What is a HELOC?

What is a HELOC?

Anna Baluch

October 16, 2020

What is a HELOC?

If you’re a homeowner in search of a way to pay off a large amount of credit card debt or cover a large expense like a home improvement project, medical bill, or college tuition, a Home Equity Line of Credit, also known as a HELOC, may be a good choice. So what is a HELOC? At its core, a HELOC is a financing option that allows you to borrow money against your home’s equity (the difference between what you owe on your mortgage and what your home is currently worth) to meet your financial goals.

Keep reading to learn more about a HELOC and how you could benefit from it.

How does a HELOC work?

A HELOC works in a in a way that is similar to a credit card. Instead of borrowing a lump sum, like you would with a personal loan, you borrow as much or as little as you’d like — up to your credit limit. Eventually, you’ll pay back the amount you borrowed, plus interest charges.

If you opt for a HELOC, you’ll need to understand two time periods: the draw period and the repayment period. Here are a few details on each one.

  • Draw period: During the draw period, which usually lasts from 5 to 10 years, you’ll borrow money when you need it and only make interest payments.

  • Repayment period: Once the draw period is over, the repayment period will begin and usually last somewhere between 10 to 20 years. Some lenders give consumers the option of paying interest only during the draw period of the loan, but there are others who offer a payment plan to help borrowers stay on track to pay off the loan with nearly equal monthly payments. If this repayment schedule is an important consideration, be sure to check your agreement or ask your lender.

Pros of HELOCs

As with any financial product, a HELOC comes with several advantages. The most noteworthy ones include:

  • Flexibility: HELOCs allow you to borrow as much or as little as you want, up to the credit limit. This can be particularly beneficial if you’re unsure of exactly how much cash you’ll need to pay for a certain expense.

  • Long repayment period: Unlike some loans that only give you a few months or years to repay them, some HELOCs offer repayment periods that may last up to 20 years or more.

  • More affordable: Compared to credit cards and other types of loans, HELOCs often come with lower interest rates. And if you use one to pay off debts with higher rates of interest, like credit card debt, a HELOC could save you hundreds or thousands of dollars in interest payments.

Cons of HELOCs

While HELOCs do offer some great benefits, they can have a few drawbacks as well.

  • Risk of losing your house: A the collateral that secures a HELOC is your house. This means that if you fail to make your loan payments, the lender may foreclose on your home.

  • Variable interest rates: The interest rates on HELOCs are typically variable, so they may decrease or increase over time. These variable rates may make it a challenge for you to budget for your monthly payments. If you are looking for a stable payment, look for a lender that has that option.

  • Fees and penalties: A HELOC usually comes with few fees and penalties. These may include early termination fees, withdrawal fees, and penalties for not meeting a minimum withdrawal threshold.

How to take out a HELOC

If you believe a HELOC can help you meet your financial goals, follow these steps to find and apply for a loan that may be right for you.

1. Calculate your loan-to-value ratio

Your loan-to-value ratio (LTV) will tell you how much you may be able to borrow with a HELOC. To calculate it, divide what you owe on your mortgage by your home’s current value. Chances are you’ll be able to tap into a percentage of less than 80% of your loan-to-value ratio.

2. Shop around

Not all HELOC lenders are created equal. Therefore, it’s in your best interest to shop around and compare lenders. You may find HELOCs at banks, credit unions, and online lenders. When evaluating your options, be sure to consider credit limits, fees, penalties, terms, and requirements.

3. Read the fine print and apply

Once you find a reputable HELOC lender that meets your needs, apply online or in-person. Read the fine print and ask for clarity on anything you don’t understand. Do not sign on the dotted line until you understand and agree to the terms and are confident you’ll be able to repay your loan.

HELOC alternatives

Now that you know the answer to the questions “what is a HELOC?” and “how does a HELOC work?” you may decide that it’s not the right financing option for you. Here are some HELOC alternatives to consider.

  • Home equity loans: With a home equity loan, you’ll use your home’s equity to collect one lump sum of cash. You’ll pay it back through fixed monthly payments over an agreed upon term.

  • Cash-out refinance: A cash-out refinance is a loan for more than you currently owe on your mortgage. You’ll keep the difference as cash and use it for anything you’d like.

  • Personal loan: A personal loan allows you to borrow a fixed amount of money and pay it back with interest with monthly installments. Many personal loans are unsecured, so you can borrow without pledging an asset like your house or car.

If a HELOC isn’t the right way to deal with debt, consider debt relief

If you’re considering a HELOC to help you out of an unhealthy cycle of debt, a debt relief program could be a better option. If you don’t have a lot of equity in your home or have a low credit score, debt relief could help you resolve your debts and take control of your financial future more affordably. For more information, speak to a Freedom Debt Relief Certified Debt Consultant. They’ll help you find out if you qualify or advise you on other options. Get started now.

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Anna Baluch is a freelance writer who enjoys writing about all personal finance topics. She’s particularly interested in mortgages, retirement, insurance, and investing.