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What Is a Home Equity Line of Credit (HELOC)?

March 22nd, 2018 6:39 AM by Jackie A. Graves, President

What Is a Home Equity Line of Credit (HELOC)?

A Home Equity Line of Credit (HELOC) is a type of adjustable rate home loan that functions much like a credit card because you can draw from it and pay it down in the same manner. Let’s take a closer look so you can determine if a HELOC is right for you.

How a HELOC Works

A HELOC is often a second mortgage, but it doesn’t have to be. If you owed nothing on your home, you could get a HELOC as a standalone first mortgage.

For example, if you owned a $400,000 home free and clear but wanted a safety net, you could open a HELOC for $200,000. In this case, the HELOC would be considered a first mortgage (because there is no other mortgage on the home), but you’re not required to take out $200,000.

Your lender provides you a checkbook and/or a credit card with your HELOC, and you can “draw” on that HELOC when needed. You will not be required to make payments on the HELOC until you draw on it using your HELOC checkbook or credit card. If you never drew on the $200,000, you’d never have a payment—but you would have some closing costs for putting the HELOC in place to begin with.

These HELOC concepts also hold true if you’re using a HELOC to buy a home. Suppose you’re buying a home for $400,000 with 10 percent down. You could get a first mortgage for 80 percent of the purchase price (or $320,000) and a HELOC second mortgage for 10 percent of the purchase price (or $40,000).

In this example, you’d have a payment on the $40,000 because you’d be drawing the full $40,000 at closing. But if you paid the $40,000 down to $30,000, your payment would then be based on $30,000.

Learn more about reasons to use a HELOC.

How HELOC Rates Are Determined

HELOC rates are based on two components: a set base rate called a “margin,” plus a fluctuating rate called an “index.”

The index for HELOCs is the Prime Rate, which is a rate that is tied to the Federal Reserve System’s interest rate decisions. When you hear about the Fed moving rates, they’re moving an overnight bank-to-bank lending rate called the Fed Funds Rate. Fed Funds isn’t a consumer rate, but it does serve as a benchmark for consumer rate levels, and the Prime Rate index that HELOCs are tied to is the perfect example. The Prime Rate is comprised of the Fed Funds Rate plus three percent.

Back in 2008 when the financial crisis was escalating, the Fed cut the Fed Funds rate all the way down to 0.25 percent by January 2009. As such, the Prime Rate was 3.25 percent (which is Fed Funds plus three percent). It stayed that way until December 2015, when the Fed finally hiked the Fed Funds rate by .25 percent to .5 percent, and then Prime became 3.5 percent.

Prime will move up or down in this manner as the Fed continues to adjust Fed Funds.

The margin for a HELOC is based on your credit quality and total equity in the home after the HELOC is in place. It’s the additional premium you’d have on the rate for the additional risk the lender is taking based on your profile.

For example, many lenders will only allow the combined first mortgage plus HELOC amounts to go up to 90 percent of a home’s value. If you’re getting a HELOC that’s taking you up that high, you’re going to have some sort of a margin on top of Prime.

If the margin in this example is 1.5 percent, then based on today’s Prime Rate of 3.5 percent, your total HELOC rate is Prime plus 1.5 percent, or 5 percent. Learn more about how to get the best HELOC rates.

Can HELOC Rates Change or Be Fixed?

In this example, your payment would be calculated using a 5-percent rate on the outstanding balance of your HELOC. So if you had paid your $40,000 loan down to $30,000, you’d only be charged 5 percent on the current balance. This is different from a typical first or second mortgage, where the payment is always based on the original balance until you pay the loan off.

In general, your HELOC payment will fluctuate based on your loan balance and on your rate moving in line with Prime Rate movements.

But there is also a feature of HELOCs called a “fixed rate draw” or “fixed rate advance” which enables you to draw a portion of the available HELOC balance as a fixed rate.

This is handy for larger expenditures such as a home improvement project that you don’t intend to pay off right away. You can use the fixed rate draw to fix that portion of your HELOC so you’re protected if rates rise later. But rate levels for fixed rate draws can often be higher than the index plus margin rate at the time you take them.

So you have to work with your mortgage advisor to determine whether a fixed rate draw is the best choice for your time horizon, and where rates are in the current economic cycle.

Qualifying for HELOCs

Even though your HELOC payment is usually just the interest (rather than principal plus interest), HELOCs will use a higher payment to qualify you to account for future fluctuations in the rate that could hike your payment.

Each lender has a slightly different qualifying formula, but a common formula is that a bank will calculate a payment using a 20-year principal plus interest payment assuming the HELOC is fully drawn.

This will result in a significantly higher payment than you’ll actually be required to make, and might present qualifying challenges.

How HELOCs Differ From Home Equity Loans

If this is the case, a HELOC might not work for you. Then you can get a traditional second mortgage, which is often called a home equity loan.

A home equity loan is a traditional principal-plus-interest payment, and there’s no ability to draw from it. If you were buying the home above with a fixed rate home equity loan instead of a HELOC, you’d get a $40,000 second mortgage, and the payment would always be based on what it was at closing.

That payment will be slightly higher than a HELOC’s index plus margin today, but that’s because the Prime Rate for HELOCs is still abnormally low.

Ask your loan advisor to present HELOC and home equity loan options for you to compare side by side. Learn more about HELOC vs home equity loans.

To view the original article click here             Apply to Buy a Home             Apply to Refinance

 

Posted by Jackie A. Graves, President on March 22nd, 2018 6:39 AM

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