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How Does a Home Equity Line of Credit Work? A Simplified Guide

Home equity lines of credit (HELOCs) are backed by your home’s equity and can be used to consolidate credit card debt, pay for renovations to your current home or pay for closing costs and a down payment for a future home. Since your early payments only include interest on the loan, HELOCs can be a great financing tool, but it’s important to understand the pros and cons first.
Home equity lines of credit (HELOCs) are backed by your home’s equity and can be used to consolidate credit card debt, pay for renovations to your current home or pay for closing costs and a down payment for a future home. Since your early payments only include interest on the loan, HELOCs can be a great financing tool, but it’s important to understand the pros and cons first.

When looking to buy another home, you may also be thinking about how to pay for the purchase, especially upfront fees like a down payment or closing costs. The most typical way to finance a home purchase is a basic mortgage, especially if it's your first. However, a home equity line of credit (or HELOC) can be a valuable financing tool. We’ll take a simple look at how HELOCs work below, but if you’re new to this type of loan, its best to talk through your options with a real estate agent. Clever Partner Agents can help you explore the best way to finance your new home and you may be able to get up to 1% of the price of your home rebated at closing.

What is a HELOC?

Similar to a credit card, a HELOC is a line of credit you borrow against as you need it, up to the credit limit set by your lender. Unlike a credit card, a HELOC is backed by the equity in your home. You may have acquired equity if your home has increased in value since you purchased it or by paying back a portion of your mortgage.

After qualifying, the bank will give you an interest rate and a draw period – the amount of time in which you can pull money from the line of credit. During this draw period, you’ll make monthly payments on the interest of any amount you owe. After the draw period, you’ll begin paying back the principal and interest in your monthly payments in order to completely pay off the loan by the pay-off date. If you were to sell your home before that date, the full amount of your loan would become due.

HELOC vs. Home Equity Loan

Both home equity loans and HELOCs are backed by the equity in your home, but there are some key differences. A home equity loan is similar to a mortgage in that a specific amount of money is loaned out and the borrower makes monthly payments of the same amount to pay off that amount plus interest by the pay-off date. Monthly payments are predictable and the interest rate doesn’t change throughout the life of the loan.

With a HELOC, the borrower is given a credit limit but only pays interest if they use that credit, just like with a credit card. HELOC interest rates are variable, meaning they can go up and down based on the financial index, but most will have a rate cap. Many banks offer a low promotional interest rate for the first year or so, then increase the rate.

How Do You Get a HELOC?

When applying for a HELOC, the bank calculates your credit limit based on the value of your home, minus any existing loans or mortgages on the property. Most banks extend credit in the amount of 80% loan-to-value (LTV). For example, if your home is worth $200,000, your LTV amount is $160,000. By subtracting the amount of any existing mortgage (in this example we will use $120,000), you would qualify for a HELOC in the amount of $40,000. You may draw out as little or as much of this amount as you wish, unless the bank specifies a minimum account balance you must maintain.

Depending on the bank’s stipulations, you may also have a minimum amount you can draw at one time. You’ll also want to make sure you discuss other requirements related to any promotional interest rates, your draw period and your final pay-off date with your lender before finalizing the loan.

How Can You Use a HELOC?

Many people use a HELOC to make upgrades to their home or consolidate other debts like credit cards to a lower interest rate. However, HELOCs can also be used to make a down payment or pay closing costs (which may also include realtor commissions) on another home, whether for your primary residence or as a rental property. This allows you to purchase a home quickly without having to first sell your current home. Once your home is sold, you are able to pay back the amount of credit drawn on your HELOC plus any existing mortgage.

Pros and Cons of a HELOC

Pros

As discussed above, you do not need to draw on your HELOC immediately. You can pull money out as you need it and pay only interest during the draw period. HELOCs are a great way to put you in the position to buy when you are ready. Additionally, you only pay interest on the amount you draw, not on the total amount available. You may also be able to deduct the interest you pay on a HELOC on your tax return, but consult a tax professional for details related to your specific situation.

Cons

HELOCs typically have a variable interest rate. Also, some borrowers may be used to paying only interest during the draw period of the loan and be unprepared to make payments of both principal and interest during the following repayment period.

A HELOC can be a great tool for purchasing another home, but you’ll want to consider the terms of the loan and your past borrowing behavior to determine if its right for you. A local Clever Partner Agent will walk you through your specific situation and help you decide which financing is most beneficial.

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Reuven Shechter

Reuven Shechter is the Outreach Coordinator at Clever Real Estate, the free online service that connects you with top real estate agents to help save on commission. He spreads the word about Clever, disseminating studies to journalists and developing relationships with media outlets. Reuven is passionate about investing in real estate and creating lasting success for families. His writing has been featured in Max Real Estate Exposure, Leverage Marketing, and more.

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