How Does a HELOC Mortgage Loan Work?

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How Does a HELOC Mortgage Loan Work?
Article Excerpt

Learn what a HELOC loan is, how it works, whether you should get a HELOC just in case, some possible disadvantages, and how to get started on applying.

Homeowners have several ways to access the equity in their home in order to make renovations, pay expenses, or pay off other higher-interest debt. One of your options is a home equity line of credit (HELOC). Where a home equity loan gives you a lump sum of cash at closing, a HELOC allows you to borrow against your equity if and when you need money.

What is a HELOC mortgage loan?

A HELOC is a line of credit where the borrowing limit is based on the borrower’s equity in their home.

A “line of credit” is an arrangement between an individual or business (the “borrower”) and a bank or other financial institution (the “lender”). The lender makes funds available to the borrower up to a pre-set borrowing limit. The interest rate can be fixed or adjustable.

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Suppose a lender extends a $100,000 line of credit to a borrower. If the borrower takes out $50,000, they will have $50,000 of available credit. A line of credit is similar to many credit cards in this sense.

“Home equity” is the portion of the value of a home that is not secured by a mortgage. If a person owns a home valued at $500,000, and has a mortgage with a balance of $200,000, their equity is $300,000.

A HELOC, therefore, is a line of credit where the borrowing limit is based on the borrower’s equity in their home. Lenders will not allow someone to borrow against all of their equity. Most lenders set the borrowing limit at 85% of the borrower’s total equity. The homeowner described above, for example, might be able to get a HELOC with a borrowing limit of $255,000, which is 85% of $300,000.

How does a HELOC mortgage loan work?

Most HELOCs have two phases. Once you have qualified for a HELOC and signed the lender’s paperwork, you will enter the first phase, known as the “draw period.” This is the period of time when you can borrow money from the line of credit. The length of the draw period may vary. Ten years is a common amount of time.

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HELOC draw period

During the draw period, you can borrow money from the line of credit. The lender may provide you with a checkbook or a credit card. You also might be able to transfer funds into your bank account.

You will have to make monthly payments to the lender. The minimum payment only covers interest, but you have the option of paying the principal down. If you only pay interest, your monthly payment will go up the more you borrow.

HELOC repayment period

Once the draw period ends, the “repayment period” begins. You cannot draw money from the line of credit anymore, and the monthly payments now include principal and interest. If you only paid interest during the draw period, you will probably see a significant increase in the amount you must pay each month. A repayment period commonly lasts twenty years.

You might have to make a balloon payment at the end of the repayment period to cover any remaining principal. It is possible, however, to negotiate a refinance option if you cannot afford the balloon payment.

If your HELOC has an adjustable interest rate, your monthly payment could change during both the draw period and the repayment period.

Should you get a HELOC just in case?

It might seem like a good idea to get a HELOC just in case you ever need it. This is not like applying for a credit card though. It can be a time-consuming process. It could cost you a few hundred dollars and might include a title search, appraisal, application fee, points, and attorney’s fees. An experienced mortgage lender will make the process easier.

The lender will run a credit check when reviewing your application. Even if you never draw any money, the HELOC will show up in your credit history. This isn’t a big drawback though; credit score dips from mortgage applications normally recover quickly. The dip won’t be drastic, either - perhaps 15 points or less.

Disadvantages of a home equity line of credit

  1. It may increase your risk of foreclosure. If your HELOC has an adjustable rate and interest rates rise, this can put you in a difficult financial position.

  2. A HELOC reduces the total amount of equity in your home. So if you sell your home shortly after getting the HELOC, you’ll walk away with less money in your pocket.

  3. There’s also the risk of you overspending. Anyone given access to tens or hundreds of thousands of dollars could get carried away. HELOCs make it easier for borrowers to get carried away by not requiring repayment of principal right away. This is a more personal consideration that may vary from borrower-to-borrower.

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