What is a HELOC and How Does it Work?
Undoubtedly, you’ve seen advertisements for loans that will “utilize” or “tap into” your home equity. The majority of these loans are HELOCs. HELOC stands for Home Equity Line Of Credit and is often times a “junior mortgage” or second mortgage. That means that it stands behind your primary mortgage in lien position on the title of your property and is paid off only after your primary mortgage is paid off in the event of sale or the default of a loan. Since their inception, HELOCs have been very popular to homeowners because they allow a homeowner to borrow money against the equity they’ve built into their home.
Common Uses for a HELOC
HELOCs have a fixed limit that you can borrow up to (represented by what’s called the CLTV or Combined Loan-To-Value ratio). You can charge up a HELOC to it’s maximum allowance and you pay interest only in the early years of the loan. HELOCs are probably most commonly used for home improvements or as a means of consolidating other high interest rate charges (such as credit cards that charge 20%+.) Some people use them for college tuition, to fund business ventures or even to finance vacations.
Advantages of HELOCs
The advantage of HELOCs is that you are paying interest only in the early years of the loan, so they act very much like high limit credit cards, but with one MAJOR difference. They are secured against your property as collateral, so if you default on a HELOC, the lender has legal right to your property.
Your Home Can Be At Risk
Although this is not a very common occurrence, the risk is still there and your should proceed with the process of selecting a lender and specific HELOC product with the same caution that you would a primary mortgage. In some cases where there is no primary mortgage, the HELOC assumes first lien position against your property.
Variable Interest Rates
HELOCs come in many different types, but the majority of them are variable interest rate loans tied to the “prime” rate. Currently, the U.S. prime rate is 8.25%. In late 2003, the prime rate was close to 4.0%, but subsequent adjustments made by Allan Greenspan and the “Fed” or Federal Reserve (the privately-owned governmental bank that determines interest rates) increased interest rates by 0.25% in successive sessions as an indication that the economy was improving. So, most HELOCs are within the range of 0.5% below prime (7.75%) to as much as 4.25% above prime (12.50%) and adjust whenever the Fed convenes and decides to adjust interest rates. Your specific FICO credit score will be a significant factor in the rate you are able to secure on your loan.
HELOC Terms
HELOC terms vary greatly, and there is usually a specifically designated “draw” period and a specific “repayment” period. Of course, these loans can be closed by being paid off at any time either by paying off the principal or re-financing your property. HELOCs usually come in terms of 15 years, although some are extended to up to 30 years.
Flexible
There are many benefits to HELOCs, as they are very flexible. You can usually pay off as much as you want (although you may be required to pay a pre-payment penalty if you close the loan within the first three to six months), and charge on the line of credit as you need. You are usually given checks and oftentimes a debit card in which to draw on that line of credit.
Lower Origination Fees
In contrast to traditional mortgages (don’t forget, a HELOC IS a mortgage) the origination fees are much, much lower and may require an annual fee of $50 or so. It can be a useful tool and some borrowers have told me that their HELOC is their “safety net” in times that money is tight or unexpected expenses surface.
HELOC’s With Fixed Rates
Not all HELOCs are variable though. If you do some homework, you may come across HELOANS© or other products that have fixed rates. Home Equity loans that are in first position (where you don’t have a mortgage in place) generally come with more favorable rates. Taking a HELOC out and paying on time can also greatly improve your credit rating, as long as you pay on time and aren’t always maxed out.
