Home equity has many advantages for homeowners; it gives the flexibility to borrow and meet various expenses when needed. A home equity line of credit (HELOC) differs from equity loans as it allows the homeowner to borrow lesser amounts only when needed. Whether the homeowner needs cash for home improvements, garage repairs, or to pay medical bills, HELOC gives you the flexibility to get financing options with more control. It is a revolving loan that the homeowners can get against the equity in their home. In this article, I’ll explain what is a Home Equity Line of Credit, give examples, and cover everything you need to know for the real estate exam.
What Is a Home Equity Line of Credit?
A Home Equity Line of Credit (HELOC) allows homeowners to draw cash against equity and repay the loan at a variable interest rate. This is a type of revolving line of credit that helps the homeowner establish credit ahead of time if needed, and the collateral is home. HELOC allows the borrower to draw funds as little and as much as they can, but up to their share of equity in the home. The main feature of this loan is that the homeowner pays interest only on the amount he takes. This way, the borrower can benefit from flexible repayment terms for paying significant recurring expenses.
Since home prices have risen dramatically, most residential properties have been regarded as ‘equity-rich.’ For this reason, HELOC is one of the best options if one is looking for low-cost financing options. This loan is secured by your house, and the interest rates are lower than those offered by credit cards. A HELOC consists of two periods:
- The draw period allows the borrower to use the line of credit actively
- The repayment period requires the borrower to pay back the amount
What is Home Equity?
Home equity is the portion of the home that the borrower has already paid off. It is the value of the homeowner’s financial contribution to the house. In other words, home equity is the appraised value of your home, less any loan balances and mortgages. The appraised value is the property’s current market value except for any liens to that property. Since home equity is the difference between the home’s appraised value minus the mortgage balance, it can increase in the following ways:
- By making mortgage payments
- By making home improvements that increase the home’s value
- When the value of the property rises
- When you make a big down payment
The best way to increase home equity is by paying the mortgage balance on time. When the borrower makes timely payments, he is reducing his mortgage balance, increasing his home share. To calculate home equity, follow these tips:
- Find out the property’s estimated market value
- Subtract the mortgage balance from the property’s market value
It is important to note that the property’s current value differs from the value the homebuyer bought a few years ago. Thus, it is essential to know the current market value for calculating accurate home equity. Various price estimator tools help calculate home equity, but consulting a licensed real estate agent is more helpful.
What is a Home Equity Loan?
A home equity loan is different from a home equity line of credit. More commonly known as a second mortgage or a home equity installment, this loan allows the borrower to obtain funds against the equity, but the loan is at a fixed rate. This is different from a home equity line of credit, as HELOC has variable interest rates. One thing to note here is that home equity is a broader term, and it comes in two kinds: HELOC and fixed-rate loans. Fixed-rate home equity loans allow the borrower to obtain a lump sum, while HELOC offers a revolving line of credit.
How Does a HELOC Work?
A Home Equity Line of Credit works similarly to a mortgage; this is why it is also known as a second mortgage, just like a home equity loan. From the lender’s point of view, the equity in the home acts as collateral. The homeowner can borrow an amount according to the CLTV (combined loan-to-value) ratio of 80 to 90% of the home’s current market value. The interest rate varies according to the payment history and credit score of the homeowner too.
Suppose the homeowner wants to convert the equity into cash and use it for covering various expenses. However, one thing to remember is that if the mortgage balance isn’t paid out, the borrower can lose the property to pay the remaining debt. Another critical point to note is that the value of real estate keeps changing, and if it decreases, the borrower will have to pay more as a mortgage than the home’s worth. The following are the main points that describe HELOC:
Draw Period
A draw period is a time when the homeowner gets funds against the equity. This loan is used for paying for recurring experiences like home improvements or for paying off debt. The draw period can be up to ten years; during this period, the borrower pays only interest on the amount borrowed.
End-of-draw
End-of-draw is the time when the borrower’s draw period ends. When the draw period ends, the borrower can’t access the funds anymore.
Repayment Period
The repayment period is different from the draw period. This period can be up to 20 years; during this period, the borrower has to repay the interest and principal balance on the HELOC.
