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When you want to remodel your home, pay off credit card debt, or finance your child's education, you may be able to borrow against the equity in your home. One option to consider is a home equity line of credit, or HELOC.
What is a HELOC?
A HELOC is a type of second mortgage. It allows you to borrow cash as needed, up to an approved credit limit, and only pay interest on the amount you borrow-similar to a credit card. Many lenders will allow you to borrow up to about 80% of your home's value.
Draw and Repayment
There are two phases to a HELOC: the draw period and the repayment period. During the draw period, many lenders require a monthly payment of interest only. The draw period can be up to 10 years. After the draw period ends, the repayment period begins. During the repayment period, the payments are higher, because you are paying principal as well as interest.
HELOC vs. Home Equity Loan: What's the Difference?
Both home equity loans and HELOCs are backed by your home's equity. However, there are several differences between them.
- A HELOC is a revolving line of credit. With a traditional home equity loan, you borrow one lump sum with a fixed repayment term.
- The interest rate on a HELOC is variable, while a standard home equity loan usually has a fixed interest rate.
- A HELOC often carries a yearly fee. However, the closing costs are often higher with a standard home equity loan.
Qualifying for a HELOC
In order to qualify for a home equity line of credit, the underwriter will consider several elements.
- The combined loan-to-value ratio of your home. The loan-to-value ratio compares the size of the loan to the value of the property.
- Your credit score. A HELOC requires a credit score of at least 620.
- Your debt-to-income ratio. Most lenders will require a debt-to-income ratio of 41% or less.
- Your prior mortgage history. You're unlikely to be approved if your recent mortgage history includes a foreclosure, a short sale, or a bankruptcy.
What Are the Benefits of a HELOC?
Here are some of the advantages of a home equity line of credit.
Low Interest Rate
A HELOC often has a lower interest rate than a credit card or a personal loan. HELOCs also typically have lower costs up-front. Many homeowners use a HELOC to pay off high-interest credit cards.
Flexibility
With a HELOC, you only pay for the amount you spend. No matter your credit limit, you only pay back the amount you borrow, plus interest. There are also no restrictions on what the money is used for.
Tax Deductions
If your HELOC is used for home improvements, the interest may be tax deductible. According to the IRS, "Taxpayers can often still deduct interest on a home equity loan, home equity line of credit or second mortgage" under the new tax law, if it was "used to buy, build or substantially improve the taxpayer's home that secures the loan." Up to $750,000 of qualified loans may be deductible (the limit is $375,000 for married taxpayers filing separately). Always consult a tax professional about your specific situation.
What Are the Potential Risks of a HELOC?
While home equity lines of credit offer many benefits, they do have potential risks.
Variable Interest Rates
Most HELOCs have variable interest rates. It's possible that your interest rate may increase in the future.
Your Home Is Collateral
Since your home is the collateral for a HELOC, there's a chance of foreclosure if you can't repay the loan and it goes into default.
Is a HELOC Right For You?
Whether a home equity line of credit is best for you depends on your circumstances. The answer will be different for each person depending on your needs.
A First Savings Mortgage lender can help you determine what works best for you. Contact us today and get the most out of your home's equity.