Equity is the value you hold in your home as an investment asset minus any balances owed, and you can convert this equity into cash in a few different ways. By selling your home, for example, you could pay off any remaining mortgage loan balance, and your equity could be paid out to you through the sale’s proceeds. Of course, some homeowners want the benefit of accessing the cash value of their home equity without the permanence of selling. In this case, a home equity line of credit could be useful.
In this article, you can get answers to important questions, including:
• What is a HELOC?
• How does a HELOC work?
• Are HELOCs the same as home equity loans?
• Are there any downsides to HELOCs?
The information in this article can help you decide if a HELOC is right for you.
HELOC 101 - What Is a HELOC?
A home equity line of credit, commonly called a HELOC, is a tool for borrowing against your home’s value. With a HELOC, your home is used as collateral for a revolving line of credit that you can access and repay as needed.HELOCs can be used to access cash for many different things, including:
• Home renovations
• Home repairs
• Education costs
• Medical expenses
• High-interest debt consolidation
• Purchasing or renovating an investment property
How Does a HELOC Work?
A HELOC is often compared to a credit card. Once you are approved for a HELOC, you can make withdrawals to pay for expenses and then repay them, similar to the way credit cards are used. HELOCs come with a maximum limit. You must keep your borrowing below the limit. HELOCs also come with a set “draw” period, during which you can borrow funds, and a set “repayment” period, during which the balance plus interest must be paid off.
How Much Can You Borrow?
Each lender has its own formula for calculating maximum limits on home equity lines of credit. Your borrowing limit depends on several factors, including:
• How much equity you have in your home. The more equity you have, the higher the borrowing limit can be. Many lenders require that homeowners maintain a minimum of 15-20% equity in their homes.
• Your credit history. The higher your credit score is, the higher your limit could be.
• Your current debt-to-income (DTI) ratio. Your DTI shows the percentage of your income that is currently allocated to repaying debts. The lower your DTI is, the higher your HELOC limit could be.
HELOC Interest Rates
As with mortgage loans, HELOCs can come with a fixed interest rate, an adjustable interest rate or a hybrid interest rate. With a fixed rate, your interest rate is locked in during the draw period and may be available until the balance is paid off. With an adjustable interest rate, your interest rate is tied to the going market rate. This means your rate can rise or fall over time. With a hybrid rate, your interest rate is locked in for a short period before becoming adjustable. Some lenders may allow the HELOC to have both, fixed and adjustable rates, on separate portions of the balance owed.
It is important to understand your HELOC interest rate because it directly impacts your cost of borrowing.
When interest rates are low and expected to rise, a fixed-rate option could save you money by keeping your interest rate lower while rates rise. However, a fixedrate HELOC could have a higher interest rate than the starting rate on an adjustable-rate HELOC, or it could have higher fees or early-payoff penalties. With a fixed-rate HELOC, the lender is taking the risk that they could lose money on your HELOC if interest rates rise. So these potential additional costs would help mitigate that risk for the lender.
How Do You Pay Back a HELOC?
While the specific repayment arrangements can vary by lender, paying back your HELOC typically follows a set path.
First, during the designated draw period, when you are free to borrow against your credit line, you may be required to make minimum payments on a monthly basis. In many cases, this minimum payment consists of interest only. This means that your entire payment is going toward interest, and none of your payment is being applied to the balance of the amount you borrowed. During this period, you could opt to make payments toward the principal balance in addition to your interest-only minimums due.
After the draw period comes the repayment period. During this phase, your payments are applied to both principal and interest. It is important to note that your payment amount could increase significantly during this period if your draw period payments were interest-only. This is because you must repay all the money you borrowed plus accumulating interest during the repayment period. It may be possible to extend your draw period if you would struggle to make the principal and interest payments of the repayment period. You would need to contact your HELOC lender to make arrangements for an extension.
Are HELOCs and Home Equity Loans the Same Thing?
HELOCs and home equity loans are not the same. But they are similar. Both tools allow homeowners to access cash based on their home equity. Here is a quick look at home equity loans and how they differ from HELOCs.
What Is a Home Equity Loan?
A home equity loan is a one-time lump-sum borrowing against the value of your home. Unlike a HELOC, which allows homeowners to borrow against equity as needed during the draw period, a home equity loan consists of a single payout, which is then repaid.
How Does a Home Equity Loan Work?
With a home equity loan, you apply for a set amount. If your loan application is approved, your lender transfers the loan amount to you. Then you begin repaying the principal and interest in monthly installments as scheduled in your home equity loan contract.
Home equity loans are typically fixed-rate. Since you know the amount you can borrow upfront and you know the interest rate, it is easier to calculate the exact amount of your monthly payments with a home equity loan than with a HELOC. Your loan documents might even state the payment amount for you so that you can see the amount before you agree to the loan.
Does a HELOC Affect Your Credit Score?
As with any loan or line of credit, a HELOC can affect your credit score in complex ways.
1. Lenders look into your credit before issuing a loan. This credit inquiry can cause your score to drop by just a few points because it signals that you are looking to increase the amount of debt you have.
2. Immediately upon opening the HELOC, your credit score could dip a bit. This is because new credit lines bring down the average length of your open accounts, which is a factor in your credit score.
3. As you begin making on-time payments on your HELOC, your credit score could rise because payment history accounts for 35% of your FICO score.
There is one important difference between the way a HELOC affects your credit score compared to the way other revolving credit lines (like credit cards) affect your score. The difference is in the way your credit utilization ratio is calculated. For standard revolving credit lines, keeping a low balance can improve your credit score, while a high balance can lower your credit score. But this is not the case with HELOCs. Because HELOCs are secured, using your home equity as collateral, the amount of the available balance that you use does not negatively impact your credit score.
What Are the Advantages and Downsides of HELOCs?
Before deciding if a home equity line of credit is a good fit for you, you should weigh the pros and cons of HELOCs.The benefits of HELOCs include:
• The ability to borrow only what you need when you need it.
• Lower interest rates than other revolving credit lines.
• Higher credit limits than other revolving credit lines.
The potential downsides of HELOCs include:
• Using your home to secure the loan. When you use your home as collateral for a loan, you risk losing to home to foreclosure if you are unable to repay the loan.
• Changes in adjustable interest rates, which can cause payments to increase with little-to-no warning.
Is a HELOC Right For You?
As with any loan, the decision to open a HELOC should be carefully considered. Being able to turn your home equity into cash can give you the financial freedom to invest in worthwhile ventures or cover expected bills.
Accepting a loan also means taking responsibility for repaying the loan principal plus interest. Before opening a HELOC, make sure you understand the repayment terms and have a plan in place to cover the projected installment payments.
If you decide that a HELOC is right for you, you can quickly and easily apply for a HELOC online through PNC Bank’s secure online portal.
The property securing the CHELOC must be located in a state where PNC offers home equity products. PNC does not offer the CHELOC product in Alaska, Hawaii, Louisiana, Mississippi, Nevada and South Dakota.