What is a HELOC? how does it work? Compared to a mortgage?

WARNING: I’m not licensed to offer mortgages nor a CPA. The following is just my opinion and should be taken with a grain of salt. Please seek professional advise before acting on any of the following.

What does HELOC mean?

The HELOC acronym stands for Home Equity Line Of Credit. It is often pronounced Hee•Lock.

As we understand, this is a way to get some money from your bank to use as required (Line of Credit) with the loan secured by your home (Home Equity as Collateral). In other words, the principal that you already paid on your home can be converted to a line of credit.

Why would I want that? What is an HELOC for?

A Line of Credit, especially when free or nearly free ($100/year or less,) is very practical as you can get money from it to get by in case of hard times or larger than normal expenses (i.e. your car was totaled and you need an immediate replacement.)

I have a line of credit which, if I use it at least once per year, is free (by using it, I have to pay some interests, but it is very small as I can borrow just $1 for 1 day.) This is always worth it in case your income slows down or in case you need some money that you do not currently have. As an entrepreneur, I often need a little cash to make do this or that month. It will generally be reimbursed within a month or two, but it would be much more difficult to not have the facility.

Now, remember that this money has a cost as interests are charged on the line of credit. Use it wisely.

Of course, you can use the money for whatever you’d like. Some people use their HELOC money to take a vacation. I do not recommend such frivolous use of your line of credit, but the bank won’t prevent you from using the money in whichever way you’d like once you were authorized to get the HELOC in the first place.

We know how the HELOC money gets used because banks ask how you are going to use the money. This is mainly for statistic purposes and from these statistics we know that most of the time the HELOC facility is used to pay for home improvements, repairs, and renovations. However, the money is also used to pay for college, cars, pay off credit cards (i.e. lower your interest rates by more than 20% sounds good, right?) or even take a vacation as mentioned above.

Interests

All Lines of Credit (LOC) that I know of have interests. These are generally higher than a mortgage but much better than a credit card (no doubt!) or even a standard line of credit without collateral.

To give you an idea, it is often 0.5% over a mortgage rate. Say the current mortgage rate is 3%, then a HELOC rate would be around 3.5%. Note that is not a rule or anything. The market dictates the rate. (The rate is actually bound to the prime rate, just like any type of credit from a bank is.) Note that it is often a good idea to shop around for the best rate. Different financial institutions will calculate their rates in different ways and one may be more advantageous to you than another. However, remember that a HELOC is likely long term (20 to 30 years total) and things tend to change over time, ever within one financial organization.

Contrary to a mortgage, the rate of a HELOC is not ever likely to be locked. In other words, it is likely to go up and down as rates change over time. The rate for your HELOC account will be adjusted on a per month basis.

So, I just said there are interests, this means that money is not free. This is still a loan and works as such.

As mentioned above, if you can pay off your HELOC without losing it, then your interests go to $0/month. A great benefit.

Points

Whenever you get a mortgage, you pay a fee to get the money. That fee is called points and it represents a percent of the total amount of the mortgage.

However, HELOC loans do not charge such an upfront fee. The financial institutions make their money because the interest rate is not fixed and over time is likely to go up. Actually, around the crash in 2008, many banks decided to stop offering HELOC because the interest rates were likely to change dramatically (And they did.) Some bank even canceled many existing HELOC accounts as they were viewed as not worth it (a liability—the bank would lose money—for a financial product that is supposed to be an asset.)

That being said, HELOC are back and it looks like a strong market. Banks have issued 4.8 million HELOC between 2012 and 2016 and they are expected to issue another 10 million by 2022.

Maximum Limit

Contrary to a usual loan, a line of credit does not force you to borrow any specific amount of money, however, you are always given a maximum amount.

Say your current home equity is around $50,000.  From that available collateral, your Home Equity Line Of Credit maximum limit may be set at $30,000. This means you can borrow between $0 and $30,000.

Good to Know: Borrowing the full amount and reaching your limit is a negative as far as your credit score is concerned. A good rule of thumb is to not go over about 80% of your credit. In our previous example, that would mean around $24,000. Note that applies to credit cards too.

Duration (Draw & Re-Payment Periods)

Contrary to a standard line of credit, a HELOC has a limited duration. Banks do that because these lines of credit have a very low interest rate compared to a standard line of credit so they have to be careful with such.

The duration will vary between banks and credit unions. Also there are two periods: the Draw Period and the Re-Payment Period, which I describe in more detail below.

Draw Period

In most cases the draw period is between 5 and 10 years (some banks will allow Draw Periods as long as 25 year. A very long Draw Period is rare though and likely comes with a balloon repayment, see below for details about that.) This means you can use your credit (borrow additional funds within your limit) for that period of time. After that period you either need a new HELOC or some other line of credit to borrow additional funds.

During the draw period, the minimum monthly re-payments are often limited to only the interests. Of course, you are not obligated to only paying interests. If you use your line of credit like a credit card, you can pay it in full as soon as you get a payment from a customer or your regular paycheck. This allows you to minimize the total amount of interests you have to pay. Just make sure the HELOC you get allows you to do that.

WARNING: A HELOC may close if you pay it in full or do not borrow anything quickly enough. In other words, you may need to keep $100 or such amount borrowed at all time to not lose the line of credit. Read your HELOC contract carefully to see what is possible and what is not.

