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Home Equity Line of Credit

A home equity line of credit, or HELOC, is a revolving line of credit you can take out against your home. Instead of borrowing one lump sum, you'll be approved for a maximum loan amount that's available whenever you need it, and interest is only paid on the amount borrowed. Before taking out a HELOC, though, you should learn how this line of credit works and whether it really fits your needs.

According to Linda Guel, mortgage loan officer at NorthWest Plus Credit Union, HELOCs are most commonly used for debt consolidation and home renovations. "With today's low rate environment, HELOCs can be a smart and flexible way for customers to improve their home, consolidate debt or deal with an unexpected cost, such as a medical bill," she says.

A HELOC can also help fund major life events such as children's college expenses, weddings and more, adds Mike Kinane, senior vice president of home equity at TD Bank.

Risks of a HELOC

Some entrepreneurs use a HELOC to provide the initial capital for starting a business, but this should be approached with extreme caution. Unless you're certain of the return and very experienced in investments, it may not be worth the risk to your home. Experts also caution against using HELOCs as a piggy bank for vacations and luxury items.

Why all the caution? A HELOC comes with more risk than most lines of credit, because you're using your home as collateral. That means you could lose your home if you're unable to make the payments. So before applying for one, consider your financial history and stability. If you already have a large amount of debt, big bills or unpredictable income, a HELOC may not be the best choice for you. The consequences for falling behind on payments are heavy and can include foreclosure.

"A good candidate for a HELOC is someone who is pretty good at budgeting their money, good at paying their bills on time, good at planning for the future," says David Reiss, a professor at Brooklyn Law School. "A HELOC can be an important part of that candidate's financial planning. I would caution someone who spends their money in a very carefree way to think twice before opening up a HELOC."

How a HELOC works

If you're approved for a HELOC, lenders will approve you for a maximum amount that's based largely on how much equity you have in your home and your credit history. The equity in your home is simply the property's total value, minus anything you currently owe on mortgages and home equity loans. A HELOC is calculated using up to 85 percent of the equity you have in your home.

The credit on a HELOC revolves. Just like a credit card, as you pay off the principal, your balance is reduced and available credit replenished. Some plans have limitations on how you can use these funds, with minimum withdrawal amounts and outstanding balance caps.

Certain lenders require an initial advance when the line is established. Depending on the lender, you may use your HELOC by writing a check, using a debit card that's tied to the account or simply transferring funds into your checking account.

HELOCs generally involve an adjustable, rather than fixed, interest rate although some offer an introductory "interest only" fixed rate. By law, variable-rate plans always have a cap to the interest rate (though it may not be capped at a rate that you can afford.) A mortgage of $2,000 could go up to $6,000 or more under the current capping system.

If you have used up your credit line and are having trouble paying it down, you may find the interest rate climbing to an unmanageable level. If you are able to refinance your home, you might be able to pay off your HELOC by folding it into your new mortgage.

It is important to look at the annual percentage rate (APR) and the costs of establishing the plan. An APR is the annualized interest rate for a whole year, rather than just a monthly fee or rate, as applied on a loan, mortgage loan or credit card. Some lenders may offer you the option to change to a fixed rate during the life of the plan.

There are also costs involved in setting up a home equity line of credit, such as an application fee, cost of appraisal and closing costs. When considering a HELOC, it's important to calculate these figures into your decision on whether this credit is viable to you. Some HELOCs also require you to take out money as soon as the deal is signed.

Most plans set a fixed amount of time you can borrow money, such as 5 or 10 years. At the end of the set period, you may be able to apply for a renewal, if the plan allows it. When the period closes, some plans may ask for payment in full, while others allow for what is known as a "repayment period."

Where and How to Get a HELOC

You don't necessarily have to use the same lender as you did with your home mortgage. Just like any type of loan, you need to shop around for the best possible fit. Questions to ask lenders should include costs like closing and application fees. You should also shop around for the index margin and total interest rate you are being offered, as the margin can vary by lender.

You can apply for your HELOC through a bank, credit union or non-bank lender depending on your needs. Banks typically work with borrowers who have a credit score of 750 or higher, whereas credit unions and non-bank lenders tend to be more lenient. Banks also tend to close quicker and offer lower introductory rates, which may balloon over time. The choice of who finances your HELOC is personal and should be based on your needs and which institution is offering you the best rates.

"Consumers shopping for HELOCs should look for a lender who will lock in today's low rates against all, or a portion, of what they borrow from their credit line," says Kinane of TD Bank. "HELOCs should provide consumers with financial flexibility, so choose a lender who offers multiple and convenient ways to borrow against or pay down your credit line."

Many homeowners are pleased to find the application process for a HELOC is not as strenuous as mortgages. Among your application materials, you'll have to include two years' worth of W-2s or tax returns, mortgage information and a list of other investments and retirement assets.

A good credi score will help you get a good deal on your HELOC, so avoid doing anything that could drop your score. "Don't apply for other credit lines before shopping for a HELOC. Those applications can lower your credit score and increase the cost of the HELOC," Reiss says.

A HELOC can help cover a financial shortfall, but money is never free. You'll want to make sure that you use the right loan for the right reasons. Shop around, do the math and make a plan. It's the only way to know if a HELOC can work for you.

References

Home Equity Loans and Credit Lines. Federal Trade Commission. https://www.consumer.ftc.gov/articles/0227-home-equity-loans-and-credit-lines

What You Should Know About Home Equity Lines of Credit. The Federal Reserve Board. http://files.consumerfinance.gov/f/201204_CFPB_HELOC-brochure.pdf

Using Your Home as Collateral. Federal Trade Commission. https://www.consumer.ftc.gov/articles/0245-using-your-home-collateral

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