Your home equity is one of the most valuable assets that can be helpful when you are in financial distress. Many homeowners often use a home equity line of credit (HELOC) to finance various expenses such as home improvements, education fees, vacations, and medical bills.

Before borrowing money against your home equity, it is essential to understand how HELOC works. That will not only improve your knowledge but also help you to get the best mortgage deals from reputable lenders.

In this article, we’ll take a look at the definition of a home equity line of credit and how it works. You will also get to understand why you should or should not take a HELOC.

What is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is typically a second mortgage that functions like a credit card. The HELOC allows you to borrow funds against your home equity, meaning you can qualify for large amounts of funds when you have more equity in your home.

You are probably wondering, what is home equity? It is the difference between the current value of your home and your outstanding mortgage balance. For instance, your home equity is worth $200,000 if the present value of your home is $350,000 and you have a mortgage balance of $150,000.

When taking out a HELOCs, you only use your home as collateral, and your lender may seize it if you default payments. Unlike mortgages, HELOCs have nothing to do with real estates. You can use the funds to finance various expenses.

With a home equity line of credit, you only pay interest on the amount of money you owe. For instance, if your HELOC is worth $90,000 and you borrow only $30,000 of it, you will only pay interest on that $30,000. However, you can still borrow up to $90,000.

How HELOCs Work

When applying for a home equity line of credit, lenders must always verify if you qualify by evaluating your home equity. They also have to consider the appraised value of your home, your income, credit score, and outstanding debts.

Lenders prefer working with borrowers who can pay off debts. For that reason, you have to demonstrate that you can repay the HELOC by providing proof of employment or income. You must also have a good credit score to qualify for the HELOC.

You can borrow high amounts of money with a HELOC if your home equity is high. As you pay off your mortgage, your home equity is likely to increase over time. That is also possible when your home appreciates with time.

How Much Can You Borrow With a HELOC?

With a HELOC, you can cash out up to 85% of your home equity. However, that may vary depending on the location and terms of lenders. In Canada, you can cash out a maximum of 65% of your home’s current value if your lender is a federally regulated institution.

If the lender combines your HELOC with your mortgage balance, you can borrow up to 80% of your home value. The interest rates for most HELOCs are variable. They can either increase or decrease depending on the prime rate.

For example, if your home is worth $500,000 with a mortgage balance of $300,000, you can a HELOC of up to $100,000 if the lender allows you to cash out 80% of your home equity. Check the illustration below.

• $500,000 × 0.8 = $400,000
• $400,000 – $300,000 = $100,000

The maximum home equity line of credit that you can get is worth $100,000.

Costs of Home Equity Line of Credit

When applying for a HELOC, you are likely to incur additional charges including the upfront lender fees such as appraisal fees, origination fees, application fees, and attorney’s fees.

Other fees may include the transaction fees, early account closing fees, title insurance fees, legal fees, and inactivity fees. Not every lender will charge all these fees. Some lenders may also charge membership fees to keep accounts open.

How to Qualify for a HELOC

One of the primary factors that lenders consider before giving out a HELOC is home equity. Other factors such as your income, credit score, and outstanding debts may vary depending on your lender’s specifications.

You must have a good credit score to qualify for a home equity line of credit. Some lenders also consider debt-to-income ratios to determine eligibility for HELOCs. As a result, some retirees find it difficult to qualify.

HELOC Qualifications

In a nutshell, let’s look at some of the requirements that you must fulfill to get a HELOC.

• Credit Score: Most lenders require a credit score of at least 620. To qualify for better rates, you must have a higher credit score of up to 740 or more

• Home Equity:The remaining home equity should be at least 20% after borrowing with a HELOC

• Proof of Income:You must prove that you will make payments without defaults

• Debt-to-Income Ratio: Should range between 40-50% (vary with lenders)

Pros of HELOCs

• Lower Interest Rates: HELOC mortgages have relatively lower interest rates than other loan types

• More Flexible: Unlike the traditional mortgages, HELOCs allow you to access any amount of cash you need so long as it’s within your limit

• Home Ownership:You can still be the legal owner of your home and stay in it

• Lower Upfront Costs:HELOCs have smaller upfront fees than conventional home equity loans

Cons of HELOCs

• Monthly Payments: Lenders require you to make monthly payments (interest-only). You must meet the minimum amount when paying off the principal balance

• Risk of Losing Your Home: If you fail to make payments, your lender will seize your home and sell it off

• Additional Fees:When borrowing funds with a HELOC, you will pay upfront fees including application, appraisal, origination, and legal fees

• Increase in Rates: Since HELOCs have variable rates, the line of credit interest rates may increase if the prime rate goes up.

• Penalties for Late Payments:Failure to make HELOC payments on time may attract penalties, and it may eventually force you to sell your home

Final Word

While a home equity line of credit might help you pay your utility bills, you must be careful. You may find yourself in a debt trap and also lose your home when you fail to make payments on time.

Lenders have different rates and terms of payments. You should choose a lender who offers the best deals such as low-interest rates. LoansGeeks is one of the best places to find loan offers that will work best for you.

By Taylor Wilman