A home equity line of credit, also called HELOC, is a type of credit in which a borrower uses the equity in his or her home as collateral. The amount of the credit may not exceed the amount of equity in the home. Many HELOCs are used as second mortgages, but most are used to refinance first mortgages. Some people choose the refinance route because a lot of money can be saved in the short term when using a HELOC as a first mortgage substitute.
As for why someone may wish to obtain a HELOC, it is a great tool for paying off debt, making improvements to the home, acquiring a vehicle in a pinch, or paying for a child’s college education. If a person is approved for a $150,000 line of credit and decides to spend $100,000 of it, he or she only pays back the $100,000 plus interest, so borrowers have some control.
Before considering this financial tool, it is good to understand the basics. The first thing to know is that a HELOC has what is called a “draw period.” This is the period the borrower can use the line of credit. After that, there is a repayment period. This is the period the borrower must pay the line of credit back to the lender. The draw period can last up to 10 years, and the borrower pays only the interest. The repayment period can last up to 20 years.
If a HELOC requires the borrower to repay the entire balance at the end of the draw period, the borrower may have no choice but to refinance because they can’t afford to pay a lump sum.
Because the HELOC balance can change daily, depending on how much money is withdrawn, the HELOC’s interest rate is a daily rate instead of a monthly rate.
The Benefits and Drawbacks
As with anything, there are pros and cons to turning to a HELOC. Some of the advantages include:
- An excellent source of funding when in a financial bind or when achieving certain goals, such as home repairs.
- The initial costs are low.
- Although the interest rate can vary from day to day, some HELOCs can be converted into fixed-rate loans, especially for borrowers who must draw large amounts of money at any given time.
The risks of a HELOC include:
- The fluctuating interest rate can create a risk, especially since HELOCs heavily respond to the market. The only exception is a HELOC that has an introductory rate that is guaranteed, but it may be guaranteed for the short term.
- The prime rate affects the HELOC rate. The prime rate can change once in a while, or it can change a lot in a short period of time.
It is ideal to weigh the pros and cons of a HELOC before jumping in and obtaining one. It is good to also assess need versus the amount of money that will eventually have to be repaid. If the pros outweigh the cons, then a HELOC may be the right move. If not, it may be best to save this option for a time when it is absolutely needed.