What’s a HELOC and How does it Work?

What’s a HELOC and How does it Work?

A HELOC, or Home Equity Line of Credit is a line of credit secured by your home.  For example, if you have a HELOC with a $50k limit, and you use $10k, then you have $40k remaining. If you pay off the $10k, then you are back to the beginning with $50k being available to you.  This feature makes it re-advanceable. 

Pro’s:

  • Quick and Easy access to money: The HELOC can be in the form of overdraft, checking account, or even made through Visa card access.  They funds can be used for anything you like.
  • Interest rate is usually much lower than unsecured, but typically a touch higher than a traditional first Mortgage.
  • In many cases, the HELOC interest can be tax deductible.  Check with your accountant to be sure.


Cons:

  • In some cases, there’s a pre-determined pay off required.  I.e. 5yrs, 10yrs, etc. This can be problematic in the future if you cannot refinance.
  • Quick and MUCH too Easy access to money: If you aren’t disciplined with your money, it can lead to a never ending debt trap
  • HELOC’s are typically tied to the bank’s prime rate.  So when rates go up, so do these. If you keep a high balance, that could eat in to your cash flow.

How is the limit determined?

What it comes down to are two main things:

  1. What is the current appraised value of your home.
  2. The total amount owing on your home.

Let’s assume your home is worth $400,000 (Based on a current appraisal) and you owe a grand total of $150,000 on it (via a first mortgage). I will further assume you do not have a current HELOC or second mortgage.

Assuming you pass credit and income verification, your lender can typically lend up to 80% of your homes’ appraised value, minus your pre-existing mortgage balances.  In some circumstances the lender might go higher than 80%, but in those cases, the interest rate might be affected.

Using this calculation, $400,000 * 80% is $320,000. Subtract what you owe (150k) and you’re left with $170,000 of a POTENTIAL limit on a HELOC (subject to passing credit checks, income verification, etc).

Do I need good credit?

Not necessarily.  If you are seeking the very best rates out there, you’ll want to have a credit score well in to the 700’s.  You’ll also need to have enough verifiably income to easily afford the payments.  Anything less and at best, you’ll simply be offered a higher rate.

Rick Orford