How Does a HELOC Work? Part 1
What is a Home Equity Line of Credit (HELOC)?
A home equity line of credit, or HELOC, is a revolving line of credit that is guaranteed by the equity in your home. The line of credit gives you access to a revolving credit line you can borrow for home improvements, unexpected expenses or to consolidate debt.
The amount you borrow is based on the equity in your home, which is equal to the value of the home minus the amount you owe on your mortgage. If your home is paid off, then the HELOC becomes the first position mortgage on your home.
How Much Can You Borrow?
Typically, most lenders will allow you to borrow between 75% and 90% of the equity you currently have in your home. This amount is based on a few factors, including your credit history, your income, and the lender you’re working with.
For example, let's assume your home appraises for $400,000 and your current mortgage balance is $150,000. In addition, the lender determines you can use 80% of your available equity based on your income, credit history, and other financial factors.
Now simply take 80% of the appraised $400,000 value, which is $320,000, and subtract the current mortgage balance of $150,000 from that amount. This results in a $170,000 line of credit.
The Phases of HELOCs
HELOCs are divided into two separate phases: the draw period and the repayment period. The draw period is the amount of time you have to draw against your line of credit without making principal payments. This time frame varies from lender to lender, but typically lasts between 5 and 10 years.
During the draw period you are required to make interest-only payments. However, you have the option to make extra payments towards the principal, if you choose.
The repayment period is when you are required to pay back both the principal and interest to satisfy the balance on the loan. Typically, the repayment period is set by your lender and can last anywhere between 10 and 20 years. During the repayment period, the ability to draw from your line of credit stops and you make fixed payments every month.
For example, a 25-year HELOC may have a draw period of 10 years followed by a repayment period of 15 years.
Payments on a HELOC
During the draw period, the HELOC will have a minimum payment due each month, similar to a credit card minimum payment.
At any time during the draw period, you may pay down the principal or fully pay off the HELOC. Unlike an installment loan, the line of credit can instantly be used again and again after paying down or completely paying off the principal.
During the repayment period, the payments for the HELOC are set up to pay down the entire principal plus interest during a given timeframe. This is similar to an installment loan that has fixed payments each month.
Some lenders will allow the borrower to pay less during the repayment period and then require a larger balloon payment at the end of the loan.
Definition: A balloon payment is a large lump sum payment due at the end of the loan. The reason for the large lump sum payment is due to the borrower choosing to pay less during the repayment period, thus requiring a large “balloon payment” at the end to satisfy the loan.
Before closing on your HELOC, make time to understand the repayment terms and ask if the repayment period has a balloon at the end.
Check out the other posts in the How Does a HELOC Work? blog series!
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.