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Home Equity Lines of Credit

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For many homeowners looking to free up money for a home renovation, a vacation, a child's tuition, or a business investment, a home equity line of credit can be a viable option. Borrowing against the equity of your home can be an effective way to make the most of the money you've already invested in your property. You will often see this type of loan referred to as a HELOC.

What is a Home Equity Line of Credit?

A home equity line of credit is a loan that uses the equity you already have in your home as collateral. The loan is secured by a lien, typically a second position lien, on your home. The second lien position (also called a second mortgage) is most common because most borrowers will already have an existing first mortgage. First or third lien position home equity loans are possible as well, but occur with less frequency.

Home equity loans can be either "closed-end" or "open-end". The home equity line of credit is an open-end loan, while a home equity installment loan is a closed-end loan. An open-ended loan has characteristics similar to that of a credit card. A borrower has a predetermined credit limit and can withdraw funds at their own discretion using HELOC checks or a HELOC withdrawal card. A monthly payment is only required if there is an existing balance, in which case the borrower has the option to pay it off in full, or make regular monthly payments according to the loan terms. The borrower may use the funds for any purpose they choose.

Most lenders are willing to extend a line of credit worth as much as 80-90% of a home's value, minus any outstanding mortgage amounts, to qualified consumers. This calculation is called the loan to value ratio (LTV). Let's look at an example. Your home is worth $250,000 and you still owe $100,000 on a first mortgage. If a lender is willing to lend at 90% LTV, you would multiply the value of the home ($250,000) by 90% LTV (.9), which equals $225,000. Subtract the first mortgage balance ($100,000) from the maximum loan amount ($225,000), and you get $125,000. This is the maximum loan amount of the line of credit in this scenario. Before the credit market problems that roiled the mortgage industry in 2008, it was not uncommon to see financial institutions lend up to or even exceeding 125% LTV. Those days are largely a thing of the past. In today's market, lenders have become much more conservative in their underwriting guidelines.

Who Uses Home Equity Lines of Credit?

Homeowners use equity lines of credit to fund virtually any expense. Homeowners may request this type of loan in order to:

  • Fund home renovations, such as a bathroom or kitchen remodel
  • Pay tuition for a child's education
  • Pay off other, higher-interest debts
  • Purchase a new car
  • Invest in a new business opportunity
  • Support the family during a period of unemployment
  • Purchase a second home or rental property
  • Have funds available for any unexpected emergencies

It's possible to secure a loan with as little as 10-20% of your home's value in equity, making a home equity line of credit an attractive option under many circumstances.

HELOC Advantages and Disadvantages

There are pros and cons to obtaining home equity lines of credit, and times when this type of loan is more suitable than others. The following guidelines may provide you with a better sense of whether a home equity line of credit is the right choice for your situation.

A home equity line of credit is often preferable to a standard loan because it can be drawn on as needed and will continue to be accessible even after any borrowed money has been paid back, much like a credit card. It's also possible to get lower interest rates on a home equity line of credit than on an unsecured loan, since your home serves as collateral on the loan. Additionally, because the loan is secured by the equity in your home, interest paid is often tax deductible.

Home equity lines of credit usually offer a variable rate; this can be risky for some borrowers, as the rate is likely to change substantially - especially if the loan terms span a prolonged period, such as 5 or 25 years. Another factor to consider is that any home equity loan would have to be paid off in the event you are going to sell your home.

Finally, anyone considering a home equity line of credit should keep in mind that withdrawing a large amount at once can have an impact on your credit rating.

Home equity lines of credit aren't for everyone, but they do offer an open-ended way to borrow money at a low interest rate and pay it back when your financial situation improves. This type of loan is perfect for someone who is conscientious and able to plan ahead to repay the loan, but it may be problematic for procrastinators or those who prefer to avoid the risk of a variable rate loan.