What exactly is a HELOC?
HELOC stands for Home Equity Line of Credit. It’s a credit line offered by a bank with the borrower’s property equity serving as collateral for the loan. The equity is the difference between the market value of the property and the amount still owed on mortgages or other encumbrances.
For example, if you owe $70,000 on your house and the market value is $250,000, your equity value is $180,000. On the basis of this equity the lender is normally willing to offer a HELOC that the borrower can draw against for five to ten years, with a repayment period of up to twenty-five years.
Should HELOC be considered a type of credit card or a loan?
A HELOC is essentially a hybrid between a credit card and a second. Like a credit card, the lender allows you to spend up to a certain limit (i.e., the amount of the equity) and you only have to pay according to the amount of credit used. Each time credit is taken up the amount of credit available declines, but it increases again with repayments. However, unlike a credit card the HELOC is a secured debt.
The pledging of real estate as security makes a HELOC similar to a second mortgage, but there is a key difference. When a second mortgage is obtained, the lender gives the borrower the entire loan amount in a lump sum, but with a HELOC the loan is taken out on an installment basis according to the borrower’s needs.
What are the advantages of a HELOC compared to other kinds of loans?
The chief advantage of a HELOC is its suitability for infrequent but major expenses in a household budget. Common examples include financing a home addition, and paying for a child’s college tuition or wedding expenses. With the current, low prime interest rates HELOCs can provide inexpensive financing. Another significant advantage is the fact that borrowers may quality for tax deductions on HELOC repayments.
For some borrowers, the HELOC can provide an economical means of debt consolidation. You might find it significantly cheaper to pay the interest on the HELOC rather than to continue paying several lenders their interest charges, administrative costs and delayed payment penalties.
Disadvantages of taking out a HELOC
The attractiveness of taking out a HELOC in certain circumstances needs to be balanced against the risks. If the HELOC carries a variable interest rate, Borrowers should be aware that interest rates can change to their disadvantage. Furthermore, if they fail to make repayments, they may ultimately lose their homes.
If you decide to use a HELOC to consolidate debts, remember that it is common for banks to charge closing fees for paying off their loans and this expense should be taken into account when calculating your expected savings. With some HELOCs personal liability for any deficiency remains even after the bank has foreclosed on the secured home. Another risk is that banks have the right to terminate an unused credit line if a decline in property value reduces the borrower’s equity.