Owning your home comes with many perks. One of the main ones as having the ability to build equity over time. Once you’ve built up equity in your property, you can then borrow against it in the form of a low-cost loan or home equity line of credit for home improvements like kitchen remodeling and the like. But, exactly how does a home equity line of credit or HELOC work, and does it have any disadvantages? Keep reading to learn the ins and outs and if they’re a good option for you.
The key to understanding a home equity line of credit is to first understand what is meant by the term “home equity”. Home equity is the difference between your home’s value and your mortgage balance. If you buy a home for $500,000 and you’ve paid $200,000 toward the balance, you might think that your home equity is $300,000. On the contrary, you have to take into account your home’s value to determine how much equity you have. If your home has appreciated to now be worth $800,000, you actually have $600,000 in equity even though you only paid in a fraction of that.
With a HELOC, homeowners can receive a low-interest loan to use as they wish while repaying it over time. The loan is secured against the equity value of your home and usually, comes with extremely competitive rates. Plus, compared with other borrowing sources such as credit cards that are unsecured, you’ll pay less in financing fees for the same loan amount.
The specifics regarding the loan terms and fees for a HELOC will vary by source. But once approved, you can access your funds and use them as you like including working on your home for example with a kitchen remodel. Most tend to have few, if any, closing costs, and they usually feature variable interest rates—though some lenders offer fixed rates for a certain number of years.
Lenders offer several different ways to access your funds.
Keep in mind that most home equity credit lines have two phases: the draw period and the repayment period. The draw period is the established time during which you can access your available credit as you choose. This period can last for quite some time–most commonly, around 10 years.
The second phase is called the repayment period. Once the date for repayment arrives, you are no longer able to access funds. Instead, you must make regular payments that include principal, plus any interest, until the balance reaches zero. Most lenders have a 20-year repayment period following a 10-year draw period. During the repayment period, you must repay all the money you’ve borrowed, plus interest. Some lenders may offer borrowers different types of repayment options or even the possibility of an extension if it's something you feel will be needed.
There are no use restrictions when it comes to using your HELOC funds. However, since you risk losing your home if you can’t pay back your loan, a home equity line of credit is best reserved for certain expenses – such as the ones that will help reduce high-interest debt or increase the value of your home. It is not a good idea to use a HELOC for other short-term expenses such as taking a vacation or buying a vehicle.
The following are a few ways where accessing a HELOC might be a good idea:
One of the smartest ways to use a HELOC is for home renovations. That’s because many home renovations increase the value of your home. Keep in mind that the type of home renovation you choose will determine how much of a payback you’ll receive as some renovations traditionally don’t get the dollar-for-dollar return that was put into them. Renovations that increase your square footage, such as a room addition or finishing a basement, are likely to give you the most bang for your buck. But even if you're not increasing your square footage, other home improvements like bathroom and kitchen remodeling will also help increase your home's value.
Some people will choose to use their HELOC to pay for higher education. First, consider if there are any lower-interest federal loans available, but if not, a HELOC can provide you with the funds you need to go to school. The beauty of investing in education is that it will hopefully result in higher-paying career options that will allow you to pay off your debt quickly.
For people who don’t have a large (or any) amount of “emergency funds” that they can access quickly, a HELOC can provide that security. For instance, if you lose your job or have to pay for a major medical procedure, where will you get the money you need? If you don’t have an emergency fund, a home equity line of credit can provide the cushion you need. You can borrow against your credit line at any time, but if you end up not using them, your untapped funds will stay put, without racking up interest charges. Just make sure your bank doesn’t require minimum withdrawals.
Every HELOC is different and requirements will vary depending on your lender. But you'll typically need the following to be approved for a home equity line of credit:
The process for obtaining a home equity line of credit is similar to that of other home loans. First, you should shop around. Just as you wouldn’t get a mortgage from the first bank you drive by, you shouldn’t get a HELOC without first doing your homework. That means shopping for the best rate but also looking at the specifics of the credit terms.
Once you identify the best lender for your needs, you’ll have to fill out the necessary documentation. Be prepared to show copies of your tax returns, bank statements, and any other financial records. After supplying the lender with all the required info, you’ll wait while your application goes through the underwriting process. This can take several weeks. Once approved, you have to sign a bunch of paperwork, but then your funds will become available.
If you own your home, it’s important to remember that you have the potential to have cash available to you, whenever you need it. Whether you want to have access to emergency funds or invest in your home by completing a major home renovation like remodeling your kitchen, a home equity line of credit can provide you with a low-cost loan and a generous payback period.
