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Owning a house has many perks. One of the most important being the ability to build equity over time. You can utilize this equity to borrow funds through a home equity line of credit, also known as the HELOC loan.
Here, your homeownership becomes equity and your house a collateral. Such an arrangement comes handy when you need to borrow money for a major renovation or remodeling and you don’t have enough cash available in your bank account.
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What is HELOC?
HELOC, also known as a home equity line, is a type of loan taken against the equity in a house. It’s quite similar to a credit card whereby it lets you borrow money up to a specific limit. You can repay the funds over time. Moreover, the available credit amount refreshes as you repay the outstanding balance.
You can use this revolving credit line for any big expense or to pay higher interest rates on a credit card debt. A HELOC, usually, has a lower interest rate than other common types of loans. Plus, this interest is usually tax deductible.
In a HELOC loan, your house is used as collateral for the line of credit. Here, the amount of available credit builds up again as you repay your outstanding balance – similar to repaying a credit card bill.
You can take a look at our guide on HELOC on rental property
Is HELOC a good idea?
A home equity line of credit is best for you if you’re a responsible homeowner with equity available against your house. A HELOC loan allows you to take out money in increments up to your credit limit. This secured financing option offers lower interest rates and the flexible draw period gives you the convenience of paying back the loan as and when you desire.
Moreover, unlike a home equity loan where you get all the money at once, a home equity line of credit loan is easy to manage. This loan type is a good choice if you have to pay for college fees, high medical expenses, or expensive home improvement projects.
However, before getting a HELOC loan, do consult a loan advisor on the pros and cons of HELOC. Keep in mind that such a credit line does carry the risk of foreclosure and requires considerable discipline.
Read more: How to Get a Personal Loan in 10 Easy Steps
How do you qualify for a home equity line of credit?
Generally, to get a HELOC, you’ll need a low debt-to-income ratio (lower than 40), a credit score of 620 or more, and a good home value (at least 15% more than you owe).
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Read more: Home equity for millennials
How does a HELOC loan work?
This revolving loan lets you borrow any amount up to the set credit limit. You can repay all or part of the balance amount by making regular payments of principal and interest until the loan is paid off. And, you can draw it down again.
Suppose you have a home worth $500,000 and have a balance of $300,000 on your first mortgage. A HELOC lender will allow you to access up to 85% of your home’s equity. So, your maximum line of credit limit will come out to be $125,000. Let’s see how:
- $500,000 x 85% = $425,000
- $425,000 – $300,000 = $125,000
Keep in mind that most HELOCs offer variable interest rates. Though some lenders do offer fixed rates. Your HELOC rate will depend on the baseline interest rates which are set by the lender.
What are the HELOC phases?
Most HELOCs have two phases:
- Draw period (10 years): You can access your available credit and repay with small, interest-only payments during this period. You also have the option to pay extra and have it go against the principal.
- Repayment period (20 years): In this phase, you can no longer access additional funds and have to make regular principal-plus-interest payments until you’ve repaid all the money that you borrowed. Some lenders let borrowers convert a HELOC balance to a fixed interest rate loan.
Keep in mind that there’s a significant jump in payments at the onset of the repayment period. Sometimes, double! This often results in payment shock for borrowers — causing them to default on their payments. And, as a result, losing their homes.
What are the pros and cons of HELOC?
HELOC is a good emergency source of money. Of course, as long as your bank doesn’t require a minimum draw when you close the loan. Also, you can borrow against your credit line at a later date without applying for a new loan then.
However, HELOCs can get those borrowers into trouble who spend the available funds on things they don’t necessarily need. Paying back the money with interest can be difficult.
Therefore, it’s best to explore both the pros and cons of a HELOC loan before applying for one.
|Homeowners can borrow a relatively large amount of cash||Lessens the amount of equity in your home when you use it as collateral|
|Costs lesser than most types of loans||If you default on your repayments for a long period, there’s a chance that you could face foreclosure|
|Potential tax breaks on renovation projects that increase the ROI or value of your home||Most HELOCs have variable interest rates which make you vulnerable to increasing interest rates|
|Flexibility to use the money for any purpose||There’s a risk involved for those with higher Customer LifeTime Value (CLTV) if the real estate market takes a dip|
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How does a HELOC affect your credit score?
Your credit score will be affected if you have too much debt and too many lines of credit. Moreover, the fluctuating payments can affect your credit score too. The variable interest rates can increase or decrease drastically.
Is it difficult to get a HELOC loan?
Getting a HELOC loan is not that hard. You can get it even with bad credit. That’s because you’re using your house as a collateral to guarantee the loan.
Read more: Types of Home Loans – Which One Is Right for You?
Are HELOC interest payments tax deductible?
Generally, HELOC interest is tax deductible — provided the mortgage debt is within the limits set by the government. And, the money is being used to buy, build, or improve your home. Having said that, you must consult your tax advisor regarding interest deductibility as tax rules tend to change from time to time.
Claiming the deduction isn’t difficult. In order to deduct the interest paid on your HELOC, you need to itemize the amount at tax time by filling up IRS Form 1040. Keep in mind that this exercise is worth doing only if your deductible expenses add up to more than the standard deductions for that tax year.