One of the most compelling reasons to own a home is the equity you’ll build in it over time. As the value of the house increases and your mortgage balance decreases, the difference becomes wealth with which you can do as you please — kind of.
In other words, the difference between what your house is worth and how much you owe on it is basically your money. You can borrow against that value, you can sell the house and keep the difference, or you can use it as a sort of a revolving “charge account” — a home equity line of credit (HELOC).
Here’s how it works.
Home Equity Loan vs HELOC
While both home equity mechanisms allow you to borrow against the value you have in your home, the home equity loan is granted in one lump sum. Meanwhile, the HELOC works more like a charge card, in that you get a maximum amount up to which you can “withdraw”. Further, you can do it over time or all at once—your choice. The withdrawal period usually lasts for approximately 10 years and you’ll typically get 20 years within which to repay the amount you withdraw.
As a result, the HELOC offers more flexibility than the home equity loan. You can also borrow only as much as you need, which can make repaying a HELOC less costly than repaying a home equity loan. However, a HELOC, just like a straight home equity loan, does permit the lender to place a lien against your home. In effect, your house becomes the collateral with which the loan is secured. Fail to meet the terms of the loan and the lender can force you to sell your home to repay the debt.
Qualifying for a HELOC
The first requirement is the existence of equity in the home against which you can borrow. Generally, loan amounts do not exceed 85% of the value of the home, less the amount of your outstanding mortgage balance. Bills.com’s HELOC calculator can help you determine exactly how much you can borrow with a home equity line of credit.
You’ll also need a strong credit history, a steady income and a steady employment history to get a home equity line of credit. Your current monthly debts will be evaluated as well, to ensure you can afford to repay the loan.
In other words, the same requirements you had to meet to get your home loan in the first place will be considered when you apply for a home equity line of credit. After all, you’re basically taking out a second mortgage on your home.
HELOCs, Interest Rates, Fees and the Margin
The interest rate charged on a HELOC is usually variable, while the interest rate on a straight home equity loan is usually fixed. This means the amount of interest you pay on a HELOC can change from time to time. The rate of change is usually tied to an index that tracks the U.S. Prime Rate.
HELOCs also come with a margin, which is a set figure imposed by lenders to ensure they get a certain amount of money regardless of the ebbs and flows of the U.S. Prime Rate. The higher the margin, the more your payment could increase over the life of the loan. Similarly, regardless of how low the U.S. Prime rate goes, your interest payments will never fall below the margin.
There can also be fees associated with HELOCs. You may encounter application fees, annual fees and even cancellation fees if you decide against taking the HELOC after you’ve been approved. You could also run into an early closure fee if you pay your balance off before the established term of the loan. Bank of America for example, imposes an early closure fee if you close your HELOC account within three years of opening it.