Is a Home Equity Line of Credit Right for You?

One of the significant benefits of buying a home or taking out a mortgage is this — as you pay down your home loan, you build up equity in the home. Equity is the market value of your home minus the amount you still owe on the mortgage.

For example, if you bought a $200,000 house and still owe $100,000 on the mortgage, you have $100,000 equity in the house. If you were to sell for $200,000, you could use part of the proceeds to pay off your mortgage and would get to keep the built-up equity.

Another advantage of having equity in your home is that you can borrow against it. One of the ways you can do this is with a home equity line of credit (HELOC).

If you need to take out a loan, a HELOC has several advantages over other types of loans, such as a cash-out refinance, personal loan or a credit card. Read on for the full details on a HELOC and how it differs from other loan options.

HELOC Definition: What Is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is a revolving credit account. It works in a way similar to a credit card. You have a maximum borrowing limit, which is based on the amount of equity you have in your home. You’re allowed to borrow up to that limit but don’t have to use the full amount. Whatever amount you borrow, you pay back with interest.

How Is the Amount of a HELOC Determined?

The amount you can take out with a HELOC depends on the current market value of your home and how much you have remaining on your mortgage. Lenders typically look at something called a combined loan to value (CLTV) ratio to determine how much you can borrow.

In the years before the housing crisis, it wasn’t uncommon to see people with HELOCs that had a combined loan to value ratio of 100 percent. For example, an individual who owed $150,000 on a $300,000, meaning they had $150,000 worth of equity in their homes, might have qualified for a HELOC worth up to $150,000.

Those days are gone, and lenders are much more cautious now. In 2015, the average CLTV on a HELOC was 61 percent.

Along with looking at the current value of your home and your equity in it, home equity line of credit requirements may include hitting a certain income and credit score to satisfy the lender that you can repay the loan. The better your score and the higher your income, the higher your credit line. Although CLTVs of 61 percent were the average in 2015, you might be able to borrow up to 85 percent of the equity of your home.

How a HELOC Works

Most HELOCs have a draw period, which is the time during which you can tap into the credit available. You can usually access the funds with a card, like a credit card, or by writing checks. The length of the draw period can vary but is often between five and 10 years. In some cases, you might be able to extend the draw period after it expires.

During the draw period, you might be able to make interest-only payments on the amount you’ve borrowed. You’re usually free to repay both the principal and the interest during that time. Once the draw period is up, it’s time to start repaying the loan in full. Some HELOCs require full payment ASAP while others let you repay the loan in monthly installments, usually over 10 or 20 years.

How to Calculate Home Equity

The first step to figuring out how much you can borrow using a HELOC is to determine how much equity you’ve built in your home. That means calculating the market value of your home, either by having it appraised by a professional or by using an online tool, which will give you an estimate.

You’ll then want to subtract the amount remaining on your mortgage from the current value of your home to find out the equity. Keep in mind that it’s possible to have negative equity in your home. If you borrowed more than the value of your house initially or if your home’s value dropped since you purchased, you might not qualify for a HELOC at the moment.

Remember that a lender is most likely not going to let you borrow the full amount of the equity you have in the home, as that’s too risky for all involved. How much of the equity your lender lets you borrow depends on your credit history but is usually going to be less than 85 percent of the value of the home minus what you still owe.

For example, your home is worth $250,000, and your lender agrees to let you borrow against 80 percent of that, or $200,000. You still owe $150,000 on your mortgage, so the maximum amount of your HELOC is going to be $50,000 — $200,000 – 150,000.

How much you can borrow through a HELOC depends not only on the amount of equity in your home but also the amount you can afford to borrow. Just because you have $50,000 worth of equity doesn’t mean you can afford to pull out that full amount over the draw period. It’s a good idea to take a close look at your budget to see if you have enough cash on hand each month to take on an extra payment.

Other factors that influence the size of your monthly payment include:

• Interest rate. The higher the interest, the more you’ll have to pay monthly.
• Loan term. The shorter the term, the higher your monthly payments but the less you’ll pay in interest overall. With a longer term, you’ll have lower payments but will end up paying more over time.

HELOC Calculator: How Is a HELOC Payment Calculated?

How a HELOC payment is calculated depends on how much you borrow, the terms of the loan and the interest rate. One thing is for sure, though. You only need to pay back, and you only need to pay interest on, the amount you draw from the line of credit.

So if you have a $50,000 line of credit but only take out $5,000 over the course of the draw period, you’re just responsible for repaying that $5,000 and won’t have to pay interest on the full $50,000. How you pay back the $5,000 depends on the specific terms you have with your lender. Some banks let you make interest-only payments while you’re in the draw period. Others expect you to make a minimum payment each month that you have a balance, which goes toward principal and interest.

Another thing to consider when calculating your HELOC payments is some loans require a balloon payment. With a balloon payment, you make interest-only payments during the draw period, then end up needing to make a lump sum payment at the end of the loan. If you can’t afford the hefty lump sum, you can risk losing your house.

