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HELOCs are a popular and commonly used product because they give homeowners access to immediate funds that can be used for flexible means.



How a HELOC Works

November 30, 2018
By Comerica Bank

Homeownership is a big step for any consumer. This is not only because it often means applying for and securing a mortgage, but also because a home itself is a valuable asset. Homeowners can even leverage their homes to get additional financing, most often in the form of a home equity line of credit (HELOC).

HELOCs are a popular and commonly used product because they give homeowners access to immediate funds that can be used for flexible means. While there are conditions to borrowing and certain advantages and disadvantages to HELOCs that homeowners must be aware of, such tools can provide quick financial help when needed. 

How does a HELOC work?

A home equity line of credit works much like a credit card. HELOCs are distinguished from home equity loans in that the latter is a lump sum loan, while a HELOC is a line of credit homeowners can draw funds from. There are similarities and differences with a credit card. For instance, homeowners have a limit they can borrow up to, make monthly payments on the balance they use and can use cash from the credit line to pay for various personal needs. However, billing rights and other specifics differ.

HELOCs are sometimes referred to as a second mortgage. This is because the amount of credit extended through a HELOC may be subordinate/junior to the original mortgage loan and the equity a consumer holds in their home. HELCOs tied to a first mortgage also exist, but are less common.

One point of note for consumers is that interest is paid on the outstanding balance (funds borrowed) of a home equity line of credit. Comparably, taking out a home equity loan would require paying interest on the entire dispersal.

How much can I get from a HELOC?

The amount a lender will grant through a HELOC depends on a number of factors. In general, these criteria relate to how responsible applicants are as consumers and as homeowners. These vetting points include:

  • Credit score, overall creditworthiness and debt-to-income ratio.

  • History of employment, income and repayment.

  • Level of equity held in the home.

  • Appraised value of the residence.

  • Outstanding liens made against the property

If qualified and approved for a HELOC, consumers will often get an offer from their lender that falls in line with general standards for HELOC lending. That is, the amount of credit extended often totals up to 80 percent of the home's value minus the outstanding debt left on the first mortgage.

For instance, if your home is valued at $450,000 and you have $250,000 still to pay on your original mortgage, a probable HELOC figure to expect would be $110,000. Once everything is settled, your bank will give you a way to access the funds, often through checks or some other common payment form. Be aware, too, that there may be state minimums for each amount you draw on the line, like $4,000 in Texas.

What about HELOC interest rates and repayment?

HELOCs resemble credit cards in other ways, like having variable interest rates. This means the rate at which you pay interest will fluctuate with the prime rate. Although other factors will affect your interest rate — including your credit history — it's imperative to understand that HELOC interest rates are variable and are not fixed even if your original first mortgage may have a fixed rate.

It is important to note that some banks also offer a fixed rate option within their HELOC product. A borrower can lock in a portion of their outstanding balance for a fixed rate and fixed term. The monthly payment would be based on a principal and interest component. Keep in mind that this is still within the HELOC so it will be only one loan account.

There are also various repayment terms that homeowners must be apprised of. These conditions will vary with each lender, but in general HELOCs are structured with draw periods lasting 5, 10, 20 or 30 years (for example). The outstanding balance (including both principal and interest) must be settled by either pay-off date or the selling of the home in question. Many HELOC agreements require homeowners to make a minimum of interest-only payments, so as to ensure homeowner cash flow is preserved. 

Talking over the exact repayment terms (like if there's a pre-payment penalty) is key to understanding how a HELOC works and what you can expect when opening an account.

What can I use a HELOC for?

The appeal of a home equity line of credit is that homeowners can use HELOC funds for expenses not related to a home. While you can draw from your line of credit for reasons like home improvements and renovations (more on this later), you can just as well borrow from a HELOC to pay credit card balances, tuition costs, insurance premiums, big-ticket purchases (like appliances) and other investments or outstanding debts. 

It's important to not treat a HELOC like the credit card it resembles. "Maxing out" a HELOC can result in negative equity and foreclosure on your home. Real estate prices are also fluid, and excessive borrowing against a HELOC may leave a homeowner owing more on the residence than it is worth, which happened to some homeowners during the Great Recession. When opening a HELOC, always have a defined plan in mind for how you're going to use the line of credit and repay it, which helps build discipline.

Is interest paid on a HELOC tax-deductible?

Another reason to only use HELOC funds for core personal expenses is that interest paid isn't always tax-deductible. According to the IRS, as a result of the reforms enacted by the Tax Cuts and Jobs Act of 2017 (TCJA), interest paid on HELOCs cannot be claimed on taxes unless funds were "used to buy, build or substantially improve the taxpayer's home that secures the loan." Under previous tax law, homeowners could deduct interest on HELOC debt of up to $100,000. While that maximum allowable amount was not changed with the TCJA, the distinction that interest can only be deducted if the credit line is utilized for home-related expenses is a significant one that affects the tax planning of many homes. Comerica does not provide tax advice, so please contact your advisor.

Home equity lines of credit can be leveraged by homeowners in a number of scenarios. However, responsible use is also a must. Talking through your HELOC offer, agreement and reasons for use with a trusted financial partner is a step any interested homeowner should take. Reach out to Comerica Bank today for more information on the benefits of a HELOC and what terms and rates you may qualify for.

 

This information is provided for general awareness purposes only and is not intended to be relied upon as legal or compliance advice. 

This article is provided for informational purposes only. While the information contained within has been compiled from source[s] which are believed to be reliable and accurate, Comerica Bank does not guarantee its accuracy. Consequently, it should not be considered a comprehensive statement on any matter nor be relied upon as such.