A home equity line of credit (HELOC) allows homeowners to leverage the equity they have already built in their homes. Because homes are among the most valuable items owned by the average person, a HELOC is a powerful borrowing option for many Americans.
By using your home as collateral, you can access a line of credit that can help pay for everything from renovations to college expenses and high-interest credit card debt. Understanding how a HELOC works and common misconceptions about this type of loan will allow you to make more informed decisions when seeking out, using and managing it.
How does a HELOC work?
A HELOC is a type of secured loan, meaning the borrower offers some type of asset as collateral. For a HELOC, the borrower’s home is the collateral. In these cases, lenders know they can recoup at least part of their investment if the borrower defaults. Having collateral on the table can make lenders more likely to offer a loan as long as borrowers meet basic qualifications. A HELOC may also offer lower interest rates than some other types of loans.
In terms of how they function for borrowers, HELOCs can be compared to credit cards. A HELOC opens up a line of credit that the borrower can, but doesn’t have to, use up to the established credit limit. Borrowers then pay back the credit used and associated interest. However, it’s generally best to use a HELOC for major expenses and credit cards for everyday purchases.
This type of flexibility allows homeowners who utilize HELOCs to only use the funds when necessary. This stands in contrast to many types of traditional loans, where the lump sum is paid out and the borrower must then start repaying the principal and interest.
HELOCs include a draw period of several years, where the borrower can use the line of credit as they see fit and generally are only required to make interest payments. The repayment period follows the draw period and also lasts for several years. During this period, borrowers pay back their lender for both the principal and any additional interest owed.
While not exclusive to HELOCs, it is important to consider whether your loan has a fixed or variable interest rate. A variable interest rate is recalculated periodically based on the terms set by your lender. This can make utilizing your HELOC more or less expensive in terms of interest repayment, based on the broader economic factors that influence how the interest rate is adjusted. A fixed interest rate, which is less common for HELOC loans, will remain steady. This approach doesn’t provide opportunities for savings but is more predictable.
What can a HELOC be used for?
A HELOC can be used to purchase or pay for nearly anything. There are few restrictions on how the funds provided through this line of credit can be spent. This is a major benefit of a HELOC as compared to loans that may only be used for a specific or narrow range of purposes.
Common uses of HELOCs are generally tied to large expenses that may be difficult to pay for directly. A home can offer a significant amount of equity. Due to the value built in many homes and the length of time that passes before the repayment period starts in HELOCs, this line of credit is often used for major purchases. Some examples of smart HELOC usage include options that can increase the value of your assets, boost your earning power or lower your debt liability, such as:
- Paying for home repairs and renovations: These activities can add value to a home, although it is important to look into whether a specific project is generally regarded as helping increase resale value. Note that spending on home improvements is the only type of HELOC debt that may be tax deductible, following rule changes established by the 2017 Tax Cuts and Jobs Act.
- Addressing the costs of higher education: Earning a degree can lead to opportunities for higher-paying jobs. While not a guarantee of increased earning power, a degree is often a path to more financially fruitful offerings.
- Consolidating high-interest debt: If you have outstanding debt on credit cards or other types of loans that come with a high interest rate, you can lower your total financial liability if your HELOC offers a lower interest rate. However, you still need to understand what caused the accumulation of that debt and take steps to address that root issue, if necessary.
- Investing in a new or existing business: If research, planning and due diligence indicates that your concept for a new business is viable, a HELOC can be a source of funding for your new venture. Similarly, you can use a HELOC to fund improvements to an existing enterprise. Just remember that there is always a financial risk when it comes to starting or growing a company.
HELOCs can also be used to meet significant expenses that can be saved for over time, but need to be paid for more quickly. Examples include:
- Supporting the education of a child: You can consider taking out a HELOC to pay for undergraduate or graduate tuition and expenses while building a plan to pay back the amount owed once the repayment period starts.
- Addressing significant medical expenses: Medical debt can arrive quickly and involve high costs. A HELOC can provide the funds needed to avoid serious financial complications in the short term and give you time to plan for future repayment.
What shouldn’t a HELOC be used for?
While there aren’t any notable or broad restrictions on how homeowners can use a HELOC, it is important to understand that responsible use is vital for staying on track with repayments and remaining in good standing with your lender.
In the most general terms, a HELOC should not be used for expenses that cannot be addressed with earnings and other assets gained before the repayment period begins, or during it. Just as is the case with a credit card, you need to have a financial plan for paying back the debt incurred by using your line of credit.
