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Overview
A major illness, home improvements or college can quickly drain a family's cash reserves. One source of cash is the equity in your home. A HELOC (home equity line of credit) is an alternative to a traditional home equity loan. There are some advantages and disadvantages to a HELOC loan, but the distinguishing feature is that you borrow only what you need when you need it, instead of borrowing (and paying interest on) a large lump sum all at once.
Identification
A HELOC is actually a revolving credit account similar to a credit card. Typically, a home equity line of credit has much lower interest rates because your home is collateral for the money you borrow. The lender provides you with special checks and/or a credit card to use. Some HELOC accounts limit transactions to a minimum of $500. This reflects the fact that a HELOC is intended for large expenses, not the day-to-day purchases we use regular credit cards for.
Size
How large a HELOC can be depends on the value of your home and on how much equity you have built up. Lenders allow a maximum percentage of the home's value (usually around 75 to 80 percent) and subtract the principal of any outstanding mortgage. For example, if your home is worth $150,000, the lender allows 75 percent and your mortgage balance is $75,000, your HELOC limit will be 75 percent of $150,000 (or $112,500) minus $75,000, or $37,500.
Features
HELOCs are set up for a limited period (such as 10 years), called the draw period. Unless the HELOC is renewable at the end of the draw period, no further charges can be made to the account. Some plans call for the balance owed to be paid off at the end of the draw period. Most HELOC loans have variable rates tied to an index like the prime rate. For example, your interest rate might be "prime plus 2 percent." Federal law requires a cap on variable-interest HELOC rates, but the possibility that your rate (and payments) could go up should be kept in mind. Some HELOCs allow you to convert all or part of the amount owed to a fixed interest rate.
Costs
When you open a HELOC account, you are borrowing against real estate, so you must pay all the costs associated with a regular mortgage. This includes an application fee, a home appraisal and closing costs. You may be charged an upfront fee ("points") as well. These costs can total several hundred dollars, which is one reason why most people use home equity lines of credit only for a specific large expenditure. There may be an annual maintenance fee and transaction fees.
Considerations
The advantage of a HELOC compared with a traditional home equity loan is that you can have the line of credit but borrow only what you need, keeping interest costs to a minimum. Making timely payments is important, not just to keep a good credit rating but also because your home is the security for the borrowed money. A potential disadvantage is that if housing values go down (as they did nationwide in 2007-2008), lenders can "freeze" or reduce the credit line. Finally, if you might sell your home in the near future, think carefully about getting a HELOC, since you may have to pay off the entire balance at the time of sale.
