Home Equity Line of Credit (HELOC)

What is a home equity line of credit (HELOC)?

A Home Equity Line of Credit (HELOC) is a Line Of Credit (LOC) that is all about a homeowner using the home's equity as collateral to obtain financing. The homeowner can draw from the LOC, make payments, and then draw capital again.

Therefore, the borrower may choose to access the funds if needed, as the funds are provided by financial institutions for a fee. This allows borrowers to quickly have access to funds in situations where there are large capital requirements.

The number of funds available on the LOC is set by the lender to an approved maximum amount, which means that the borrower can only draw capital up to that amount. For most homeowners, a LOC is made available for large amounts such as those over $30,000.

The borrower is expected to pay LOC back in full at a variable interest rate. This means that the financial institution providing the capital is protected from interest rate risk, as returns change based on the current market environment.

Types of HELOC

HELOCs are a popular instrument today to fund capital needs for homeowners; there are unique ways in which a home equity LOC has evolved over the years. Today, however, there are two prominent ways in which a home equity LOC is structured.

A Home Equity LOC can be structured as a traditional/variable rate or a hybrid/fixed rate home equity LOC. The table below highlights the factors associated with each type:

A fixed-rate home equity LOC is referred to as a hybrid home equity LOC because the structure of such a LOC is a cross between a traditional home equity loan and a traditional variable rate HELOC.

The differences outlined above for each type of home equity LOC mean that traditional home equity LOCs are generally considered to be riskier instruments for lenders. That's because the monthly payments are variable. Therefore, they can change month over month.

Therefore, if interest rates were to rise suddenly, then the borrowers would find themselves to be making much higher payments. Hence, lenders are more stringent when evaluating the credit quality of borrowers when offering such an instrument that has interest rate risk.

Furthermore, as traditional HELOCs are only paid back in interest, lenders may find themselves in a predicament due to fluctuating interest rates. Due to these reasons, even the amount that a borrower can usually borrow for such a LOC is lower than a hybrid home equity LOC.

Purpose of a Home Equity Line of Credit 

HELOCs are generally best for people that need quick and large access to funds. This is a given as the collateral of the loan amount is a house, meaning that the borrower is usually looking to use the capital for large expenditures.

Hence, HELOCs are usually used for the following cases:

• Emergencies such as sudden medical bills or other emergencies

• Educational funding, such as paying off college tuition 

• For large home improvement projects such as renovations on an existing property, such a scenario means that the home can be used as collateral to fund renovations.

• Investment projects such as the borrower using the LOC to fund an investment property or self-owned business

• Any other special use cases where an individual may require substantial capital 

Borrowers should evaluate the purpose of why they need capital and work with their lender to understand the home equity LOC and its terms. 

HELOC Qualification Requirements

Borrowers should be aware of eligibility requirements set by lenders to qualify for a home equity LOC. This section will highlight these requirements.

There are several criteria that lenders wish to meet before issuing a home equity LOC. Note that such requirements are similar to a traditional home equity loan. Generally, these include:

1. A sufficient percentage of your home equity as collateral for the loan amount

2. Good credit score

Usually, you want to have a score greater than 680 to be considered for a home equity LOC.

3. Low debt to income ratio (DTI)

Generally, the ratio should be at 43% or lower; this means that your debt owed should not be more than 43% of your annual income. 

However, this criteria varies from lender to lender, with some requiring a DTI of 30% or lower. If applicable, you can pay off a sufficient amount of your credit card debt, student loans, and mortgages to ensure that you meet this criterion.

4. Sufficient income

Be prepared to disclose your income verification documents to lenders

5. Reliable borrower history

Although a good credit score shows that you have a reliable payment history, lenders issuing HELOCs look much closer at previous transactions.

You can check the latest rates if you find yourself eligible for a home equity LOC. 

Given the nature of home equity LOCs, many real estate investors have leveraged their investment properties to borrow more money, allowing them to purchase more cash-flowing property and increase their incomes, and repeat the cycle.

Such a process allows investors to make investments using investments as it allows individuals access to untapped equity in their real estate without a sale; this process can work very well as long as individuals make sure they are able to meet dues confidently.

Alternatives to HELOC

There are many available alternatives for borrowers that do not meet the eligibility requirements set by lenders for a home equity LOC. This section will highlight the most common alternatives for borrowers searching for financing options.

Do you think that you are not qualified for a home equity LOC? 

There are other alternatives that you may instead find yourself to be qualified for: 

1. Personal Loan

You can apply for a personal loan with a lender; such a loan comes with fixed terms and a payment schedule. Generally, the lender does not question why you need the loan as long as you meet the criteria set.

