Home prices have been steadily increasing over the last couple of years.
And that means people have more equity in their home they can borrow from using a home equity line of credit.
This article will help you understand the home equity refinance process better and provide tips.
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What is a Home Equity Line of Credit
A home equity line of equity is also known as a HELOC (pronounced as Hee-lock) for short. A HELOC is a second mortgage that uses the equity you have in your home as collateral for a line of credit.
The line of credit works like a credit card. You’re given a maximum credit limit and are only charged interest of the amount you borrow.
You have a monthly payment that goes towards the principal and interest. As you pay off the debt it becomes available to be borrowed again.
As an example let’s say your house is worth $200,000 and your mortgage balance is $100,000. You can borrow up to 80% of the loan-to-value ratio which in this case is $60,000.
On your $60,000 HELOC you have a balance of $30,000. If you were to make a $20,000 payment the credit is available again and you would have $40,000 available to spend.
- Equity- In order to qualify for a HELOC you must have positive equity in your home
- 80% Loan-to-Value- Most lenders allow you to borrow up to 80% of the LTV ratio. You should have at least a 75% LTV ratio to be able to qualify.
- Income- You debt-to-income ratio will be figured to ensure you can afford another loan on top of your mortgage. Most lenders require a maximum DTI ratio of 43%.
- Current on Mortgage Payments- In order to be eligible for a HELOC, you must be current on your mortgage payments and not have any late payments in the past 12 months.
- 640 Credit Score- Each lender has its own credit score requirements so the minimum will vary from lender to lender. You should have at least a 640 credit score to qualify for a HELOC.
Pros and Cons of Home Equity Lines of Credit
- Low-interest rate than a personal loan
- Pay interest only on the balance, not the total credit line
- May offer interest-only payments during the draw period
- Variable interest can increase your rate over time
- Possibility of overspending with a large line of credit
- Reduces the amount of home equity you have
HELOC vs Home Equity Loans
HELOC’s and home equity loans are very similar. As with a HELOC, a home equity loan lets you use your home equity as collateral for a loan. But instead of a revolving line of credit, you are given a lump sum and are charged interest on the entire amount borrowed.
For example, if you have a $200,000 home and your mortgage loan balance is $100,000 you can borrow up to $60,000.
With a home equity loan, you would receive one lump sum of $60,000 and make monthly payments until it is paid off with a typical repayment period of 5-15 years.
If you got a HELOC you would receive a $60,000 line of credit that you can borrow from on an as-needed basis. You will make monthly payments and as you pay off the debt you are able to borrow it again.
Fixed and Variable Interest Rates
When you get a HELOC or home equity loan your lender will typically give you the choice between a variable and a fixed rate.
A variable rate means the annual percentage rate will increase or decrease with the prime rate. A variable rate comes with an interest rate below the prime rate for a period of time usually one year. After that, the rate will adjust to the prime rate and can greatly affect your payment.
A fixed rate is a rate that is fixed and will not change during the loan term. Fixed rates are often the best choice because they are predictable.
The Draw Period
The draw period is the initial period you can borrow against the credit line and monthly payments are applied to the interest only. Terms vary but usually, the draw period is 10 years. At the end of the draw, the interest-only payments are replaced with interest and principal payments.
When the draw period ends your monthly payment will increase significantly. But you have a few options.
Get another HELOC- When the draw period is up you can get another HELOC and move the balance over and reset the draw period.
Refinance your HELOC- You are able to refinance your HELOC to reduce the payments.
Pay off your HELOC early- During the draw period, you can make payments towards the principal balance so that you can reduce or pay off the balance before the draw ends.
Home Equity Closing Costs
- Home Equity Loans- 2%-5% of the loan amount in closing costs
- HELOC- Little to no closing costs
Closing costs are fees charged by the mortgage lender for processing the loan. One of the main advantages of a home equity line of credit over a home equity loan are the closing costs.
A home equity loan will have closing costs similar to the percentage you paid when you bought your home. With closing costs ranging between 2%-5% of the loan amount means that on a $50,000 home equity loan your closing costs will be between $1,000-$2,500.
With a line of credit, there are usually very little to no closing costs involved. This is a big advantage of HELOC’s vs home equity loans.
What is Better a HELOC or Home Equity Loan?
Your situation will determine which is the better option for you. Both come with similar rates, however, with a home equity line of credit you are only charged interest on the amount borrowed.
Some people are using the loan for certain large purchases like installing a pool or paying off high-interest credit card debt. If that is the case you may be better served just getting a home equity loan so you are not tempted to make additional purchases.
In an emergency like if you lose a job and need money to pay the bills until you get back on your feet, a home equity line of credit may be a good idea. This way you can pull out money as you need it and not have to pay interest on a lump sum payment.
Is HELOC interest payment tax deductible?
Yes. However, under the new Tax Cuts and Jobs Act of 2017, enacted Dec. 22, 2017 borrowers are no longer able to write off home equity loans or line of credit interest unless the loan was used to buy a new home or substantially upgrade the home.
If you use funds for personal expenses such as paying off credit card debt, vacations, to buy a car or student loans then the interest paid is not tax deductible.
Read more about the HELOC interest payment laws on the IRS website.
Home equity lines of credit can be a great way of getting a loan to make additions and upgrades to your home.
They come with low-interest rates and long repayment periods, however, if used unwisely you could find yourself in more debt than you started with.
It’s important to only spend the funds from a HELOC on increasing the market value of your home or to make needed repairs.
Are you ready to apply for a HELOC?
Randall has over 15 years of experience in the mortgage and credit industries. He spends a chunk of time helping consumers understand their credit, advise them on how to increase their credit, and lending his mortgage expertise to help them find the right type of loan. Randall lives in Dallas, Texas with his two sons.