What is a Home Equity Line of Credit (HELOC)?

A Home Equity Line of Credit, or HELOC, is a type of revolving credit that is secured by your home equity. It functions much like a credit card, allowing you to borrow money as needed up to a pre-approved limit, repay it, and then borrow it again.

How Does a HELOC Work?

When you're approved for a HELOC, a lender gives you a credit limit based on your home's value, your outstanding mortgage balance, and your credit score. This is typically done as a percentage of your home's appraised value minus the amount you owe on it (your Combined Loan-to-Value or CLTV).

HELOCs have two main phases:

• The Draw Period: This is a fixed period, often 10 years, during which you can withdraw funds up to your credit limit. During this time, you are typically only required to make interest payments on the amount you've borrowed.
• The Repayment Period: After the draw period ends, you can no longer borrow money. You must begin repaying both the principal and any remaining interest. This period can last from 10 to 20 years.

Pros and Cons of a HELOC

Advantages

• Flexibility: You only borrow what you need, when you need it. This makes it ideal for ongoing projects or unexpected expenses.
• Lower Interest Rates: Because a HELOC is secured by your home, its interest rate is often lower than that of unsecured debt like credit cards or personal loans.
• Interest-Only Payments: The ability to make interest-only payments during the draw period can keep your initial monthly payments low.
• Potential Tax Deductions: The interest paid on a HELOC may be tax-deductible if the funds are used to "buy, build, or substantially improve" the home that secures the loan. (Consult a tax advisor).

Disadvantages

• Variable Interest Rates: Most HELOCs have variable rates, meaning your monthly payment could increase if interest rates rise.
• Your Home is Collateral: This is the biggest risk. If you are unable to repay the loan, the lender could foreclose on your home.
• Risk of Overspending: The easy access to cash can be tempting, potentially leading to unnecessary debt.
• Fees: HELOCs can come with various fees, including annual fees, transaction fees, and closing costs.

HELOC vs. Home Equity Loan

A HELOC is often confused with a home equity loan. The key difference is how you receive and repay the funds. A home equity loan provides a lump sum of cash upfront, which you repay in fixed monthly installments over a set term. A HELOC, as we've discussed, is a revolving line of credit.