2. CD Loan

If you already have a sufficient deposit amount in a bank, you can take out a certificate of deposit amount to use the cash as collateral and borrow against it.

3. Credit Card Loan

A short-term credit card loan can be taken up to finance an emergency. You can explore 0% APR credit cards that let you borrow for 0% interest as a promotional limited-time offer; explore credit card options in the market to evaluate if this works for you.

4. Private Loan

A private lender can offer you a loan. However, they usually charge much higher interest rates. Further, ensure that the terms set by the lender are understood fully. 

Most people go to close family to access funds based on trust, although this may impact your relationship with the person.

Home Equity Line of Credit (HELOC) Phases

A Home Equity LOC can be described as working in two phases. The two phases are called the draw period and the repayment period. Note that payments have to be made during both periods.

Phase 1: The Draw Period

The draw period is referred to as the first phase because the borrower is allowed to draw capital on their LOC as long as they don't meet the limit.

Hence, as long as the LOC has more capital available than you have previously drawn after repayments, the payments will be minimal as they are usually interest-only payments on the amount borrowed.

The draw period may be refinanced if eligible; this means that you can extend your draw period.

Phase 2: The Repayment Period

The lender will outline when the repayment period begins. In this period, you are unable to draw further capital from the home equity LOC until you have repaid the lender back in full. 

Therefore, when the repayment period starts, the lender will expect you to make full monthly payments of both principal and interest. Therefore, you should expect your monthly payments to go up drastically as you are now starting to pay down your outstanding balance.

Your lender will explain to you when each phase begins and will structure the home equity LOC according to your needs and eligibility. Usually, the draw period lasts ten years, while the repayment period lasts 20 years.

Home Equity Line of Credit Example

A home equity LOC can be difficult to understand. However, we will use examples to illustrate how such a financial instrument works. 

Assume that you are a homeowner requiring a substantial infusion of capital into your business, amounting to $150,000; therefore, you decide to draw a home equity LOC. 

Here are some numbers that you provide to your lender:

• Your home is currently valued at $1,000,000

• The outstanding mortgage balance is $400,000

• The total line of credit you want is $400,000 because you predict that you may need further capital infusion into your business later on.

• You have a credit score between 680 to 739, which means your lender views you as having good credit

• Therefore, your current loan to value ratio is 40% ((400,000/1,000,000)*100)

• You plan to withdraw $150,000 at account opening due to your capital requirements.

You receive the following information from your lender based on your financial standing and the fact that you requested to withdraw $150,000 at account opening:

• The lender offers at 5.8% variable APR

• Variable-rate Monthly payments sit at $880 today; this may change month to month

• 30-year term (10-year draw period followed by a 20-year repayment period)

• No closing costs for loans up to $1,000,000

• The lender offers a 0.1% interest rate discount for each $10,000 drawn at account reopening, up to a maximum of 1.5%

Note that the terms above vary from lender to lender and depend on the financial standing and requirements of the borrower. Therefore, you must carefully consider which lender is best for you.

If you were to open this home equity LOC, you would have received an interest rate discount of 1.5%, thus placing your variable APR at 4.3% today. 

This means that you will be able to fund your business requirements while also having a LOC of $250,000 ($400,000-$150,000) still available to draw from if needed.

Check the websites of various lenders to compare what lenders are offering quickly.

HELOC formula is:

Here are the formulas for borrowers to understand how their home equity LOC works:

Maximum amount of borrowable equity = (Your home’s value) x (your lender’s LTV percentage)

Your HELOC credit limit = (Maximum amount of borrowable equity) – (what you currently owe on your mortgage) 

HELOC Advantages & Disadvantages

Like any other financial instrument, there are clear risks and benefits associated with a home equity LOC that borrowers should be aware of and evaluate based on their needs. 

Here is a table below that highlights these factors:

Perhaps the most important factor associated with a home equity LOC which is attractive to borrowers, is the ability to have immediate access to capital during the draw period. This means that borrowers can always rely on the lender providing the capital as long as it is within LOC limits.

However, a home equity LOC comes with significant interest risk, which means that a rising interest rate environment will periodically increase borrower payments month over month.

Therefore, borrowers have a much higher chance of defaulting in an uncertain environment where interest rates are not stable. This is not the case with a traditional fixed interest rate loan, where a borrower does not have to worry about fluctuating monthly payments.

You must be wondering whether you should apply for a home equity LOC. However, there is no definitive answer for whether a borrower should finance their needs using a HELOC, as the situation and requirements of each and every individual is different.

It is true that a home equity LOC can provide significant advantages over other instruments, but being aware of the risks is crucial.

Research and authored by Imran Husain | Linkedin

Uploaded and revised by Omair Reza Laskar | Linkedin

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