The specifics of responsible HELOC use will vary from one person to the next based on income, investments, necessary expenditures and budgeting. In general, you should avoid major purchases with a HELOC without a plan to address the debt once the repayment term arrives. There is nothing wrong with using a HELOC to pay for a vacation, home improvements that likely won’t add significant value or other expense as long as you have an effective strategy for paying that money back when the time comes.
What makes a HELOC right for me?
Wondering how to make a HELOC work best for your needs? HELOC loans can be especially beneficial if you meet a few key qualifications that position the terms and conditions in your favor:
- A strong credit score: Your credit score will impact whether you qualify for the line of credit as well as influence the interest rate your lender offers to you.
- A high level of equity in your home: The less that is owed on your home, the more credit your lender can offer in a HELOC.
- A low debt-to-income ratio: Debt-to-income ratio represents how much income you have available after addressing recurring debt. A lower debt-to-income ratio is desirable for many lenders.
What are popular misconceptions about a HELOC?
HELOCs are not particularly complicated, but their unique nature has led to some common misconceptions about them. Answering the question “how does a HELOC work?” means understanding its purpose, common uses and popular but incorrect assumptions about this line of credit.
Consider these four misunderstandings of HELOCs, along with details about their true nature.
1. HELOC is another name for a home equity loan
This is an especially common misconception for HELOCs. A home equity line of credit and a home equity loan are both types of home-secured debt you can take on to access the existing equity in your home. However, they differ significant in how funds are distributed, accessed and repaid:
- A home equity loan is a lump-sum amount paid to the borrower with a repayment schedule much like a mortgage. Terms may last for 5, 10, 15 or 20 years. The one-time loan starts to be paid back immediately through monthly payments at a fixed interest rate.
- A home equity line of credit extends credit up to a defined limit to homeowners, which they can draw on as they wish. Draw periods commonly feature lower, variable interest rates and usually last 5, 10 or 15 years, during which minimum payments usually cover only interest. The homeowner must stop drawing on the account and repay any remaining premium and interest balances during the repayment period, which is of equal length to the draw period.
2. You can access all the equity you hold in your home
Your HELOC limit is determined by the difference in the home value and what you still owe on your mortgage. If you have a home valued at $375,000 and $225,000 remaining on your mortgage, you might reason that you would be offered a HELOC worth $150,000. However, lenders very rarely make 100% financing available.
Many providers cap HELOCs at 80-85% of the home's value, so you would more likely see a $93,750 credit limit. However, the terms of every HELOC will differ. Shopping around for lenders is important since other factors like closing costs still apply. If you have significant equity in your home, a HELOC may be worth pursuing once you have evaluated your needs and options. If you lack significant equity in your home, a HELOC might not be a viable choice depending on your needs.
3. HELOCs can only be used for home renovations
While home remodels and repairs are highly effective uses for HELOCs, many more options exist. It is easy to see why the misconception saying otherwise persists. The Tax Cuts and Jobs Act of 2017 restricted instances in which interest paid on HELOC debt is deductible. Before, it was allowed regardless of how funds were used; now, interest may only be tax deductible when the HELOC is put toward the home that secures the loan.
That does not mean other uses for a HELOC are not viable. You can still leverage one to help pay college costs, consolidate high-interest debt, purchase goods and services or invest in a new or existing business.
4. New homeowners cannot get a HELOC
Lenders generally prefer that homeowners hold around 20% equity in their home before extending a HELOC. This structure favors homeowners who have built up equity through mortgage payments made over several years or decades. But that does not mean other homeowner populations, like first-time homebuyers, cannot get a HELOC.
For instance, if you made a larger-than-average down payment on a high-valued home, you might be able to quickly tap into the equity of your home because of the comparably lower outstanding mortgage amount.
HELOCs offer homeowners flexible means to liquidity with low interest rates, which makes them a highly useful and versatile product to many homeowners who meet the necessary qualifications. However, getting the most value out of your HELOC means avoiding the pitfalls associated with these myths.
Taking the next step with a HELOC
By now, you should have plenty of information to answer the question that started this article: How does a HELOC work?
Being informed is critical to making the best possible financial decisions, such as whether to use a credit card or a HELOC to address financial needs. Understanding how HELOCs work, how you can tap into equity and what common misconceptions exist can help you decide if and when a HELOC is right for you.
To take the next step forward with a HELOC, get in touch with the team at Comerica Bank to learn more about our offerings.
