mortgages

What Is a Home Equity Line of Credit (HELOC) and How Does It Work?

7 Minute Read

You’ve just binge-watched the latest kitchen remodel show and now you’re absolutely convinced that your kitchen’s dated cabinets and countertops need. to. go. But there’s no TV crew knocking on your door offering a free renovation so, you know you’ll need to scrape up the extra cash to tackle this must-do project. But how?

Maybe you’ve heard some friends talk about how a Home Equity Line of Credit (or HELOC) helped them pay for their recent remodel. But what exactly is a HELOC, and is it really a good financing option for things like a home remodel, new furniture, or even college tuition?

What is a Home Equity Line of Credit?

A HELOC is a type of home equity loan that acts like a credit card. You can use it for individual purchases as needed up to an approved amount. It’s what’s called a revolving credit line, which means you have access to a circulating pool of money as you borrow from the HELOC and pay it back.

Say your credit line is $40,000 and you spend $35,000 of it updating your kitchen. You would only have $5,000 left to use until you replaced the $35,000 you originally borrowed from the pool. Whatever you pay back on the $35,000 you took out, you would once again be able to use toward other purchases.

But just remember, making minimum payments—like most people who use credit cards or credit lines do—will not fill your pool back up very quickly, especially with all those interest charges!

One thing that makes a HELOC different than a credit card is that a HELOC uses the equity in your home as collateral. Don’t miss that: A HELOC uses the equity in your home as collateral. Hold that thought because we’ll talk more on it later!

How is HELOC different from a Home Equity Loan?

Well, to be honest, Dave would tell you a HELOC is not much different from a home equity loan. The main difference is that home equity loans allow you, the borrower, to take the full lump sum you’ve been approved for all at once, rather than the charge-as-you-go method with a HELOC.

Both the HELOC and the home equity loans are similar in that you borrow against the equity in your home. Equity is the portion of your home you own outright. It’s calculated using your home’s current value minus your mortgage and any other liens against it.

Let’s say your home is worth $180,000 and you still have $100,000 in your mortgage balance. You’d have $80,000 in equity you could potentially access through a HELOC or home equity loan.

Based on your home equity and several other factors, lenders determine what amount they will actually extend to you in credit. Here’s how:

Applying for a HELOC

Since a HELOC is really like a second mortgage, applying for one is similar to applying for your first mortgage. Lenders will go through another formal process of evaluating your financial situation to determine if you’re a credit risk or not. They’ll look at your:

  • home’s current equity
  • home’s appraised value
  • proof of employment and income
  • credit history
  • credit score (720 or above is most favorable)
  • outstanding debts

After verifying these things, lenders will decide how much of a credit line they’re willing to offer you. In most cases, borrowers are approved for around 80% of their home’s equity. So, in our example above of a homeowner with $80,000 in equity, they’d likely be approved for a credit line of $64,000.

Keep in mind that HELOCs have the same upfront costs as a mortgage, including documentation fees, appraisal fees, credit check fees, third-party fees, etc. But once you get the offer, you’ll need to agree on the terms, which can vary. This is where you’ll really need to pay attention.

How does a HELOC work?

Repayment: There are as many different borrowing and repayment schedules for HELOCs as there are lenders. Most people looking to get a HELOC want a longer term, like a 30-year repayment option. But of course, Dave would tell you having no debt is always your best option.

Interest rates: Fixed-rate HELOCs are rare. So you’ll need to be prepared for fluctuating interest rates over the life of your credit line. Dave says these rates are basically based on a banker’s mood and not on the market as we’re all led to believe. So beware!

Immediate payback and credit freezes: Another very important thing to know about how a HELOC works is that when your credit term expires, the balance must be paid in full. The same is true if you sell your home. And even if the loan doesn’t expire, the bank can freeze your credit line if the value of your home declines below its appraised value. In all three of these fine-print scenarios, you could find yourself in a tight (even critical) financial spot—especially if you’re carrying a high HELOC balance.

Why you should avoid HELOCs

By now, your kitchen cabinets and countertops might not be looking as shabby as when you first started reading. That’s because HELOCs are not the answer to your cash-flow problem. Here’s why:

1. You’re putting your home at risk.

Just because HELOCs seem common doesn’t take away the fact that they can also carry serious consequences. If you default or misstep in any way, the bank could take your home! Is that new bedroom furniture you just “have to have” or that 10-day vacation you just “can’t wait to take” really worth losing your home for?

2. Saving and paying cash is smarter in the long run.

Taking on debt of any kind robs you of true financial peace. When you lay your head on the pillow at night, what would you rather be thinking about: planning a party in your paid-for kitchen, or making payments on your shiny new countertops . . . for the next 30 years?

With tools like Dave’s 7 Baby Steps, you can create and stick to a savings plan. You’ll still have that remodel project done in no time—but it’ll be finished debt-free!

3. HELOCs don’t really create cash-flow.

Plain and simple, a HELOC is debt. And debt doesn’t make anything flow but tears. The best way to create cash-flow is to pay off all your debt using the debt snowball method. Increasing your income through a second job or side hustle will also generate extra money for things like home improvements, college tuition, or your kid’s wedding. If too much of your income is going toward your mortgage payment, you could also consider selling your home and downsizing to one that’s more affordable. Use our mortgage calculator to see if this option is right for you!

The bottom line is: before you apply for a HELOC and borrow against what is probably the biggest asset you own, make sure you consult with an experienced financial expert. It’s the best way to figure out if you’re making a smart financial decision for you and your family.

The financial experts at Churchill Mortgage have helped hundreds of thousands of people plan smarter and live better. Before you commit to a HELOC, Dave recommends talking with his friends at Churchill to help you find the right answers for your specific situation.

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