How Does a HELOC Work?

A home equity line of credit (HELOC) allows you to borrow against your home’s equity to meet any needs you have. Unlike a home equity loan, a HELOC is more like a credit card based on your home’s equity. You can borrow against it from time to time, pay it back, and borrow from it again. 

Even the best credit cards cannot compete with a HELOC's typically low-interest rate for well-qualified candidates. So, how does a HELOC work? How does it fit within your financial objectives?

It’s critical to understand how a HELOC works, what it means to borrow against your home, and how HELOC interest is applicable. If you open one after that, you’ll likely see several significant benefits: low interest rates, a long-term repayment period to keep monthly payments low, and the flexibility to use these funds for anything you need. Even better, as a form of revolving credit, you can keep utilizing those funds whenever necessary.

In this article, we’ll cover all of the details of a HELOC loan and how it may work to fit your needs. Let’s break down the details so you can make the best decision for your financial health.

How a Home Equity Line of Credit (HELOC) Works

A home equity line of credit uses your home's equity, which is the value of your home minus any mortgage balance. To determine your equity, consider the current market value of your home if you sold it today. Then, subtract the balance of your existing mortgage loan. If you own a home worth $250,000 and your current mortgage balance is $150,000, you have as much as $100,000 in equity.

Most mortgage lenders allow you to borrow up to 80% of your home’s equity. In the above example, you could borrow as much as $80,000 from your home for any other need. You’ll still need to qualify for the line of credit and meet all HELOC requirements set by the bank or mortgage lender.

Your home is collateral for this loan, which makes it different from an unsecured personal loan. Unlike traditional credit cards, your home’s value secures the HELOC. If you default on the repayment, the lender could pursue legal action against you, including foreclosing on your home. Therefore, you should only utilize this type of funding if you are confident you can repay it.

Revolving credit is what makes this loan unique

If you were to obtain a home equity loan, it would be like getting a second mortgage on your home. That means you’d receive a lump sum payment for any needs you have. A HELOC is much different. Thanks to its revolving credit nature, it’s more like a credit card. 

You can borrow from a HELOC as often as you need, borrowing just what you need when you need it and paying back only the funds you borrow. 

Your credit limit is set by the amount of equity you have. You cannot borrow more than that, but you don’t have to access all of it right away.

Variable interest rate

Another factor to consider about HELOCs is that they often have variable interest rates. That means that HELOC rates can change over time. If interest rates drop, your rate may drop, saving you money through a lower HELOC payment. At the same time, your interest rate could also increase if market rates increase. 

Lenders select the structure of the credit line. Variable interest rates, which can vary widely from one month to the next, depend on the market changes of a specific index and margin. An index is a specific financial tool used by banks and credit unions to adjust lending projects. Many banks adjust their interest based on that index's upward or falling variable rates.

The Process of Tapping Into Home Equity

How do you get a home equity line of credit? To do so, you will need to apply for credit with a lender offering these loans. Triad Bank offers HELOCs that could fit your specific financial goals.

You'll complete a formal application once you find a lender you wish to work with. The process is often a bit easier than a traditional mortgage loan, but you’ll still need to work through several steps:

• Credit qualifications, including providing access to your credit report
• Income verification 
• Home value determination, which may require a market appraisal to determine equity 

You’ll then get an offer from the lender. You’ll know how much the credit limit could be, the monthly payment amount, and the interest rate. You can then decide to move forward with the loan.

Managing Withdrawals and Repayments Effectively 

Managing your HELOC credit line is just as important as monitoring and paying down your credit card debt. The sooner you pay off any borrowed funds, the lower the overall cost. Your goal should be to use HELOC funds when you need them, pay them off in the shortest amount of time possible to lower costs, and ensure you’re constantly monitoring the HELOC interest rate when making purchases. If the rate jumps, it may not be the best time to use HELOC funds for your specific needs.

There are a few steps to take to maximize use of these funds:

• Choose the right lender. Seek out a HELOC lender with competitive rates and flexible loan terms.
• Maximize your HELOC repayment. If you can pay a bit more each month, do so to reduce your long-term payment.
• Know your credit limit. Avoid trying to use beyond your credit limit. 
• Tap into these funds as an emergency fund. Having an emergency fund could help minimize the need for high-interest credit cards in personal finance.
• Choose a lender with mobile banking so you can continuously and easily monitor your balance and make payments on the go.

Costs and Responsibilities

As a loan, you will pay interest to use a home equity line of credit. Understanding what the costs are and how that could impact your financial well-being is critical.

Types of interest payments involved with a HELOC

As noted, most HELOCs have a variable interest rate that can change monthly. That means your minimum payment can fluctuate over time. 

Factors influencing credit limits and available funds

As with all home loans, your HELOC’s credit limit is based on the available home equity in your property. The more equity you have, the higher the lender may consider increasing your credit limit. However, lenders also look at other factors, such as:

• Your credit score and on-time payment history
• Your income (to determine if you can make monthly payments on time)
• The other revolving credit you have
• Your history of making on-time payments on other home loans

This information helps your lender determine if they will issue a HELOC to you, as well as how much of a credit limit they provide. 

