How does a home equity line of credit work?

A home equity line of credit (HELOC) is a type of loan that allows you to borrow against the equity in your home. Equity is the amount of your home’s total value that you own outright, and it can increase as you pay your mortgage or as your home’s value appreciates.

With a HELOC, you can borrow up to your approved amount as needed, and you only pay interest on the amount you borrow. The credit limit is typically determined by taking a percentage of your home’s appraised value and subtracting any outstanding mortgage balance.

How does a home equity line of credit work, though? HELOCs can be a flexible and affordable way to access the equity in your home, but they do come with some risks. Before taking out a HELOC, it’s important to understand how they work and what the potential pitfalls are.

How does a home equity line of credit work?

A HELOC works like a credit card, as you’re given a line of credit up to a certain percentage of your home’s equity. The percentage varies from lender to lender, though most limit borrowing up to 80 percent of the total equity.

For example, let’s suppose your home is valued at $200,000 and you have an outstanding mortgage balance of $100,000. This means that you have $100,000 in equity. If your HELOC limit is 80 percent, you would have a credit limit of $80,000 ($100,000 x 0.80 = $80,000). Visit Solarity Credit Union’s HELOC calculator and crunch some numbers to see how much you can borrow.

Once you’re approved for a HELOC, you can borrow against it as needed up to your credit limit. You can use the funds for anything, such as home improvements, debt consolidation or other major expenses.

As you repay the borrowed funds, your credit limit is replenished, so you can borrow against it again. HELOCs typically have a draw period, which is the time when you can borrow against the line of credit, and a repayment period, during which you must repay what you’ve borrowed plus interest.

Draw periods are typically 5 to 10 years, and repayment periods are usually 10 to 20 years. This means that after the draw period ends, you’ll have to start repaying the principal plus interest on any outstanding balance.

HELOCs tend to have variable interest rates, which means your monthly payments might change depending on market conditions. Many HELOCs also have a rate cap, which limits how much your interest rate can increase over the life of the loan.

It’s important to note that with a HELOC, you’re not actually required to borrow the full amount of your credit limit. You can simply use it as a source of funds if and when you need them.

What are the benefits of a HELOC?

There are several potential benefits of taking out a HELOC, including:

• Access to funds. A HELOC can give you quick and easy access to cash when you need it.

• Flexibility. You can use a HELOC for just about anything, from consolidating debt to paying for unexpected expenses.

• Affordability. HELOCs typically have lower interest rates than credit cards or personal loans, making them a more affordable option.

• Potential tax benefits. Interest paid on a HELOC may be tax-deductible. However, this isn’t the case if you use the funds for something other than home improvements.

What are the risks of a HELOC?

There are also some risks that you should educate yourself about before taking out a HELOC, including:

• Variable interest rates. As mentioned, HELOCs typically have variable interest rates, which means your monthly payments could fluctuate.

• Interest-only payments. During the draw period, you’ll only be required to make interest payments on your outstanding balance. This means that if you don’t pay back the principal during this time, you’ll end up paying more in interest over the lifetime of your loan.

• Limited time to repay. Once the draw period ends, you’ll have to start repaying the principal plus interest on any outstanding balance. This means you could end up with a larger monthly payment than you’re expecting.

• Risk of foreclosure. If you can’t afford your monthly payments, you may risk foreclosure on your home.

Before taking out a HELOC, it’s important to understand how they work and weigh the risks and benefits to see if it’s the right for you.

Other ways to access home equity

In addition to a HELOC, there are other ways you can access your home equity, including:

• Cash-out refinance. With a cash-out refinance, you take out a new mortgage loan for more than you owe on your existing loan and receive the difference in cash. This can be used for anything you want, but it typically results in a higher interest rate and monthly payment than a HELOC.

• Home equity loan. A home equity loan is a lump-sum loan with a fixed interest rate and repayment period. You borrow a fixed amount of money and make fixed monthly payments over the life of the loan.

• Bridge loan. A bridge loan is a short-term loan that provides funding for a specific purpose, such as buying a new home before selling your current home. Bridge loans typically have high interest rates and must be repaid within a year or two.

Choosing the right option for you depends on your specific needs and financial situation. Be sure to compare the interest rates, fees and terms of each before making a decision.

Bottom line

A home equity line of credit can be a helpful tool in many situations. Just be sure to understand how they work and the risks involved before signing on the dotted line. Other options, such as home equity loans or cash-out refinancing, may be better suited for your needs. Whichever route you opt for, be sure that you compare interest rates, fees and terms to get the best deal.