How does a HELOC work?

A HELOC is an abbreviation for Home Equity Line of Credit.  The difference between a loan and a line of credit is the way they are structured.  A loan is typically paid back in a series of installments and once the loan is paid back the account is closed.  On a Line of Credit, the account is a revolving account where you can utilize the open line of credit even once the balance is paid in full or partially paid down.  (Think of a credit card)

This flexibility can allow you to have an open line of credit larger than you need at the moment without having to pay interest on the unused balance.  Say you are doing home improvements that you are anticipating costing $40,000 but you want to have a buffer so you open a line of credit for $50,000 just to be safe.  If you only end up using the $40,000 you don't pay interest on the remaining $10,000 of available balance.  This flexibility gives consumers more opportunity to access their homes equity while only paying interest on the balance they use.  If there is no balance, there is no payment or interest.

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Most HELOC's are structured with a draw period followed by a repayment period.  Typically the first 10 years is the draw period where you can use the revolving line of credit, then after the 10 year draw period is over it converts to a fully amortized installment loan for the next 20 years.  Some programs may have a 15 year draw and a 15 year repayment period, but this is a little less common.

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HELOC's come in a few forms.  Traditionally HELOCs are adjustable rate mortgages (ARM's) that are tied to the Wall Street Journal (WSJ) Prime Rate.  There is a margin above the prime rate that is dependent on risk factors such as FICO scores and remaining equity. So an example is that you could have a margin of 1.5% and if the prime rate at the time is 5.5% your interest rate could be 7.00% at that moment until the prime rate changes.  There are also Fixed Rate options where your rate is fixed for the life of the mortgage.  These fixed rate options typically come at a higher interest rate.

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HELOC's have many use cases that make them such a popular option for many consumers.  The flexibility also comes with some risks to be aware of:

- Interest Only Payments during the Draw Period

Now not all HELOC's are structured this way and also this is not always a bad thing, but if you only intend to make the minimum payment during the draw period you will have no payments going towards principal.  My recommendation is to come up with a game plan on how you are going to make additional payments towards principal during this period (whether on monthly payments or large lump sum payments).

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- Adjustable Rate HELOC's

Adjustable Rate HELOC's are more common due to the lower initial interest rates and wider availability, but have a potential long term risk of increasing over time, but on the flip side the rate can also decrease as the index (WSJ Prime Rate typically) goes down.

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If you would like to discuss more about HELOC's please call or email.