How do home equity lines of credit work?

Home equity lines of credit (HELOCs) are secured loans backed by the equity in your home.

This type of loan allows you to access a credit line to draw money from over a set period vs. being given a lump sum of money. In this way, these loans are similar to how credit cards work, and borrowers are typically only charged interest on the amount of funds they use. 

The money can be used for many things and is not tied to a specific purpose. From remodelling your home, starting up a new business, helping your child buy their first home, to assisting them in paying for college, a HELOC is ideal for any situation, depending on your need. They are a smart way of consolidating debt and paying off other mounting debts. 

Before signing up for any loans or financial solutions, it’s essential to understand the process and how it may or may not impact your life. In this blog, we’ll dive into everything you need to know about HELOCs, preparing you to make the best choice for your financial needs.

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How do HELOCs work?

A HELOC is similar to a second mortgage or home equity loan but differs in that you only draw a portion of the funds. In this way, the HELOC is similar to a credit card. You will not receive a lump sum of money, and you only pay interest on the amount you pull out. 

HELOC funds are available on demand but cannot go over the agreed-upon amount.

For example, if you have signed a HELOC for $250,000, you can borrow up to that amount as needed. You will be charged an interest rate based on the amount you use of that $250,000. If you never exceed more than $50,000 of the line of credit, you only pay interest on the $50K used, not the initial $250,000. 

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HELOCs vs. mortgages

It’s easy to confuse HELOCs with mortgage loans, but they vary slightly. HELOCs are available for homeowners to use as needed, not for one specific purpose. Mortgages are used solely to purchase a home. With a mortgage loan, the money you qualify for will never be in your possession, and it is used to pay the seller of the home. These loans also come with monthly payments and are set for 15 to 30 years.

In comparison, HELOCs are lines of credit that use your home as collateral. These funds are secured against your dwelling, but you don’t necessarily need to use them to pay for a home or real estate-based purchases, and the funds are yours to use as you please. There are many forms of HELOCs, including optional monthly payments with lower interest rates and others requiring you to give up a portion of your equity. 

Since you use your dwelling as collateral, the interest rates available for HELOCs tend to be lower than other loans. It is a more attractive option versus opening up an unsecured credit card or taking out a reverse mortgage. 
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Need more info on the differences between a reverse mortgage and a home equity loan? Dive in here.

What’s the catch? 

HELOCs are secured against your home. Meaning that if you fail to pay back your loan, the lender can foreclose on your home.

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What is a HELOC used for? 

HELOCs are loans with no specified use. You can use the money for anything you need, but it is prudent to spend it thoughtfully as you need to pay it back. Don’t forget that your home is too important to borrow against for frivolous reasons. Before committing to a HELOC, have a clear understanding of how you will spend it and pay it back. 

Some common ways that HELOCs can be used include home improvements and renovations, paying off existing loans or college for a loved one, and even starting a business.

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How do you apply for a HELOC?

Getting a home equity line of credit is similar to applying for a primary mortgage. Lenders consider a few things in the process, including how much your home is worth, according to the amount of home equity you have, your current income, and existing debts, along with your FICO credit score.

The lender can identify how much of a credit risk you may or may not be and understand what your collateral is worth by collecting this information. They will also require you to provide proof of employment and other income and have a strong credit history. Once they have this information, the lender will determine how large a credit line you can manage. 

An example of a HELOC amount would be a $400,000 home equity line of credit on a 5-year term. A bank may offer you a variable rate that could rise due to rate hikes, while a Fraction Mortgage rate is based on the appreciation of your home. Learn more here. 
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HELOCs and interest rates

HELOC rates vary lender to lender.

Banks rely on many indexes and margins to determine these variable rates, including the US Prime Rate. Most banks in the US use the US Prime Rate as an index and add a fixed percentage (otherwise known as a margin) to the index rate to determine the interest rate you pay. This rate is subject to change often. 

Interest is typically paid based on the balance of the first 10-year draw period of a 30 year HELOC. Following that, you will have to pay both the interest and principal for the remaining 20 years.

Borrowers can sometimes lock in an interest rate. By doing this, you can set your variable interest rate at a certain percentage until the borrower changes it. Some fees come with locking in your interest rate, and locked interest rates are typically higher than variable rates on the same loans.
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How much can I borrow with a HELOC?

