FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Home Equity Line Of Credit

Updated on March 19, 2024
Article byJyotsna Suthar
Edited byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Home Equity Line Of Credit (HELOC)?

A home equity line of credit is a type of mortgage an individual avails by keeping their house as collateral. Its prime purpose is to allow individuals to borrow as many times as a credit card but up to a certain limit. 

What is Home Equity Line of Credit

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Home Equity Line Of Credit (wallstreetmojo.com)

It is a revolving credit facility that allows individuals to borrow money as needed. Borrowers use it to finance large expenses like house renovation and education bills. However, banks can also seize houses if borrowers fail to repay. 

Key Takeaways

  • HELOCs are a type of the second mortgage that allow multiple withdrawals against houses (collateral). They are similar to credit cards involving a revolving credit facility. 
  • Borrowers can borrow 60-80% of the house equity for 30 years. Also, they need to keep 15-20% as house equity.
  • Debtors can withdraw against a draw period of 10-15 years. After the draw period, it is necessary to pay the balance amount. 
  • The borrower can lose their house if repayment fails within the stipulated time. 

How Does Home Equity Line Of Credit (HELOC) Work?

A home equity line of credit allows individuals to borrow multiple times, like a credit card, with timely payments. It allows homeowners to build equity over a period. They can use their homes as mortgages to secure a low-cost fund. It helps to fund expenses like paying off credit payments, larger purchases, cash for renovation, and emergency debts.

Here, the individual uses the home equity, i.e., the value difference between mortgage balance and house, as collateral for availing the home equity line of credit loan. Collateral is a valuable asset that creditors have a right on and can seize from the debtors if they fail to make loan repayments.

The working of HELOC is the same as the credit cards. It gives a revolving credit facility that allows applicants to borrow as many times at a certain limit. Lenders also willingly offer rates lower than personal loans, which are very competitive. In addition, most HELOCs give special checks or credit cards to borrowers.

It enables them to withdraw within a specified period from when they open their accounts. This timeframe is known as the draw period, which is between 10-15 years. During the draw period, borrowers can borrow but need to make timely payments. Once the draw period ends, the person cannot access money from the line of credit. 

After the draw period, the borrower has to pay off the balance loan amount (balloon payment) within a certain timeframe. Banks also refer to it as a repayment period which is usually 30 years. During the repayment phase, a person cannot borrow additional amounts.

Also, the borrower has to pay an interest rate on the balloon amount that is usually variable. Due to varying home equity line of credit rates, the payment will differ monthly.  On the failure of repayment, the borrower might also lose the house. However, the lender might not permit extra withdrawals if the house equity drops.

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

A home equity line of credit loan type includes traditional and hybrid credit. Let us look at them:

#1 – Traditional HELOCs

This type of HELOC is the same as described above. There is no fixed repayment of the loan amounts. Also, the interest is of a floating type that allows repayment of interest on the money withdrawn. The traditional home equity line of credit requirements allow owners to borrow only 65% of their home value. They need to have 15% to 20% equity in their house. 

#2 – Hybrid HELOCs

The fixed rate home equity line of credit enables borrowers to set a part of the loan as fixed. Simply put, they have the flexibility of a home equity and a fixed interest rate. It is a combination of a home equity loan and a traditional HELOC. Yet, some lenders allow borrowers to switch back to the variable rate. A hybrid HELOC allows individuals to borrow up to 80% of the house value. However, the lender might charge hidden fees in the fixed-rate home equity line of credit.

Example 

Let us look at the HELOC example to comprehend the concept better.

On July 23, 2022, the Federal Reserve announced a hike in interest rates by 0.75%. In addition, during a House Financial Services Committee, Jerome Powell, chairman of the United States Federal Reserve, stated how much consumers have to pay on loans.

It further stated how the home equity line of credit has increased from 2.25% to 2.5%, probably the fourth hike in the past five months. The current HELOC rate in the United States is 6.67%. However, in 2021, the average rate was between 5.29% to 5.96%. 

HELOC vs Home Equity Loan

While HELOC and home equity loans have collateral, they differ in many ways. For example, the former provides many withdrawals against home equity, whereas the latter provides only one-time access. In addition, the person can pay variably in the former, but the latter has fixed interest rates. However, home equity loans are a plus point during inflation compared to HELOCs. 

BasisHELOCHome Equity Loan
MeaningHELOC is a revolving credit facility against home equity.Home Equity Loans are loans borrowed by keeping a house as collateral.
WithdrawalsMultiple timesOnce
Lump sumSmall amounts in multiple intervalsFixed lump-sum amount
Interest rates4% to 6%6% to 8%
Nature of ratesBoth variable and fixedFixed
Interest-payment optionYesNo

Home Equity Line of Credit Pros And Cons

Availing loans easily lead to overspending and stretches the borrower’s budget. HELOCs have various advantages and disadvantages, as described below.

Pros

  1. Costs low than other loan types.
  2. Easy availability during unforeseen situations.
  3. Borrowers can avail of relatively larger cash amounts.
  4. Availability of tax saving potential on the usage of home funds.
  5. Saves interest rate on unused money.
  6. Drawing on credit line wherever required.

Cons

  1. Tempts borrowers to spend on nonessential goods and services.
  2. Home equity shrinks when borrowers use homes as collateral.
  3. Increases the risk of going ‘underwater’ for borrowers with higher CLTV (higher combined loan-to-value) if the real estate market dips.

Frequently Asked Questions (FAQs)

1. How to qualify for a home equity line of credit?

Following are the home equity line of credit requirements:
– Have a certain percentage of house equity 
– Maintain a good credit score (between 600-700)
– Provide sufficient documents 
– Have a low amount of debt
– Show a strong payment history.

2. Are home equity line of credit tax deductible?

Yes, HELOCs are tax deductible, provided the borrower uses the amount for home renovations and repairs. According to Internal Revenue Standards (IRS), individuals can claim only $750000 (or $350000 if married and filed separately). However, using HELOC for paying debts and education bills will attract taxes. 

3. How to increase home equity line of credit?

Borrowers can increase HELOC limits by applying for a loan modification. Or else going for a new HELOC by settling the current equity loan. 

4. How long does it take to get a home equity line of credit approved?

Lenders take 2-6 weeks (1.5 months) to approve a HELOC application. However, the process can speed up if the applicant supplies all the documents as early as possible. 

This article has been a guide to What is Home Equity Line of Credit. We explain how it works, its types, example, pros & cons, and compare it with home equity loans. You can learn more about it from the following articles –