HELOCs have two parts

When considering the costs of HELOCs, you must also consider how the lender structures the loan. Most of these lines of credit have two components:

• The draw period: This is the period of time when you can borrow and pay back funds. This may be available to you, for example, for ten years.
• Repayment period: The length of time after the draw period ends that you have to repay the remaining portion of borrowed funds. This period could range from 10 to 20 years.

Many times, during the draw period, you’re only required to make interest-only payments. Once that period is over, though, you must pay the principal amount (the amount you borrowed) along with the interest that continues to accrue.

Common charges and fees associated with a HELOC

Every lender establishes their fee schedule. Those costs may include:

• Origination fees: A percentage of the credit limit.
• Appraisal fees: Varies depending on your area.
• Legal fees: The hourly rate attorneys charge to prepare the loan.
• Credit reporting: A flat-rate charge to check credit history and credit scores.
• Title insurance costs: Title insurance is not always required but may be necessary. 
• Title search fees: Used to determine your right to borrow against a home. 

In addition to the costs of obtaining a HELOC, you may also pay additional expenses related to using the account. Lenders set the terms for these costs, too. They may include:

• Annual fees: Not always in place.
• Inactivity fees: If you don’t use the account, you may be charged a fee.
• Early termination fees: Sometimes called a prepayment fee, this could be charged to you if you close your loan.

Utilizing HELOC Funds

Why tap into HELOCs in the first place? From a wealth management perspective, note that these loans, secured by the value of your home, are often far less expensive than using a personal loan or credit card for some purposes. They are as easy to use as your debit card – swiping your card allows you to use them easily. Yet, you are using your home’s equity, so you’ll want to carefully decide to use (or not to use) HELOCs. 

Using HELOCs for home improvement

With only interest payments, you could tackle those home improvement projects you’ve put off for so long and not have a large monthly payment. Consider:

• Replacing the roof, siding, or windows to improve energy efficiency
• Adding onto your home to create more living space
• Updating your home with new energy-efficient appliances

Putting your home’s equity back into the property is an excellent way to boost overall value. With that lower interest rate, this method beats most personal loans to do the same work.

Utilizing HELOCs for debt consolidation purposes

Those who have a significant amount of debt on high-interest credit cards can use HELOCs for debt consolidation. This process would allow you to pay off your high-interest-rate cards and then have one single payment to make each month. To determine if this is a good option for you, keep the following in mind:

• Be sure the savings from debt consolidation are lower than the costs of the new loan. For example, estimate 4% to 6% for closing costs on the HELOC. 
• A cash-out refinance like this can help you lower your debt obligations, but you’ll need to be careful not to continue to use those credit cards. If you did, that could double your debt.
• If you know you cannot make payments on your debt, consolidating could be ideal if the interest rate is substantially lower. That could help you improve your credit score over time.

Investing in Education and Major Life Expenses Using a HELOC

Your home’s equity is a valuable asset you can use in tough times or unexpected situations. You can also use these funds to better your life. Consider the following:

• In some cases, HELOCs may be more affordable than student loans or an alternative way to pay for college education if you do not qualify for student loans. 
• Using HELOCs for medical procedures not covered by your insurance company could be one way to speed up access to the care you need.
• In financially difficult times, you may be able to pay off unexpected costs with low-interest HELOCs to get back on track and avoid bankruptcy. 

Risks Involved in Borrowing Against Your Home

Before you decide to utilize a HELOC, consider the realistic risks involved in the process. Just because you meet home equity loan requirements does not outright mean this is the best financial decision for you. Consider the following risk factors.

Non-payment could mean losing your home

If you fail to make payment on time, the lender has the legal right to pursue foreclosure against you. This process allows the lender to force the sale of your home to recoup the investment. If there is any risk that you may not be able to repay this loan, avoid using these tools. 

Payments could change over time

In recent years, the prime rate (a commonly used index rate) has increased significantly from just a few years prior. That means that monthly loan payments with variable interest rates have risen significantly. Carefully consider the advantages of borrowing these funds and the risk that the payment could increase considerably over time should rates continue to rise. 

You are taking on more debt

It’s always wise to limit the amount of debt you take on because of interest. Consider the risk of this added debt burden on your monthly expenses and overall financial health. Will using these funds help you reduce your overall debt expense thanks to lower rates and debt consolidation? It may if you do not use your credit cards to increase your debt even more. 

Your home’s value could change

In some situations, a home’s value could drop. This could be due to changing real estate trends or inflationary pressures. If your home’s value decreases and you now have two loans on it, you may be upside down on the loan. That means you owe more than your home is worth.

Conclusion: How a HELOC Works for You

Being wise about this financial decision is critical. The good news is that many people will find there is true value in a home equity line of credit over other funding for several reasons:

• Interest rates are often competitively lower 
• These loans may be more accessible to those with less-than-perfect credit
• You may be able to use these funds to pull yourself out of debt 
• With sound financial management, you can use HELOCs as an emergency backup fund if you need to take time off work or have an emergency. 

It's critical to make this decision based on financial need. Before committing to these lines of credit, it’s always wise to speak to your wealth management team to discuss their value.

Let Triad Bank offer you the guidance you need. Contact us today to speak to a home loan specialist about the availability of a HELOC that fits your needs.

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