Lenders will collect necessary equity and income information from you and input them into formulas that help them decide. The criteria for approval vary lender by lender, but it is prudent to do your research beforehand and review several banks and lenders during your process. 

The amount a lender may offer you for your HELOC is dependent on the amount of equity you have in your home and your ability to repay. Before the 2008 financial crisis, there were looser regulations, and homeowners could borrow up to 100% of their home equity. 

This is no longer the case. Currently, you are only allowed to borrow up to 80% of the equity in your home. There are new, stringent guidelines that come with borrowing that are in place to protect you and your family from any potential downfalls. 
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Will a HELOC impact my credit score?

On most credit reports in the US, HELOCs are classified as a revolving type of credit, which is the same designation given to credit cards. Despite this similarity, HELOCs and credit cards do not impact credit scores in the same way. 

To understand how a home equity line of credit impacts your credit, you have to dig into the concept of “credit utilization ratio.” This ratio accounts for 30% of an individual’s credit score, and credit bureaus suggest keeping your overall revolving balance under 30% of your overall credit limit. In the case of a HELOC, this would undoubtedly be a difficult thing to do as borrowers tend to use a majority of their balance immediately for large purchases or expenses. 

The amount drawn for HELOCs would easily not follow the 30% credit utilization ratio, and your credit score would be impacted. Understanding this, credit bureaus do not factor HELOCs over $35k in credit utilization. But this is not a hard and fast rule as each credit bureau has its own rules and criteria. 

There is no official cutoff amount, and accepted wisdom states that any HELOC over $35k will not affect your credit utilization ratio. Although, anything under that number may count.  

In this case, if your HELOC is for a smaller amount, make sure to keep it below 30% of your credit limit. 

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How do I pay a HELOC back?

Once you’ve reached the end of the term, you have options on how to pay back the loan. HELOC borrowing and payment schedules vary depending on the borrower, but typically you can expect a 30-year repayment period. Know before you sign: frequently, lenders require you to pay the entire loan and accrued interest immediately at the end of the draw period. Others may extend repayment over many years.

HELOCs aren’t all built the same, and many conditions and considerations are dependent on the provider you choose. For example, the Fraction Mortgage is an open line of credit, but has the unique advantage of optional monthly payments.* You don't have to pay back any equity for up to 5 years.

Some Home equity lines of credit may allow you to use your line of credit over many years without repaying the principal. Meaning that you could borrow up to the approved credit amount within the fixed draw period (5 or 10 years), making interest payments on the balance. Once that loan line limit is hit, you’re required to pay the interest and principal over the remaining years. 

To keep your line of credit open and avoid triggering a repayment, you can choose to open a new HELOC at the end of your draw period. One reason that borrowers may choose to refinance their HELOC in this way is to continue borrowing without having to take on a substantial increase in the minimum monthly payment amount. 

As a borrower, there are various considerations you must account for before applying. Understand that you may be paying back the loan for a long time and the interest that comes with it. There are also one-time fees that come with lender appraisals and closing costs, and if you choose to pay your loan back early, you may be subject to prepayment penalties. 
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What happens to my HELOC when I sell my home?

If you choose to sell your home before your loan term has been completed, you must immediately repay what you owe on the HELOC balance.

If your home sale price exceeds the amount owed on your line of credit or any outstanding mortgages, you will easily be able to pay your HELOC and accrued interest off. If your home is “underwater” or worth less than what you owe to lenders, then you have to make up the difference or negotiate a deal (a short sale) with your lender.

One unique difference of a HELOC compared to other loans is that these lines of credit are tax-deductible. 
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Should I get a HELOC? 

HELOCs are an excellent solution for many reasons and can be more attractive than credit cards, which come with high rates and late fees. These loans can be a good option for those who have rising debts, consolidate debts or have unexpected expenses come up.

Before using a HELOC to pay off debts, work with a debt counselor or financial planner to help you create a plan for managing your finances and getting out of insolvency. As with any significant financial decision, take time to understand your options and ask questions. 

Fairer and more socially conscious financing options are available that won’t put your hard-earned equity at risk. Fraction can potentially help you reduce your debt to income ratio (the amount you spend monthly paying back debt) by up to 50% on average simply by eliminating monthly payments.*

Contact us today to learn how you can apply for our Fraction Mortgage.