as collateral. Be sure to take a look at your own financial situation to determine whether a HELOC is the right choice for you and do plenty of research to find a lender who best fits your financial needs.
For more advice on tapping your home equity, see The Simple Dollar’s previous articles on HELOCs and home equity loans: