A home equity line of credit or HELOC is a loan with your house as collateral. If you use a HELOC to pay off your credit cards, you are trading unsecured debt for secured debt. Experts at Illinois Legal Aid and Michelle Singletary at PBS suggest that this places your home at unnecessary risk. The HELOC can work to your benefit if you need money and available sources are limited.
How It Works
The home equity line of credit is a contract; the interest rate and terms may be different from one lender to another. You will need a home appraisal, and to know the total amount owed on the home. If you have equity in the home, you can determine how much equity is available by subtracting the total owed on the loan from the appraisal value. This is your actual equity. Your lender will not make a loan for the total equity, but may offer 75 percent of your equity in a HELOC. For example, if your home is valued at $100,000 and you owe $60,000, you have $40,000 in equity. The lender may offer 75 percent, or $30,000, in a HELOC loan.
Costs
Your costs for the HELOC are similar to a home mortgage. You owe an application fee and appraisal costs, along with any points or upfront expenses. You also owe closing costs including title search, attorney's fees, mortgage preparation, filing fees, property insurance and title insurance. You may also have to pay membership or maintenance fees. The lender charges a transaction fee every time you draw on the line of credit. Costs are substantial. Make sure it is worth it to you. If you need a small amount of cash, the HELOC is not a good source.
Draw Period
Your loan sets a period of time or "draw period" for you to use the line of credit. Ten years is common. You may have to draw some of the loan funds when the lender gets the HELOC set up. The interest rate is variable, so it depends on when you borrow money that determines the interest rate. A lender can freeze or reduce your line of credit if the value of the home decreases or if it appears that you may not be able to repay the loan.
Repayment Terms
You may have 10 years draw period and 10 more years for payback. You may make payments every month that cover all of the interest and some of the principal, or you may pay interest only, depending on the terms. When the HELOC plan ends, you have to pay it all back, no matter how much is still outstanding. This is a "balloon payment" and may cause you to lose your home if you do not plan for it. If you sell your home, you must repay the HELOC at the closing.
Alternatives
Second mortgages are usually for a set interest rate, and payback is for the entire loan and interest. This loan is easier to understand with less risk if you need equity from your home. If you are a senior citizen, you may qualify for a reverse mortgage with similar risks to the HELOC. The reverse mortgage does not require payback during your lifetime, but accrues interest and fees over the life of the loan. You may lose your home if you do not maintain the taxes and insurance, or if you do not live in the house for an extended period of time. Always attempt to borrow money with the least risk to you. Use credit cards for unsecured loans instead of risking loss of your home.
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