What is a Home Equity Line of Credit and How Does It Work?

Being a homeowner is a major accomplishment in life. Your home is likely the biggest purchase you'll ever make, and you deserve to be rewarded for your hard work and perseverance in owning a home. A Home Equity Line of Credit is a perfect opportunity for you to maximize your home's value and achieve long-awaited goals.

What is a Home Equity Line of Credit?

A Home Equity Line of Credit, commonly called a HELOC, is a line of credit where your home serves as your collateral for the funds. In other words, you'll be allowed to borrow a certain amount of money from your borrower as determined by the portion of your home that you own, or your equity. The home serving as collateral for this line of credit means that the financial institution can take your home if you're unable to pay the funds back.

A HELOC is a line of credit, meaning it operates similarly to a credit card. You'll pay back the money you borrow (as well as interest), and in doing so, the funds will return and become available to you once again. HELOCs are often an attractive option as you don't need to borrow the funds all at one time, like you would with a traditional loan.

How Does a HELOC Work?

The exact amount of your HELOC will be determined by the equity you've built up in your home and your lender. You can determine your home's equity by taking your home's current market value (what it's worth) and subtracting that from the amount you still owe in your mortgage to your home.

Let's look at how to calculate your home equity. Say your home's current value is $350,000 and you still owe $150,000 towards your mortgage. You would subtract these two values, leading to you having $200,000 equity in your home. From here, your lender will allow you to borrow a percentage of that home equity.

HELOCs also come with a draw period, which is the amount of time when you're allowed to borrow funds. Draw periods are determined by your borrower and are generally set for a few years' time. During this draw period, you'll just make payments on the amount of money you borrow. Additionally, any interest applied will only be tied to what you borrow, as opposed to your full credit line.

Am I A Good Candidate for a HELOC?

There could be several reasons why you would want to explore applying for a HELOC. You may be a good candidate if:

• You've built up enough equity in your home. Many lenders will recommend a 15-20% stake of equity in your home to apply for a HELOC.
• You have a strong credit score. Many lenders would want to see a score that is close to 700.
• You have a manageable debt-to-income ratio. This is the ratio of your gross monthly income that goes towards your monthly debts, like your mortgage or rent, any car payments, credit card bills, etc. Lenders will often want to see a debt-to-income ratio that is around 40% or lower.

While not as firm a requirement as the ones listed above, it also helps if you have a defined, clear purpose for using your HELOC. You shouldn't just tap into your home's equity simply because it's there or you're seeking another line of credit.

Ways to Use a HELOC

Fortunately, there are a variety of ways in which you can use a HELOC. It's truly a smart way to realize long-awaited goals, complete bucket list items, or maximize your rewards as a homeowner.

With a HELOC, you can:

• Complete home renovations and improvement projects.
• Consolidate your debt and simplify your monthly payments.
• Go on a long-awaited family or dream vacation.
• Fund a major purchase or investment, like returning to school or starting a business.

Pros of a HELOC

Just like there are a variety of ways you can use a HELOC, there are also several benefits that come with making the most of your home equity. Some of these benefits include:

• A lower interest rate—HELOCs often come with lower interest rates compared to credit cards, a personal loan, or other forms of lending. This is generally because the investment is less risky, as the line of credit is secured by your home.
• Flexibility—you don’t need to borrow the funds available to you all at one time. Instead, you can borrow only the funds you need, as you need them.
• Potential tax deductions—if you’re using your HELOC for home renovations and projects, you may be eligible for tax deductions on the interest you collect.

Cons of a HELOC

While HELOCs are a great option when it comes to consolidating debt or accomplishing home improvements, they aren't without their drawbacks. It's crucial to review your finances and truly understand everything you're taking on.

Some of the drawbacks of a HELOC include:

• A variable interest rate, meaning that the interest rate will change over the course of your draw period. This impacts how much interest you pay and could mean a monthly payment that changes. Review the product you apply for carefully, as not every line of credit will have a variable interest rate.
• With a HELOC, your house serves as the collateral, or the security for your line of credit. This means your house is on the line and dependent upon you borrowing responsibly and making the payments each month.
• You may also need to pay some additional fees with a HELOC. This could include an origination fee for opening your account, as well as an annual fee to keep the line open over the course of its draw period.

HELOCs with American Heritage Credit Union

We're proud to offer several Home Equity Line of Credit options to our members. Our Platinum Fixed-Rate Home Equity Line of Credit is unique, in that it offers all the benefits of a HELOC combined with a fixed rate. You'll enjoy peace of mind knowing you will have fixed monthly payments.

With all of our HELOC products, you can borrow up to 95% of your home's value, with credit lines ranging from $5,000 to $1.5 million. Learn more about our HELOC products here.