Home Equity Line of Credit

HELOC, or home equity line of credit, is a loan set up to be drawn on in increments rather than one lump sum. A standard mortgage for $100,000 for example, would be paid out to the borrower in its entirety at closing. A HELOC, on the other hand, is guaranteed by a lender for up to $100,000 which can then be drawn in the amounts and times of your choosing through a special credit card, checks or other withdrawal methods.

HELOC: Characteristics

The majority of HELOCs, or more simply, home equity lines, are second mortgages. Although an increasing number of home equity lines are being used to replace a current mortgage. Using a HELOC to replace an established mortgage can save money, but it can also be riskier than other types of home loans.

Home equity lines have a specific draw period; the borrower must use the finds within this period of time and then there is a repayment period in which it must be repaid in full. Draw periods are generally about five to ten years and during that time the borrower is only responsible for paying interest on the line of credit. The repayment period is usually about ten to twenty years and requires the borrower to make payments to the principle of the line of credit divided by the total length of the repayment period. There are some types of home equity lines that require the entire balance to be paid in full at the end of the draw period. Most homeowners choose to refinance though other means at that time.

HELOC: Calculations



The balance of a home equity line of credit changes often depending on any repayments, payments on interest and any draws, so interest rates for a HELOC are not calculated monthly as is standard for other types of loans, but is rather done on a daily basis. APRs are also calculated differently and mean different things on home equity lines than a standard loan. The APR on a HELOC refers solely to the interest rate and nothing more.

HELOC: Risks

The major drawback to a home equity line of credit is the vulnerability to interest rate hikes. Fluctuations in the market hit HELOCs first and harder than standard loans. If the prime rate changes on August 31st, the HELOC rate change is effective September 1st. Home equity lines do have a guaranteed introductory rate, however, it usually only lasts for a few months. In contrast, standards loans using ARMs have guaranteed introductory rates for up to ten or more years.

An unintentional risk of a HELOC is the potential for it lowering the borrowers FICO score by maxing out their line of credit, missing any interest payments during the draw period or late payments during the repayment period. It can also have a positive impact, however, if the borrower does not max out their line of credit as it is seen as a revolving credit line. To avoid negative impact on FICO scores, the borrower should follow the basic principles of good credit habits; take on new credit only when it is unavoidable or necessary, keep balances low on any line of credit and make all monthly or weekly payments in full and on time.

There are some advantages to HELOCs as it is a convenient way of financing intermittent needs. You draw only what you need, when you need it and only pay interest on the drawn funds, not the total amount of the line of credit. This can be a useful option for homeowners, but it is essential they understand all aspects of a HELOC before signing on the dotted line.