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Explaining HELOCs

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A home equity line of credit (HELOC) is a type of loan in which the borrower can draw on a line of credit rather than receiving a lump sum as with standard mortgage refinancing. Many homeowners use a home equity line for major items such as home remodeling or renovations, college educations or to pay off multiple debts rather than using it for small daily expenses.

HELOC Characteristics

The majorities of HELOCs are second mortgages or used to refinance a first mortgage. It can save the homeowner money in the short-term, but HELOCs also carry a risk. HELOCs work by the borrowing applying for an amount up to the value of his home. For example, on a standard mortgage, he may borrow $175,000 which he would receive as a fixed dollar amount in one lump sum upon approval. However, with a home equity line, the borrower would receive a line of credit for up to $175,000 on which he can draw as needed in any amount necessary. This is especially beneficial for homeowners that use it to do home repairs with multiple contractors to pay. The homeowner accesses his funds through specialized checks or with a credit card linked to his home equity line of credit.

HELOC Repayment Terms

Most HELOCs are given a statute of draw term, or a draw period, in which he has access to the line of credit. This is usually negotiable with the lender depending on how the funds are used. HELOCs have a draw period and then a repayment period after the draw term has expired. Typical draw periods last between five and ten years, during this time the homeowner pays on the interest only. The repayment period of a home equity line is generally between ten and twenty years depending on how much of the line of credit was used. The monthly repayment due is based on how much is owed divided by the amount of months in the repayment period. There are some HELOCs that demand the total balance owed to be paid at the end of the draw period, most homeowners with this type of home equity line refinance with a standard mortgage at this point in the amount of the full balance.

HELOC Benefits

A home equity line can be advantageous for intermittent payments such as paying college tuition, remodeling the home or paying off credit cards. Another benefit is with a HELOC, interest is only based on the funds that are drawn, not on the total amount approved. The upfront costs of a home equity line are relatively low. On a $175,000 HELOC, the settlement costs may be anywhere from $3,000-$7,000. However, if the borrower is paying a higher than normal interest rate, the settlement costs may be covered in part or in whole by the lender. There are some HELOCs that can also be converted into a fixed rate mortgage at the end of the draw period, saving the homeowner from needing to deal with mortgage refinancing again.

HELOC Risks

HELOCs are not without their risks, however. The biggest downside with a HELOC is the vulnerability to interest rate risk. Every HELOC is an adjustable rate mortgage (ARM), but the ARM of a HELOC is much riskier than the ARM on a standard mortgage. HELOCs are impacted by the change in market instantly rather than having a fixed rate period with a standard ARM mortgage.

A homeowner should look at all available options to see which one is best for his or her situation before pursuing a HELOC, while there are many benefits – remember that there are also risks that should be taken into careful consideration.