A HELOC account, or Home Equity Line of Credit account, is where your money from your second mortgage sits. The HELOC is unique because it does not give you a lump sum of money. For example, let’s say you took out $50,000 as a HELOC. You do not receive that $50,000 at one time. It sits in an account that you can withdraw from. Think of it like a checking account with the rights of a credit card. You can write a check or use a designated ATM card to retrieve the funds, like a checking account. But, you can reuse the funds as you can on a credit card. Once you use funds and pay the back, they are available again. This goes on until your draw period ends.
Paying the Funds Back
Unlike a standard second mortgage, you only have to pay interest on the funds you borrow. This is the case throughout the draw period. Typically, home equity loans allow you to draw funds for the first 10 years. At the end of those 10 years, you enter the repayment period. At this point, the account closes and you cannot draw funds anymore. The payments you make during the repayment period cover the principal and interest amortized over the rest of the term. This usually means for the next 20 years.
The Interest Rate
The interest rate on a HELOC account also works differently than a standard loan. More often than not, it is a variable interest rate. There are several indexes the rate may coincide with and each loan has its own margin. The lender will tell you the index for your rate as well as the specific margin. The most common index used is the prime rate. This rate can change from month to month. What does not change is your index, though. For example, if your margin is 2%, it remains 2% for the entire draw period. The lender then adds 2% to the prime rate each month to calculate your interest rate.
You should always know the caps on your interest rate. Every lender sets a cap before you close on the loan. This helps limit the amount your interest rate changes. There is a periodic and lifetime cap. The periodic cap limits how much the rate can change each month. For example, if the cap is 1%, your rate cannot increase or decrease more than 1% any given month. The lifetime cap determines how much the interest rate can increase or decrease over the life of the loan. This cap is usually much higher than the periodic cap.
How to Use a HELOC Account
People use a HELOC account many different ways. The most common is for home improvements. It just makes sense to tap into the equity of your home in order to improve it. You see an instant return on your investment this way. Borrowers who use the funds to fix up their home draw the funds out as they need them. Whether they do the work themselves and need the funds to purchase the supplies or they hire contractors, the money is there to use as they need.
Other uses for HELOC funds include:
- Emergency fund for car, medical, or house emergencies
- College tuition
- Dream vacations
- Large purchases
Some people prefer using a HELOC for purchasing a car or paying for a wedding because the rates are often low. Plus, you might be able to write off a portion of the interest you pay on the loan on your taxes. Keep in mind, though, you will not see any return on your investment when you use the funds for something other than your home.
Making Sure you can Afford a HELOC
A HELOC account might seem like a great idea at first. You have funds at your disposal, as you need them. You only need to secure approval once and you can reuse the funds over the next 10 years. However, you should keep in mind that the payments change. If you have fixed income or cannot deal with fluctuating bills, this might not be the right account for you. Look at the worst-case scenario – the highest your rate can go. Can you afford the payment that coincides with that rate? If you cannot see yourself affording that payment, do not take the HELOC as that payment could become reality – there is no way to predict it.
Applying for a HELOC
There are many lenders you can apply for a HELOC with, but starting with your current lender or bank may help. They often provide current customers with a discounted rate in order to keep them coming back. You should also shop around with different lenders, though, so you can see what is available out there. Many lenders have a maximum amount you can borrow as well as a maximum loan-to-value they allow. In most cases, this equals 85% of the value of your home. Make sure you have the equity and that your credit is in good condition before you apply. A second loan is risky for any lender as it is in second lien position. If you default on your loan in the future, the second lienholder is the last to get paid. They usually do not get paid at all in this case.
If you want a HELOC account, make sure you shop for the most favorable terms. Interest rates are often low to start, but increase over time. Make sure you can afford the payments and that you need the money. If it is for frivolous purchases, rethink your decision. If, however, you want to reinvest in your home in order to make a profit, this can be a very profitable way to make the changes you need. Talk to your lender about your options and apply for your HELOC today.