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By Kathryn Pins
When you have big expenses, it’s good to know your financial options. Many people don’t know that a home equity line of credit is a way to get the cash you need when you need it. So, what is a home equity line of credit and how could it help you? We share the ins and outs of this financial option.
A home equity line of credit, or HELOC, is an “on-demand” loan that leverages the equity in your home. Your home equity is the difference between your home’s market value and the remaining balance on your mortgage. If you put a good amount down on your home and you’ve been making payments for a few years, you probably have a lot of equity in your home to borrow against.
A HELOC is helpful when large expenses come your way, whether they’re planned or unexpected. It’s common to use a HELOC to pay for home repairs and remodels. However, most people don’t realize that a HELOC can also be used for debt consolidation, medical bills, or any other big-ticket items. With a HELOC, you could get a low interest rate and flexible low monthly payments, which is why it’s ideal for big expenses.
Instead of cashing in valuable investments or dipping into your savings, a HELOC could be a good alternative. It’s important to take a look at the possible interest rate on your HELOC and compare it to your investment returns to help you make the right decision.
A HELOC allows you to borrow from your home as a line of credit, similar to a credit card. Once you open a HELOC, you can borrow what you need, when you need it, until you reach your credit limit. You control how much you borrow, and unlike a loan, you only pay on what you spend. So, like a credit card, you have a line of credit that’s there as you need it. If you don’t use it, it’s still there, just in case.
HELOCs have a draw period and a repayment period. The draw period is when you’re able to take money from your line of credit. The repayment period is when you make payments back to your principal (which you will do during your draw period too if you’ve taken a draw already). For example, you could have a seven-year draw and a 15-year term. You can take out money for seven years, but you have a long time (15 years) to make payments back. So, you can take your time if you need to pay for that big expense.
The majority of home equity lines of credit have variable interest rates. A lender will adjust the rate based on the prime rate. The amount of times an interest rate will change depends on the lender. Some lenders only adjust their interest rates once a year while others adjust their interest rates monthly. If you want a greater sense of security with a variable rate, look at the fine print to see if how often the rate changes.
It is very uncommon to see a HELOC with a fixed rate. With a fixed rate, your monthly interest rate payments will stay the same whether the prime rate moves up or down.
A HELOC Interest-Only (also known as an IO) is a line of credit as explained above, but you only pay interest (and principal, if you choose) for a part of your repayment period. After that point, you will pay full principal and interest payments. For example, with an Alliant HELOC IO, you would pay only the interest on the loan for the first 10 years, plus any principal if you choose. After 10 years, you will pay principal and interest like a traditional HELOC. A HELOC IO is good if you anticipate needing funds and want lower, interest-only payments initially
Not every HELOC is the same, and you don’t have to get a HELOC from the same bank where you have your mortgage. The closing costs for a home equity line of credit could average up to 5 percent of your overall loan. However, there are many lenders who don’t have closing costs on a HELOC. Although closing costs of 2 to 5 percent are lower than a mortgage, these costs could make a significant impact on your wallet.
When shopping around, look for a HELOC with no closing costs, application fees or appraisal fees in addition to hunting for the best interest rate.
Typically, you’ll need to meet the following requirements to qualify for a home equity line of credit:
The more equity in your home, the higher line of credit you could potentially have.
If you’re wondering, "how much equity do I have?", you can either take your home’s market value minus your remaining balance, or add up the payments to your principal and your down payment. For example, your home has been appraised for $850,000 and have $600,000 still owed on your mortgage. The equity in your home is $250,000.
Why is equity important? The equity in your home determines your loan-to-value ratio (LTV), which lenders use to help determine your line of credit. Each lender has a different LTV they’ll provide. Some will go up to 90 percent. To determine the maximum amount of credit you could get on your HELOC, you could do some simple math:
LTV = (Home equity line of credit + mortgage balance) / home’s market value.
In the example above, the highest line of credit you could get is $165,000 with an LTV of 90 percent. However, it’s important to remember that there are other requirements that will determine how big your line of credit is.
A quick way to calculate your debt-to-income ratio, or DTI, is to divide your monthly debt payments by your monthly gross income. You will usually see your debt-to-income ratio as a percentage. A good debt-to-income percentage is anything below 15 percent. As a rule of thumb, you shouldn’t let your DTI go above 36 percent.
On the FICO scale, a score of 670 or higher is categorized as a “good” rating. Scores above 740 are considered “Very Good” or “Exceptional.” If your score is lower than these ratings, then take a look at how a credit score is calculated to help you move that number even higher. Scoring an even higher credit score can help you to qualify for a great home equity line of credit.
Many lenders require property insurance as well as flood insurance in some cases. When you apply for a HELOC, you may need to provide documentation that you have property insurance on your home.
A home equity line of credit is a great option to have, whether you want to have it open as a safety net or you have a specific expense in mind.
Kathryn Pins is a marketing content specialist at Alliant. She’s passionate about finding and communicating meaningful financial information with Money Mentor readers. Kathryn is a saver who gets more excited about certificates and her Roth IRA than shopping. When she does spend her earnings, it’s on furthering her education, travel, unique experiences, and loved ones.