Home Equity Line of Credit Pros and Cons: Pros of a HELOC

For the right person, a home equity line of credit offers some advantages. Take a look at the pros of a HELOC:

• Tax-deductible interest rate. You can deduct the amount of interest you pay on a HELOC from your tax return.
• Flexible principal. Since a HELOC is a revolving loan, you only end up borrowing the exact amount you need.
• Lower initial payments. During the draw period, you are usually only responsible for making payments on the interest.
• Lower initial interest rate. Since the interest rate on many HELOCs is variable, many offer a very low introductory rate.
• Fewer fees. You don’t pay closing costs on a HELOC as you do on a cash-out refinance.
• Some lenders let you convert to a fixed rate. After the draw period, your lender might allow you to switch from a variable interest rate to a fixed interest rate, which can save you money in the long run.

Cons of a HELOC

HELOCs aren’t without their drawbacks. When weighing the differences between refinancing, a home equity line of credit and other loan options, considering these disadvantages to getting a HELOC:

• Your payments could jump. A variable interest rate might mean lower payments at first, but if interest rates go up, so will your monthly payments.
• There’s the temptation to over-spend. Some people look at a HELOC like a piggy bank and end up getting into too much debt. If you don’t have a specific plan for the money, there is a chance you’ll fritter it away or spend more than you intended.
• Your lender can freeze the HELOC. If something happens to your home’s value, you lose your job or your income drops, your lender might freeze your HELOC. You won’t be able to access the equity in the home and might need to start repaying the principal right away.
• Your home is collateral. Your home acts a collateral on a HELOC. You can lose your home if you are unable to pay back the loan as agreed.

What Is Better: To Refinance or Get a Home Equity Line of Credit

Some homeowners might wonder if refinancing their current mortgage and using some of the money received after the loan is refinanced is the better option for them. When you refinance your mortgage, you take out a new home loan and use the principal of that loan to pay off your current mortgage. Often, refinancing saves you money in the long run, since you usually can get a better interest rate on your loan.

In the case of a cash-out refinance, you borrow more money than you owe on your current home loan. You’re then able to use some of the principal borrowed to pay off the existing mortgage and the rest for another purpose, such as a renovation project or paying for a child’s college education.

As with a HELOC, you need to have some equity built up in your home to qualify for a cash-out refinance. For example, you have $150,000 left on your mortgage and have $100,000 worth of equity in your home. You can apply for a new loan with a principal of $200,000, pay off the $150,000 owed on your current loan and use the remainder for your renovation project or another purpose.

Whether it makes more sense to refinance or open a home equity line of credit depends on your circumstances. If you have a high-interest rate on your first mortgage, for instance, then refinancing for an amount greater than what you owe on the house may be the better solution, if you can get a better interest rate or improved loan terms. But if you have a low-interest rate already and want to be able to draw from the equity as needed, a HELOC may be the answer. Here are a few questions to ask yourself to see which option is right for you.

• When will you need the money? If you need cash in a lump sum, such as to make a single, large payment, a cash-out refinance might be the better pick. If you’ll need access to the money over time, such as to pay various contractors or to pay for a few different projects, a HELOC might work better.
• What’s your appetite for risk? HELOCs often come with variable interest rates, which means you can get a really low rate at the beginning that can increase if rates go up. Refinanced mortgages usually have fixed interest rates. In fact, that’s their appeal for many homeowners You might not get as low of a rate with a fixed rate, but you’ll have the assurance it will stay the same for the life of the loan.
• How much money will you need to borrow? With a HELOC, you only repay and pay interest on the amount of the credit you use. With a refinance, you borrow a set amount and need to repay it all, with interest. If you’re not certain you’ll need a large amount of money, a HELOC might be the better pick.

What a HELOC Means for Your Taxes

One of the perks of having a mortgage is you can deduct the interest you pay on the loan from your income if you itemize your deductions. When you take out a HELOC, you are also able to deduct the interest from your income. Doing so can mean a lower tax bill.

There are limits on the size of the mortgage, though. The limits are based on how you plan on using the money from the HELOC.

For example, if you open a HELOC to make improvements to your home, the maximum loan amount you can deduct interest from is $1 million. That includes the amount of your first mortgage, if you’re still paying it, and the amount you end up paying interest on from your line of credit.

The amount of eligible interest is reduced if you aren’t using the funds to improve your home. For example, if you open a line of credit to pay for your child’s college, you’re only able to deduct the interest from the amount of the loan that’s under $100,000.

For example, if you receive a HELOC with a borrowing limit of $150,000 and use part of it to purchase a car and the rest to fund your child’s college education, interest on $100,000 of it is deductible. The interest on the remaining $50,000 is considered “personal interest.” Like the interest on your credit card or any personal loans, you can’t deduct it on your tax return.

HELOCs vs. Personal Loans or Credit Cards

Opening up a home equity line of credit often has several benefits over using a traditional credit card or personal loan to pay for home renovations or other big projects. Personal loans and credit cards are usually unsecured loans, meaning there’s no collateral behind them. For that reason, they typically have much higher interest rates than a HELOC, since the risk is higher for the lender. Also, you can’t deduct the interest you pay on a credit card or personal loan from your taxes.

Interested in a HELOC?

You can have your cake and eat it too with a home equity line of credit from PeoplesBank. Whether you want to fund a home improvement, dream vacation, or college tuition, we offer the ability to lock in your rate with the flexibility of a line of credit. Learn more about our current HELOC special today!