All About Home Equity Line of Credit or HELOC
If you have seen any television lately, you know that they are also one of the “hot” items lenders offer. Everyone, it seems, wants you to get a HELOC and, by doing so, solve many of your financial problems.
Part of the loan product’s popularity stems from the current housing market. Many homeowners – even those who bought just one or two years ago – find themselves with a substantial amount of equity in their homes. Thanks to the ever-upward spiral of home prices, a homeowner who purchased a $500,000 home last year may find themselves with $40,000 or $50,000 of equity in their home, even if they financed the entire purchase.
But a HELOC isn’t for everybody. Many home buyers consider a HELOC without fully understanding what it is. “There are a few differences between a HELOC and a second mortgage,” explains Pia Elvina of Associated Mortgage Group in Fremont, California.
Elvina says two of the differences are a HELOC’s adjustable rate and its draw period. “You can get a second mortgage that has a fixed rate, but HELOCs have an adjustable interest rate,” she explains. “Also, a HELOC is similar to a credit card, in that once you pay off the balance, you can use the money again for something else.”
A HELOC is also similar to a credit card in that it allows a borrower to pay either a minimum monthly amount or any amount higher. Unlike a credit card, however, Elvina says that the HELOC doesn’t include the financing charges credit cards almost always incur.
In general, second mortgages that aren’t HELOCs have a lump sum and fixed time period. Just like your original mortgage, you borrow a set amount and pay it off each month. When you have completely paid off the second mortgage, you can’t usually reuse the money. You would usually need to apply for another second mortgage. HELOCs, on the other hand, allow you to use some or all of the amount borrowed, and to continue reusing it during what is known as the “draw period”.
Elvina says the draw period is defined by the specific loan – and she encourages all homebuyers to scrutinize the details of their particular loan offer. “Some lenders have a draw period of about 10 years, while others have up to 5 years,” she explains.
If a borrower still has a balance at the end of the draw period, the remaining amount is treated more like a standard mortgage. “Any balance at the end of the draw period is amortized. You pay principal and interest each month, for a specific time period,” Elvina notes.
Elvina says some homebuyers may be better suited to using a HELOC than others, although each case is different. “Someone who would use it well is someone who could pay the loan a bit faster than normal, so they can reuse it during the draw period,” she explains.
In fact, Elvina cautions borrowers to consider whether they can afford the entire loan package, and not focus solely on the minimum monthly payment required. “To qualify, lenders look at the minimal interest payment only,” she explains. That means a homeowner may qualify for a larger loan because the monthly payment covers interest on the money borrowed only.
However, at the end of the draw period, when the HELOC’s balance is amortized, payments will jump to cover the entire cost of the loan, and include both principal and interest.
For example, a homeowner who takes out a HELOC may have to make minimum monthly payments, of interest only, of $500 per month during the draw period. If, however, there is an unpaid balance at the end of the draw period, those payments could increase substantially, because the lender now expects both interest and principal to be paid. “It wouldn’t be a good idea for someone maxing out their current liability,” she explains.
The HELOC’s flexibility, however, does make it an attractive financing option for some homeowners. “Someone who is self-employed could use the flexibility,” she says. “When they have a good month, they can pay more than the minimum, interest-only payment. When they have a not-so-good month, they can just pay the interest.”
However, because the rates fluctuate, buyers should be aware that even their minimum payment might be considerably higher if interest rates rise. “It does take some discipline, and the interest rates do fluctuate. And interest-rate wise, the trend is generally upward.”
Because each loan offered, and each person’s financial status, are unique, homeowners should discuss their particular situation with a lender or mortgage broker.