Re-Payment Period

After the Draw Period comes the Re-Payment Period. At that point the bank forces you to pay back interests and principal each month. The amount will be like on a mortgage, an equal monthly amount which includes interests and principal (amortization.)

Once the Re-Payment Period starts, it is not possible to borrow more from your Home Equity Line Of Credit.

The duration of the Re-Payment Period varies depending on the bank. It can be as long as 20 or even 25 years. However, be careful, some HELOC require a payment in full at the end of the draw period (i.e. 0 years!) This is what is called a Balloon Loan. In most cases, investors use Balloon Loans when they purchase a Fixer-Upper, because they need the money to purchase and fix the property. Later when they sell the property, they get the loan money back and can repay the loan in full at that point. Without such a scheme, it is often very difficult to pay a Balloon Loan back. I strongly suggest you make sure you have the option for amortization with your HELOC if you are likely to carry a large line of credit until the Re-Payment Period.

Note that a HELOC does not ever prevents you from paying back faster than the scheduled amortization. Paying faster allows you to pay additional principal amounts quicker (i.e. when you make your normal payment Interest + Principal and then add Principal from the following month(s) to that payment.) As a result you avoid those full Interest + Principal payments, so you save by skipping some of the interests, which is a good idea at the start of the Re-Payment Period since that’s when your payment interests will be the highest.

Although it is a line of credit at first, once the amortization comes in place, it is likely to require you to make payments of the exact monthly amounts. Contact your financial institution to see what the amounts need to be when making additional payments to make sure they will be properly assigned to your principal.

When should I get my HELOC?

Many people work in a reactive manner. This is one reason why we were, at some point, forced to have an insurance for driving a car. If you try to get the insurance after you’ve got an accident, it’s not going to work.

To my point of view, your HELOC is going to be like an insurance. You want it when things are going good for you and not once you need the money. At the point you need the money is the point when you lost your job, need an expensive item such as a car or a truck… and you are likely to be refused the HELOC at that point since there would be no current income to pay it back.

So a good idea is to be prepared.

At the same time, waiting can be good too as it increases your equity and therefore the possible maximum limit of your HELOC. It will very much depend on how much you’d like to have in that line of credit.

Of course, there are people who spend any credit money they have access to, whether they really need it or not. If you are one of these people, skip on this step. Also, if the HELOC is not free or very small costs (under $100/year) then you may want to wait as long as you can before getting that line of credit.

What is the Tax Impact of an HELOC?

An interesting aspect of a home equity loan is that the interests are considered tax deductible as long as the larger part of the money was used for repairs of the house. You may be able to deduct some or all of your HELOC interests. Please check with your CPA to make sure what is possible or not.

What are the risks linked to an HELOC?

A HELOC is very similar to having a second or third loan on your house since your house is the loan collateral. If somehow you have difficulties repaying the HELOC, then you take the risk of having your bank foreclose on your home.

Since the bank carrying the HELOC will be the second or third loan, it will be in their interest to foreclose quickly on you. Going faster increases their chance of getting their money back since the first loan would otherwise have priority and if the house sells for less than what you owe total, that HELOC lender would lose their money altogether.

Note that your HELOC may be a recourse loan as well. This means that you may still need to repay it after a foreclosure if the sale of the house did not produce enough to cover the remaining balance on the HELOC. (Say you owe $30k and the sale of the house covered $20k of the HELOC balance, the remaining $10k balance will still be owed by you personally if you get a HELOC which is a recourse loan.)

So in other words, it weakens your position in terms of keeping your home since the HELOC lender is more likely to move forward with a foreclosure. So keep that in mind before you move forward with an HELOC.

Why not just take a mortgage?

Actually, it will very much depend on your situation. You should check with a professional CPA to make sure what’s best for you.

However, the basic idea is that with the HELOC, you can choose to borrow the full line of credit or limit yourself to a much smaller amount.

One potential problem when you do some renovation is a quote that’s off and it’s often the case. Yet, you get the mortgage for an amount equivalent to the quote. Say the quote is for $50,000 to renovate your entire kitchen area and remove a wall. So you get a loan for $50,000. The contractors work on your kitchen and one of three possibilities happen:

  1. The work costs less, quite a bit less, say $40,000. You still have to repay a $50,000 loan with corresponding interests (although you should be able to use the $10,000 to repay much principal early.)
  2. The work costs approximately the same. Best situation! This rarely happens, though.
  3. The work costs more. Hopefully you have some savings to cover the extras…

With the HELOC, you can look into getting a line of credit which is, to follow our example above, about $20k over the quote: so $70,000. If case (1) occurs, you never withdrew the extra $10k. If case (3) occurs, you can borrow some more without renegotiating a new loan. So there are a few advantages.

There is another possible advantage, although there are many different types of loans and some mortgages will offer similar repayment options. However, a HELOC generally only charges you interests on what you borrowed so far. So say you have to pay the company $15,000/mo. You only owe the interests on that $15,000 on the month after your first payment. With a mortgage, your repayments start on the first month, whether the work started and/or whether you paid the contractors anything.

Also as mentioned above, an HELOC is a Line of Credit so in most cases you can reimburse any amount any time. If you finally get that $200 back that your friend borrowed last year, you can immediately put it on your account. The interests on those $200 will stop accumulating immediately. You just can’t do that with a regular mortgage (I’ve never heard of such, at least.)

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