A Home Equity Line of Credit is a type of home loan that allows a borrower to open up a line of credit using their home as collateral.
With a HELOC, the homeowner may borrow up to a pre-determined amount set by the mortgage lender
In other words, a HELOC is a lot like a credit card because of its revolving nature. When you open a credit card, the bank sets a certain limit, say $10,000. You don’t need to pay interest on the total amount, or even withdraw or spend any of the $10,000, but it is available if and when you need it.
That’s also how a HELOC works. Your bank or lender will give you a line of credit for a certain amount, say $100,000. And you can draw upon it as much as you’d like, up to that $100,000, if and when you want.
it gives a borrower the option to use the line of credit if they need it, without having to pay interest if they don’t.
Term of a Home Equity Line of Credit
A HELOC normally has a 25 year term, with a draw period and a repayment period. The draw is typically the first 5 to 10 years, followed by the repayment period of 10 to 20 years. During the draw period, the homeowner can borrow as much as they’d like within the line amount, and can make interest-only payments on the amount drawn upon.
Interest Rate of a Home Equity Line of Credit
The HELOC interest rate is determined by the average daily balance and the prime rate plus the margin designated by the bank or lender. Most banks and lenders give borrowers prime rate with zero margin, or even less than prime.
After the draw period, the borrower must pay off the principal of the HELOC, along with the interest. This period is known as the repayment period. Usually the loan balance is broken down into monthly payments, but there could also be a balloon payment because of the way the loan amortizes. Also note that some HELOCs don’t have a repayment period, so full payment is due at the end of the draw period.
Home Equity Line of Credit vs. Home Equity Loan
With a conventional home equity loan, you receive a lump sum and make monthly mortgage payments on the total amount borrowed, usually at a fixed rate. A HELOC, on the other hand, not only gives the borrower the freedom to decide when and if to use the money, but also how much they need to pay back and when.
The main reason to avoid a HELOC
The main reason being that a HELOC is an adjustable-rate mortgage, tied to prime. Whenever the Fed moves the prime rate, the rate on your HELOC will change. So your interest rate can fluctuate greatly, even if the fed moves prime in so-called “measured” amounts.
HELOCs don’t have periodic interest rate caps like standard adjustable-rate mortgages, just lifetime caps, so the rate can fluctuate.