How does a Home Equity Line of Credit work?

When it comes to home finance, it pays to know your options. Homeowners looking to access cash often use a Home Equity Line of Credit (HELOC, for short). The way a Home Equity Line of Credit works is different than a traditional mortgage.

Let's take a look at how they work and what they can do for you.

What is a HELOC?

A HELOC is a common type of second mortgage. Homeowners obtaining a HELOC often have a need for additional cash.  Typical uses are debt consolidation, home remodeling or accessing cash to purchase another property.

A unique structure

HELOCs are different because they have a unique structure. For the first 10 years, the loans are in a "draw period."  During the draw period, homeowners can access any portion of the available cash on demand and pay only the interest on the funds in use each month.

During a draw period, homeowners can also pay back funds at any time.  If more cash is needed, the funds which were recently paid back can be accessed again.  In this sense, a HELOC is similar to a credit card.  Different from a credit card, however, HELOCs come with relatively favorable interest rates (only slightly above traditional mortgage rates).

Adjustable rates

HELOCs also come with adjustable rates that follow the prime rate published in the Wall Street Journal. Rates can vary each month and will be impacted by the prime rate and the margin (more on margin in a moment).

When the draw period ends after 10 years, a payback period begins. During the payback period, funds can no longer be accessed from the HELOC. The outstanding balance is converted to a regularly amortizing loan spread over 20 years.  Said another way, the balance is converted to a "normal" 20-year mortgage.  At the start of the payback period, the interest rate is typically fixed and will remain so during the next 20 years.

Shopping for a HELOC

Virtually all banks, lenders and credit unions will use the prime rate as the core component of determining the interest rate during the draw period.  This is called the "index."  A bank will also set a "margin" for the draw period. Banks may offer a promotional margin for an initial period.  For example, a bank may offer "Prime minus 0.50% for 6 months, then Prime plus 0.25% onwards."

In this case, if the prime rate is currently 5%, the initial rate will be 4.5%.  It is important to note that if prime increases, so will the effective interest rate.  The promotional margin simply reflects a relative adjustment to the published prime rate.

Why a HELOC?

There are several reasons why you may consider a HELOC over a traditional refinance.

Maintain your great interest rate

It is no secret that mortgage interest rates have increased since their historic lows.  While they may still be low, rates in the 3% range aren't coming back anytime soon.

Homeowners looking to access additional cash may be hesitant to refinance out of their low rate - and rightfully so!  The HELOC, as a second mortgage on the property, is a great option to maintain your first loan and still gain access to cash.  As a second mortgage, the loan operates independently of any first mortgage on a property.

Low costs to obtain

The transaction costs associated with a HELOC are significantly lower than a traditional refinance. The costs of a HELOC are typically limited to an appraisal (around $350).

In contrast to a traditional refinance that involves an appraisal, title charges, lender charges and other fees, HELOCs come out as a far less expensive option.

It is worth noting that many banks offering HELOCs will also require a borrower to open a checking account. If it is not a requirement to obtain a HELOC, it is often a requirement to obtain the promotional rate.

Flexibility

The flexibility provided by a HELOC during the draw period makes them extremely advantageous. In addition to the flexibility of taking money on demand, the flexibility to pay it back and draw again is unique. This is in stark contrast to "closed-ended" mortgages (like your first mortgage) where payments are made and funds cannot be withdrawn.

Flexibility also comes in the form of lower monthly payments.  For most HELOCs, the minimum required payment is equal to the interest accrued during the prior month. In contrast to a traditional mortgage that requires interest and principal,

HELOCs provide for a significantly lower payment. HELOCs also allow some or all of the principal balance to be paid off at any time with no penalty (unless stated otherwise in their terms). This feature allows HELOC borrowers to use them for short-term cash needs - such as cash to purchase and flip a house or buy a car.

Qualifying for a HELOC

Qualifying for a HELOC is similar to most traditional mortgage products.

A homeowner looking to obtain a HELOC will need to have good credit, documented income and some type of assets for reserves. Additionally, banks will require that the total amount borrowed against the home does not exceed 80% (or in some cases 90%) of the home value.

HELOCs can be a flexible way to obtain cash without disrupting a current first mortgage. With mortgage rates inevitably rising in the future, HELOCs will certainly maintain their place as a viable home financing product.

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