What is a Home Equity Line of Credit, and How Does it Work?

 

Homeownership is certainly full of challenges — but for every obstacle, there’s a benefit. One of those benefits is the power to leverage the home equity you build as you pay down your loan, and a home equity line of credit (HELOC) is one great way to achieve that.

What is a HELOC, then? In short, it’s a revolving source of funds that works much like a credit card. Your line of credit is secured against your home equity, and you’re free to use the funds as you wish, whether you’d like to make kitchen renovations, finish your basement, or purchase a plot of land. Generally, you can access your HELOC funds by writing a check, using a credit card, or making an online transfer.

In contrast to home equity loans, HELOCs don’t typically come with closing costs. They also usually have variable interest rates, but certain lenders will offer fixed rates for a limited time.

How Does a HELOC Work?

Most HELOCs function in the same way and operate in phases. You can usually draw funds against your equity for 10 years, after which you’ll have a 10-year repayment period. The minimum payments are normally interest-only, and after the first 10 years, you’ll pay down the principal with interest.

When you begin the HELOC application process, it’s also important to remember that it’s an adjustable-rate mortgage. The rate floats in tandem with the Federal Reserve’s benchmark interest rate, also known as the prime rate

It’s a common misconception that adjustable-rate mortgages are best avoided because of sky-high interest rates, but prime rates haven’t reached double digits since the 1980s. (Today, the public simply won’t tolerate high rates.) Still, it’s best to remember that the government’s prime rate will affect your payments.

The Pros and Cons of a HELOC

It’s crucial to understand the pros and cons of a HELOC before diving headfirst into the application process.

On the plus side, being able to borrow against your credit line without a new loan offers a great source of emergency cash if your bank doesn’t require a minimum withdrawal amount. As mentioned before, you’re not limited in terms of what you can purchase using your HELOC funds, either.

When borrowers spend beyond their means, however, they might find themselves in hot water during the repayment phase. You can ask for an extension beyond the draw phase (and certain lenders might even offer to convert your balance to a loan with fixed interest), but you shouldn’t count on those options.

It’s also worth noting that your monthly payment could almost double when it’s time to repay your HELOC. If the balance is high enough and you’re unprepared, you risk defaulting on the mortgage and losing your home — so be sure to use your line of credit prudently.

This isn’t an exhaustive list, however, and not all HELOCs are created equal. Your best bet is to have an in-person conversation with your lender to find options geared toward your financial situation and goals.

Why Get a HELOC?

Most of the time, borrowers begin the HELOC process to secure funds for home improvement projects. The reasoning behind this is simple: Because these projects cost more, it isn’t ideal to put them on higher-interest credit cards. And in some cases, credit card companies won’t allow purchases of that size. A HELOC is always going to be a lower-interest option.

The home-improvement investments HELOCS fund add to the value of a home, and that new market value will increase your home equity (you’re essentially using equity to build equity). Usually, you’ll also be able to access more of your equity than with a normal home equity loan.

Another great reason to begin the HELOC application process would be to pay certain bills or consolidate debt. You can open a HELOC with no down cost, so applying for one might make sense if you need to pay down credit cards or student loans.

Beginning the HELOC Application Process

If you want to learn more about what a HELOC could help you accomplish or have already decided on applying, consider contacting the experts at American Bank of Missouri. When walking you through the HELOC process, we’ll consider your financial situation when mapping out your options. While other lenders might offer a one-size-fits-all package, we listen and look for ways to offer flexibility.

Borrowing against your home equity is a big step, but partnering with a community bank will ensure that you have enough attention and guidance. We’re ready to listen, so come in and meet our experts when you’re ready to talk about your financial future.

 

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