Home Equity Line of Credit - A Special Mortgage
Shopping for a mortgage and came across the term “HELOC” or Home Equity Line of Credit? A HELOC is a special mortgage product and combines different elements of traditional mortgage loans with revolving credit (like your credit card).
Because you offer the lender the added security of your home you receive better terms than an unsecured loan or line of credit, such as your credit card, including:
- Lower interest rates
- Long term
However, to make things more complicated, Home Equity Lines of Credit are offered with different types of payment plans. HELOCs are not for everyone. Before you take out your home equity line of credit, learn about:
- Reasons to Take out a HELOC
- The components of HELOC
- Qualifying for a HELOC
- Dangers of a HELOC
Reasons to Take out a Home Equity Line of Credit
A Home Equity Line of Credit is a combination of a mortgage loan and a credit card (or revolving line of credit. Your equity in your home (the value less than your previous loans) can be a source of funds for all kinds of reasons
- Home Improvements and Remodeling
- Paying for education
- Debt Consolidation
- Making Large purchases
The two main attractions of a home equity line of credit are:
- Flexibility in withdrawing money: If you don’t need all the money at once, then with a HELOC you can withdraw funds, as you need them. You don’t have to make payments on money that you don’t need.
- Flexibility in paying the loan back: Although there are different types of payment plans, in general a HELOC offers flexibility in paying back the loan, with a possibility of paying back interest only for an extended period. You can also pay back on then draw money, based on the level of credit you received (like your credit card).
The Components of a Home Equity Line of Credit
A HELOC, like any type of loan or credit arrangement comes with terms that set the:
- Amount you Borrow or Credit Limit
- Time frame and Payments
- Length of HELOC
- Type of Interest Rate Interest
Amount to Borrow or Credit Limit:
A HELOC offers you a maximum amount of money you can borrow, but allows you to control the balance by letting you take out and pay back your loan. The total amount you can borrow depends on your LTV (Loan to Value ratio). According to the Bank of America Web site, they offer (from July 2012), home equity lines of credit up to a CLTV (combined loan to value ratio) of 85 %,( based on their underwriting requirements and subject to their pricing schedules.
Here is an example of the maximum line of credit:
- CLTV of 70%: $ 210,000
- Current Debt: $150,000
- Maximum HELOC: $60,000
That means that you can withdraw funds up to $60,000 during the life of your line of credit. You can for example take out $20,000, pay back $ 15,000 and then take out $50,000. You cannot go above the $60,000 limit.
Period and Payments:
Mortgage loans come in different forms, such as:
- 10-yr mortgage, 15-year mortgage, 20-year mortgage, 30-year mortgage
- FRM, ARM
- Principal and Interest payments, Interest only payments, balloon payments
The same is true for HELOCs, but even more complicated, because of the added flexibility. Always make sure that the lender explains to you the mechanics of your payment schedule. What are the minimum payments? When do you have to make payments? How often does your interest rate change? Can you lock into fixed rates?
Here is some basic information, but remember, the terms change from lender to lender and your particular situation.
In general, you have two periods, a draw period and a repayment period, although some lines of credit are for a limited period with a balloon payment at the end of the initial period.
Draw Period: During the draw period you have a draw period in which you can take out money up to your credit limit, make principal repayments and then make more withdrawal. (Check with the lender if there are minimum withdrawals). The draw period varies but is typically up to a maximum period of 10 years.
Principal Repayment Period: Principal repayment is usually up to 20 years. There are a number of repayment plans, as explained below.
Variable Rates: The traditional line of credit comes with a variable interest rate. That means your interest rate will be an index plus a margin. One common index is the prime rate. Wells Fargo, according to their Web site (July 2012), writes: "Wells Fargo Home Equity Account The Annual Percentage Rate (APR) is variable and based on the highest Prime Rate published each day in The Wall Street Journal Money Rates Table (the "Index"), plus a margin. The Index as of the last change date of December 17, 2008 is 3.25%".
