What is Home Equity Line of Credit (HELOC)?
Home Equity Line of Credit (HELOC) is a line of credit given to a person using their house as collateral. It is a type of loan in which a bank or financial institution lends a certain amount within an agreed amount time. Since the collateral is a house, HELOC is mostly used for large items. For example, the purchase of property, payment of medical bills, or education.
Quick Summary Points
- Home equity line of credit (HELOC) is a loan using a house as collateral.
- It is similar to a line of credit as the borrower can use any amount at whatever time they choose.
- There are traditional and hybrid HELOC. The payment schedule and amount depends on the type.
HELOC vs. Mortgage
The structure of a HELOC is different from a mortgage, but both use a house as collateral. When a person decides to use a mortgage to purchase a house, they get the entire sum of the mortgage up front. On the other hand, a HELOC is more similar to a credit card limit. The person with the HELOC can borrow up to a certain amount at whatever time they choose.
The second difference is the interest rate attached to the loans. For most mortgages, there is a fixed interest rate that is decided at the time the mortgage is signed. For a HELOC, there is usually a floating rate that is based on the prime lending rate. This makes HELOC riskier as the borrower has to tolerate a volatile interest rate. If the prime lending rate suddenly increases, then the borrower will have to shoulder the increase payments.
The third difference is the payment of the loans. For a mortgage, there are fixed interest and principal payments. They are often paid on a monthly basis and are decided when the mortgage is signed. A HELOC only requires interest payments. It is similar to a credit card in which only the minimum payment is required, and the principal payments can be pushed back. If a borrower uses $10,000 of the HELOC on a 2% interest rate, the borrower only needs to pay back $200 in interest payment and not the principle of $10,000. The principal is only required at the end of the draw period.
Different Types of HELOC
HELOC is separated into traditional and hybrid categories. Traditional HELOC is as described above. The interest rate is floating and is subject to change, and there are no fixed payment requirements. The requirements for a traditional HELOC is more stringent. It allows homeowners to borrow up to 65% of a house’s value and to qualify the borrower needs to have 20% of home equity.
On the other hand, hybrid HELOC allows homeowners to borrow up to 80% of the home’s value. Hybrid HELOCs are more like mortgages as a portion amortizes, which means it requires both payments of principal and interest. For example, since borrowers can borrow up to 80% of a home’s value, a portion such as 15% will be amortizing while 65% is like a traditional HELOC.
Traditional HELOCs are seemed as more dangerous. It is due to the fact that borrowers only need to pay the interest payment, which is based on a floating rate. If the interest rate suddenly rises, then homeowners may find themselves in a situation in which they can not make payments. Also, like a mortgage, falling home prices will leave borrowers with “negative equity.” It means they will incur more debt then what their property is worth.
Below is the information for homeowner A:
The appraised home value is $1,250,000. Since the homeowner is applying for a hybrid HELOC, the maximum amount available for the line of credit is 80% of the home value. For this hybrid product, the HELOC portion is 65%, while the amortizing mortgage portion is 15%.
Below is the calculation for Homeowner A’s maximum HELOC credit limit:
The HELOC credit limit can be calculated by taking the maximum amount available for the line of credit and subtracting the outstanding mortgage amount. The HELOC available for Homeowner A is $960,000.
Below is the information for homeowner B:
The appraised home value is $1,250,000, and the homeowner does not have other loans that use the house as collateral. For a traditional mortgage, the maximum amount available is 65% of home value.
Below is the calculation for Homeowner B’s maximum HELOC credit limit:
To arrive at the HELOC credit limit, multiply the home value with the max value of the loan percentage. Since this homeowner does not have other outstanding loans, the max HELOC limit is $750,000.
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