What you need to know about HELOCs
Are you looking to do a renovation or have some other expense that you need a line of credit for? Here’s what you need to know about a Home Equity Line of Credit, otherwise known as a HELOC.
What is a HELOC?
HELOC stands for home equity line of credit. Unlike a home equity loan, a HELOC is a credit line that a homeowner can draw against. Similar to a home equity loan, you use the equity in your home as collateral to borrow against, and the amount of equity you have in your home helps to determine the amount that you can borrow.
With a HELOC, you get approved to borrow a certain amount of money, and then can write checks or pay by a special credit card up to that amount, rather than borrowing a fixed amount all at once.
Who can qualify for a HELOC?
To qualify for a HELOC, you’ll need to have more than 20% of your home value in home equity and good credit. The bank will assess your income and debts to determine if you will be able to qualify for the HELOC.
How do you pay back a HELOC?
HELOCs typically have two phases. The first phase is the draw period during which the homeowner can use the line of credit. Draw periods are usually 5 or 10 years. During the draw period, the homeowner only pays the interest on the loan. The second phase is the repayment period, where the loan must be repaid. Repayment periods are usually 10 to 20 years, though some HELOCs require the homeowner to repay the full loan at the end of the draw period.
During the draw period, the homeowner pays only interest on the amount borrowed. HELOCs always have an adjustable rate, never a fixed rate. HELOCs can have an introductory interest rate that is usually only for a short period of time, such as six months. The adjustments in interest rate for a HELOC are set by the prime rate. Unlike adjustable rate mortgages, which have caps on how much the interest rate on a loan can adjust, HELOCs have no caps and the interest rate can adjust along with the prime rate. The interest rate that you pay is determined by the prime rate plus the margin. For example, if the prime rate is 3.25% and your margin is 1, then your rate is 4.25%. If the prime rate rises to 4.25%, then your rate will be 5.25%.
Why do people typically get HELOCs?
HELOCs can be appealing in order to pay for things that are occasional and not a lump sum amount. People get HELOCs for things like making a series of home improvements that are not all at the same time and within a defined budget, or education expenses that are ongoing, for example.
Can your lender freeze your credit line?
Yes, if home prices drop and a lender thinks that the lien on your property will not cover the amount of your credit line, they can put a lower maximum amount that you can borrow on your credit line, or freeze it altogether. This can also happen if a lender “reasonably believes” that you won’t be able to make your payments due to a change in your financial situation.
If a lender freezes your credit line you do have some options. You can talk with your lender and find out why they froze your credit line and see if it can be restored. If it is a matter of home value, a new appraisal may help your situation. If it’s a credit issue, make sure you get a copy of your credit report and check for errors. You can get a free copy by following the instructions here. You can also shop around for another line of credit.
What happens if you can’t pay back your HELOC?
Because a HELOC puts a lien on your property, by not paying your HELOC, a bank has a legal right to foreclose and then the proceeds from the home sale are used to pay off the loan balance. If you are 30 days late, you are considered in default. State laws determine when your lender can begin foreclosure proceedings.
If your home is foreclosed on, the bank that has your mortgage will get paid back first, and the bank that has your HELOC will get paid back second (assuming they are different banks).
Your best bet is to try to negotiate with the bank that has your HELOC to try to reduce rates or payments. The best time to do this is before you miss a payment, or at the latest, shortly after.
What sort of consumer protections are there around HELOCs?
The federal Truth in Lending Act requires lenders to disclose the details of your HELOC, including interest, charges, payment terms and adjustments. You should be given this information when you apply for the credit line, and also get more disclosures before the credit line is finalized.
The Truth in Lending Act gives you three days from the day the account was opened to cancel the credit line. You can change your mind for any reason – just inform the lender in writing within three days. The lender is required to cancel the credit line and return all fees.
Should you get a HELOC?
There are many different types of HELOCs, and because the terms vary and they are adjustable rate products, you can imagine that they are also sometimes difficult to understand.
Make sure that you ask for the loan details upfront and go through the payment structure and ask a lot of questions until you fully understand how the draw period, draw period payments, interest rates, and payback periods work. The loan officer will probably want to rush you through this – don’t let them! Take the time you need to understand exactly what the HELOC will cost you.
It is helpful to make a chart to compare features of HELOCs before settling on one. Making a chart of the differences will also help you understand exactly how the credit line and payback periods work, as well as give you as sense of what the credit line will cost you overall, compared with the amount borrowed.
Do you want to learn more about how to make your home a financial success, no matter what type of loan you pick (or don’t pick)? Read about our new book: The Game Plan for Homeowners: Control your Destiny and Win Big While Avoiding the Traps. It’s available now in both digital and print copies and takes you through everything you need to know about making your home a financial success in the short and long term, without getting taken advantage of.