Also known as a HELOC, a home equity line of credit allows you to borrow against the equity you have in your home. Unlike a home equity loan where you receive your money in one lump sum payment, a HELOC lets you draw money from a line of credit and make monthly payments. You can make a minimum payment or repay all of it just like a credit card.
What is Equity?
Your home's equity is how much your home is worth minus the current principal balance of your mortgage. For example, if the current market value of your home is $300,000, and you owe $200,000 on your mortgage, you have $100,000 in equity. Most lenders express equity as a percentage. So, using this example, you would have 50 percent equity in your home.
How HELOCs Work
If you qualify for a HELOC, your lender will determine your line of credit based on the equity in your home. However, the majority of banks and mortgage lenders do not let you borrow 100 percent of your equity. The maximum amount most lenders will let you borrow is 85 percent of your equity, but every lender has their own borrowing guidelines for HELOCs.
Using the example above, your home is worth $300,000 today, and you owe $200,000, leaving you with $100,000 in equity. If a lender lets you borrow 85 percent of your equity, your line of credit would be $85,000 (.85 X $100,000 = $85,000).
Remember that a HELOC is a second mortgage on your home with its own interest rate. Although you may have a fixed interest rate on your primary mortgage, you will have an adjustable (variable) interest rate on your HELOC. A variable rate means your interest rate could go higher or lower during the HELOCs life cycle.
If you fail to make payments on your HELOC, your lender can start foreclosure proceedings just like they would if you started missing multiple payments on your first mortgage. Although HELOCs are similar to credit cards, the majority of cards do not require you to put up collateral to secure the line of credit.
How to Draw the Money From a HELOC
You can use the money from a HELOC during what is known as the draw period. You can either use your checkbook or a card to get money from your line of credit during this period. Most draw periods last for 10 years. During this time, you will make interest-only payments each month. Once the draw period ends you will enter the repayment period.
You start paying the money back in monthly installments once you enter the repayment period. Your payment will consist of principal and interest. Therefore, your payment will probably be much higher during the repayment period compared to the draw period. How long the repayment period lasts varies by lender, but it can last up to 20 years.
Reasons to Use a HELOC
Most homeowners use HELOCs to renovate or repair their homes. Since many homeowners do not have an exact budget to renovate their homes, they often choose the convenience of a HELOC. Some homeowners use HELOCs to pay for a child's education. Advisers may recommend you use the equity to help you build wealth over time. Since most renovations increase the value of a home, a HELOC in this situation is not a bad choice. Keep in mind the interest payments could be tax-deductible if you use the equity to complete renovations or repairs.
How to Qualify
As previously stated, the majority of lenders will not let you borrow more than 85 percent of your equity. In some cases, lenders only allow 80 percent. The only exception is a VA home loan, which lets you borrow up to 100 percent of your home's equity.
Also, most lenders require you to have a minimum credit score of 620. Obviously, a higher credit score will give you a better chance of qualifying with a low-interest rate. Also, it is best that your debt-to-income ratio does not exceed 38 percent. Also known as your DTI, the ratio is how much of your gross income you spend on bills. For example, if your gross income is $2,000/month, and you spend $800/month on bills, your DTI would be 40 percent ($800/$2,000 = .40 or 40 percent).