Refinance the property
The borrower can also refinance the property to get a new loan. However, the sooner the borrower pays off the loan, the lower the monthly payment.
Home Equity Loan Vs. HELOC
HELOCs and home equity loans are similar in many ways, but there are a few differences. If the borrower wants to choose either of them, the following are the main factors that differentiate them:
Factors | Home Equity Loan | Home Equity Line of Credit (HELOC) |
Interest Rates | Fixed | Variable |
Monthly Payments | Same regular | Change over time |
Funds Disbursement | Upfront lump sum | As needed |
Repayment Terms | Start right after funds disbursement | Interest-only payments during the draw period, repayment of principal and interest during the repayment period |
Annual Percentage Rates | High | Slightly low |
Applications | Major purchases, large home improvements, debt consolidation | Home renovations, home improvement, medical bills, tuition fees |
Home Equity Line of Credit Examples
Example 1: Let’s suppose a homeowner wants a home equity loan or credit for home improvements. However, she doesn’t know how to calculate home equity. A local real estate agent helps her calculate the equity by finding the selling price of the houses in the neighborhood. A house in her neighborhood was sold for $250,000, and at that time, she had a mortgage balance of $100,000. According to these details, the home equity is calculated as follows:
- Equity = Current market value of home – mortgage balance
- Equity = 250,000 – 100,000
- Equity = $150,000
This means that the home equity is $150,000, and the homeowner can take a loan of $150,000 for home improvement. This loan benefits her as she knows that home improvement and renovations will add to her property’s value. Ultimately, she will have to pay a loan lower than her property’s value.
Example 2: A person wants to buy a car worth $50,000 but doesn’t have enough money to purchase it. He decided to take out a loan and discussed it with a loan officer. Fortunately, he has a home with a value of $380,000 and $200,000 equity in it. The person decides to have a total line of credit of $100,000 and use $50,000 to buy the vehicle. Following are the details of this home equity loan of credit:
- Home value: $380,000
- Equity: $200,000
- Total line of credit: $100,000
- Cash Required: $50,000
- Monthly payment: $361 (based on initial withdrawal of $50,000)
- Interest rate: 7.820% variable APR
- Term: 30 year
The 30-year term includes a ten-year draw period followed by a 20-year repayment period. During the draw period, the homeowner can continue to draw cash of up to $100,000. Once the draw period is over, the homeowner must repay the loan over 20 years in monthly payments.
Home Equity Line of Credit Frequently Asked Questions
How to Apply for a HELOC?
To apply for a home equity loan of credit, the borrower must first collect all the necessary documents. For instance, the homeowner must know the property’s estimated value, gross monthly income, current tax, original purchase price, and information on any liens. Once the documents are ready, the homeowner can submit a HELOC application to a lender. Most banks and credits offer HELOCs so the borrower can reach out to them for the application. Once the application is approved, the borrower can get funds against their home equity.
Why Take a Second Mortgage?
A second mortgage or home equity line of credit offers many uses. These loans are most suitable for recurring expenses such as renovation, home improvements, and remodeling that increase the value of your home. This way, property value increases because the borrower invests in the property and makes it more livable. The borrower can also use HELOC to pay off other high-interest debts. Besides that, the loan can also be used to buy a car, go on a trip, or pay tuition fees.
How to Qualify for HELOC?
Lenders have a few requirements for offering a home equity line of credit. The lenders evaluate the credit history, income, credit score, and other debts. Most lenders will also require a CLTV (Combined loan-to-value) ratio of around 85% or less. Besides that, a credit score of 620 or more and a debt-to-income ratio of lower than 43% helps get favorable rates and terms.
What to Know for the Real Estate Exam
HELOC is a powerful tool that can help the homeowner cover various expenses. When a homeowner obtains a home equity line of credit, he uses the home as collateral. Thus, it is essential to understand the rates and terms of HELOC before borrowing. The homeowner must borrow an amount that he can comfortably pay off later according to the budget. With HELOC, the borrower can also have tax-deductible interest and get flexible repayment options. This line of credit is more suitable for regular and organized borrowers who want to benefit from their home’s equity. A few HELOC alternatives are home equity loans, cash-out refinance, and personal loans.
For more on loans and real estate finance terms, check our real estate vocabulary flashcard app.