How Does A Home Equity Line Of Credit (HELOC) Work?
A home equity line of credit works very much like a credit card and all of them work the same way. The only differences are that a home equity line of credit is attached (recorded) to the equity in your home; it has a much higher credit limit, and the interest you pay is typically tax deductible. You will need to check with your certified public accountant (CPA) on the tax deductible aspects of a home equity line of credit because they can vary from person to person and home to home. All home equity lines of credit are adjustable rate mortgages. They are usually tied to the prime lending rate which means when the prime lending rate moves so does the interest rate on your line of credit. The interest rate the lender will charge you can depend on your credit rating, the equity in your home and the size of the loan you are applying for. The interest rates don’t change by much and for the most part the interest rate you receive will be prime rate or prime plus or minus 0.50% to 1.5%. Home equity lines of credit are usually free (no closing costs) to obtain but do have an annual maintenance fee of about $50.
Home equity lines of credit vary slightly in term. They usually have a 15- or 30-year term with a draw period of either five or ten years respectively. The draw period is the timeframe in which you can use the line of credit like a credit card. During the draw period the lender will only charge you interest on the balance that you owe on the line of credit. You can always over pay to reduce the balance. At the end of the draw period the lender will take the balance you owe on the line and amortize the balance over the remaining term of the loan.
Let’s look at how this works. For this example let’s assume that the prime lending rate is 7.75%. The lender has approved your loan and given you a line of credit of $100,000 for a 30-year term. With a 30-year term the draw period would be 10 years. If you took a 15-year term the draw period would be five years. The interest rate you receive on this loan is prime rate, or 7.75%. When you open the line of credit you took no draw on the line, which means you owe nothing. You have not used any of the money made available to you so you have access anytime you want over the 10-year draw period to the whole $100,000 that was made available to you. Your payment at this time would be zero.
Let’s say a month goes buy and you need $8,000 to remodel your bathroom. The lender will supply you with a checking account that is attached to the line of credit. At this point you simply write a check from this account for the $8,000. Now your balance on the line of credit is $8,000, and you have a beautiful new bathroom. The lender will start to charge you interest on that money. Your minimum payment at this time would be $8,000 times 7.75% divided by 12 (months) equals $51.67 per month. This is an interest only payment. If you make this payment the balance of $8,000 would remain the same. Now let’s say you got a large, unexpected bonus at work and decided to pay off the $8,000. The loan balance would be paid off but the line of credit is still available to you for the remainder of the 10-year draw period. The only way to close this loan is to request that it be closed. The line would also be closed if you sold the home. You can not take the line of credit with you. You would have to apply for a new line on your new home.
During the 10-year draw period you’ve used the account, paid it off and used it again. Now let’s say that at the end of the 10-year draw period you still owe $60,000 on the line of credit. Understand that the draw period is now over and you can no longer write checks on the account even though you have not used the whole line of credit. The lender would at this time take the $60,000 you owe and calculate a fully amortized payment that would pay off the loan over the remaining 20 years. Your payment would be, assuming that the prime lending rate was the same, $492.57 a month. Realize that the loan is still adjustable and the payment will change if the prime lending rate changes. Some home equity lines of credit have three-year prepayment penalties. This does not mean that you will be assessed a penalty for paying off the balance on the line of credit. They will only charge you the prepayment penalty if you decide to close the line of credit all together within the first three years. The prepayment penalty is usually small – typically only around $400. Not much at all.