Fixed Rates: Most lenders offer a fixed rate option. Chase for example offers (according to their Web site on July 2012) a “Chase Fixed-Rate Lock” option whereby you can take all or part of your line of credit and change it into a fixed rate principal and interest payment loan based on the current home equity loan rates. As you pay down the loan you will free up your available credit line. This is only available during the draw down period and subject to all relevant Chase terms. Wells Fargo allows you to take a "fixed-rate advanc" whereby you have a fixed interest rate from day one and can pay interest only payments for up to five years (higher interest rate for a five year vs. a one-year period) and then principal payments up to a total of 5-20 years, subject to additional Wells Fargo Terms.
Your repayment terms will vary depending on the type of interest rate you choose. In general, you can choose between an initial period of interest only payments (up to 10 years) and then a principal and interest period of up to an additional 15 years (totaling 25 years maximum). There are some instances that the line of credit will be offered for a limited period, subject to a renewal clause. Always make sure that you fully understand all of the terms of your loan or line of credit, including all the fine print. If you are unsure, then ask your loan officer again.
Most lenders do not take application fees for a HELOC and some waive upfront fees. However, shop around and make sure that you check for these types of fees:
- Origination fees
- Annual Fees
- Prepayment Fees (If you close the line before a certain period, often 3 years)
- Transaction fees for using the line of credit.
- 3rd party fees including Attorney Fees, appraisal fees, title insurance
- Escrow fees including: property insurance, title insurance, property tax
Qualifying for a Home Equity Line of Credit:
Just like any mortgage loan, lenders have strict underwriting criteria based on two major areas:
- The property: Most lenders only offer a home equity line of credit against a primary residency. LTV values range, but a CLTV (Combined Loan to Value Ratio, which is your existing mortgages plus your new HELOC) usually cannot exceed 80%. Your interest rates will vary depending on your CLTV.
- Your credit worthiness: Lenders look for a clean credit report (no late payments, collection accounts, or judgments). In addition, your DTI (Debt to Income ratio) should not exceed 45%). That means your total monthly mortgage (principal, interest, property tax, property insurance and HOA fees) plus your total other debt (student loans, auto loans, credit card payments – minimum payments,) should not exceed 45% of your total gross income.
Pros and Cons of a Home Equity Line of Credit
Pros: As earlier stated, the main benefit of a HELOC is its flexibility. You can guarantee yourself a certain amount of money without drawing it all at once. You can also choose among a variety of payment plans, including interest only period. You can also pay down the line of credit and then take out money again. Since you are pledging your house as collateral, you get lower interest rates than unsecured loans, such as credit cards.
Cons: However, HELOCs are loans that are more complicated and carry risks. If mismanaged, your house will be at risk of foreclosure. Here are some of the dangers of a home equity line of credit:
- Change in Payment due to Variable Interest Rate and Payment Structure:
Your payments will change over the course of the loan, based on the fluctuation of the index (usually the Prime Rate). If you choose an interest only payment to begin with, then your payments will increase once you get to the second period of principal and interest payments. You can eliminate some of those risks by locking into a fixed rate payment schedule, whereby your payments are set for the entire period of the loan.
- Freezing/closing off line:
Lenders will usually include clauses in the loan contract, which allow them to freeze or close off your line of credit. Make sure that you understand those clauses.
According to the CFPB (Consumer Financial Protection Board) Web site, a lender can freeze your account (limiting access to additional funds) due a significant decrease in the value of the house or can include changes in your marital status, house value, or a change in your financial status and the lender does not believe you can make the payments.
The CFPB also points out that there are in general a change in marital status is not a sufficient reason to terminate an account, but if one party requests to close the account, or if one party was qualified based on the spouses’ income and there is a divorce, then they the lender can request for the borrower to reapply.
If you have equity in your house and need funds to renovate your home, consolidate debts, pay for education (not all lenders offer that option), or pay for large expenses, then a home equity line of credit may fit your needs.
Since a HELOC is a complicated type of mortgage loan with more complicated payment and interest rate structures, make sure that you understand your obligations and plan for all the projected payments.