Home prices have been steadily increasing over the last couple of years.
And that means people have more equity in their homes than ever before that they can borrow from.
This article takes an in-depth look at home equity lines of credit, the requirements, and who is eligible.
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What is a Home Equity Line of Credit?
A home equity line of credit, HELOC for short, is a second mortgage that uses the home equity a homeowner has as collateral for a line of credit. Borrowers can borrow up to 80% of the loan-to-value ratio.
The line of credit works like a credit card. You’re given a credit limit and are only charged interest on what 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.
Home value $200,000 - Principal balance - $100,000 - Max Loan = $60,000 - loan costs
- 680 minimum credit score
- No late payments in the last 12 months
- Loan-to-value ratio must be under 70%
- Maximum 45% debt-to-income ratio
- Borrow up to 80% of the home’s market value
HELOC Pros and Cons
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.
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 use 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.
Fixed and Variable Interest Rates
When you get a HELOC or home equity loan, your lender will typically give you a 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 can 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.
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.
A cash-out refinance lets you tap into your home’s equity to get cash. The difference is that a cash-out refinance includes paying off your existing mortgage plus the cash of up to 80% of the LTV ratio in one loan.
They also have lower credit score requirements than HELOCs. You need a 620 credit score to qualify for a cash-out refinance vs. a 680 score for a HELOC or home equity loan, making it easier to qualify.
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, buying 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, you could find yourself in more debt if used unwisely than you started with.
It’s important to only spend the funds from a HELOC on increasing your home’s market value or making needed repairs.
Are you ready to apply for a HELOC?