What Is A Home Equity Line Of Credit?

Home Equity Line of Credit (HELOC), a type of adjustable-rate home loan, functions in the same way as a credit card. You can take it out and repay it in the same way. Let's take a closer view to see if a HELOC is right in your case.

How A HELOC Works

Although a HELOC can be referred to as a second mortgage, it does not have to. For example, a HELOC could be used as a standalone mortgage if you have no liens on your home.

If you own a $400,000 home and want a safety net, you can open a HELOC to get $200,000. The HELOC is considered a first mortgage because there is no other mortgage on your home. However, you don't have to take out $200,000.

You can draw on your HELOC whenever you need it by having your lender provide you with a checkbook or credit card. You won't be required to pay any HELOC payments until you draw it with your HELOC credit card or checkbook. For example, you would not have to pay a HELOC payment if you didn't draw on $200,000; however, closing costs will be incurred in order to put the HELOC in effect.

These HELOC concepts are also applicable if you use a HELOC for a home purchase. For example, let's say you want to buy a house for $400,000 and put 10% down. A first mortgage could be for 80 percent (or $320,000), and a HELOC second loan for 10 percent (or $40,000).

This example would show you a payment of $40,000, as you would be closing on $40,000 total. Your payment would be $30,000. If you reduced the $40,000 to $30,000, however, it would still be $40,000

How HELOC Rates Are Determined

HELOC rates are calculated using two components: a fixed base rate, called a "margin," and a fluctuating rate, called an "index."

The Prime Rate indexes HELOCs. This rate is linked to Federal Reserve System interest rate decisions. The Fed moves the Fed Funds Rate, an overnight bank-to-bank lending rate. Fed Funds is not a consumer rate. However, it serves as a benchmark rate for consumer rates. The Prime Rate index to which HELOCs are linked is an excellent example. The Fed Funds rate plus three percent make up the Prime Rate.

In 2008, as the financial crisis was intensifying, the Fed slashed the Fed Funds Rate to 0.25 percent in January 2009. The Prime Rate, which is Fed Funds plus three percentage, was therefore 3.25 percent. The Prime Rate remained the same until December 2015 when it was raised by the Fed Funds rates by. Twenty-five percent and.5 percent respectively.

As the Fed adjusts Fed Funds, Prime will change in this way.

Your credit score and equity in your home are the main factors determining the margin for a HELOC. This is the premium you would pay on the rate to cover the extra risk that the lender takes based on your credit profile.

Many lenders won't allow the first mortgage and HELOC combined amounts to exceed 90 percent of the home's actual value. You will have some margin if you get a HELOC that is so high.

If you multiply the margin by 1.5 percent using today's Prime rate of 3.5 percent, then your total HELOC rates are Prime plus 1.5 percent or 5 percent. Find out how to get the highest HELOC rates.

Are HELOC Rates Subject To Change, Or Can They Be Fixed?

Your payment would then be calculated using a 5-percent interest rate on your HELOC balance. So, for example, if you paid down your $40,000 loan to $30,000, then you would only be charged 5 percent of the outstanding balance. This is in contrast to a traditional first or second mortgage, where the payment is always based upon the original balance until the loan is paid off.

Your HELOC payment will fluctuate depending on the loan amount and if your rate moves in line with Prime Rate movements.

HELOCs also have a "fixed-rate draw" or "fixed-rate advance" feature, which allows you to draw a percentage of your HELOC balance at a fixed rate.

This is useful for larger expenses, such as home improvements that you don't plan to pay off immediately. In addition, fixed-rate draws can be used to fix the HELOC portion. This protects you from rising rates. However, fixed-rate draws are often more expensive than the index plus margin rates at the time they are taken.

You will need to consult your mortgage advisor to determine if a fixed-rate draw is a right choice for you and your time frame. Also, consider where rates are at the moment.

Qualifying For The HELOCs

HELOC payments are usually only interest, but HELOCs will pay a higher amount to allow you to take into account future rate fluctuations that could increase your payment.

Although each lender will have a different qualifying formula, the common rule is that banks will use a 20-year principal and interest payment to calculate a payment if the HELOC has been fully drawn.

This could lead to a much higher payment than what you are actually required to make and may pose qualifying challenges.

How HELOCs Differ From Home Equity Loans

A HELOC may not be the right option for you if this is the case. You can then get a traditional second mortgage (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. For example, a fixed-rate home equity loan would be used to purchase the house above. The payment would remain the same at closing.

This payment will be slightly more than HELOC's index plus margin, but this is because HELOCs' Prime Rates are still extremely low.

Ask your loan advisor for HELOC and home equity loan options to help you compare them side by side. Find out more about home equity loans vs. HELOC.