What you should know about a HELOC

March 9th, 2012 Jeff Burkhart

If you own a home, you may have heard of Home Equity Loans and Home Equity Lines of Credit (HELOC).

Because a home often is a family’s most valuable asset, many homeowners use home equity credit lines to finance major items, such as education, home improvements, or medical bills.

If you are in the market for credit, a home equity plan is one option that might be right for you. Before making a decision, however, you should carefully weigh the costs of a home equity line against the benefits. Shop around to ensure you are utilizing the best credit terms without posing undue financial risks. And remember, if you are unable to repay the amounts you’ve borrowed, plus interest, you could potentially lose your home.

What is a home equity loan?

A home equity loan is different from your original mortgage loan. It’s a loan in which the lender agrees to lend a maximum amount within an agreed period (called a term), where the collateral is the borrower’s equity in his/her home. Your equity is the amount you would receive after selling a property and paying off the mortgage.

A home equity loan provides a one-time advance and has a specific monthly payment with a specified repayment time frame. Flexible terms and competitive rates make this a convenient way to borrow money.

What is a HELOC?

HELOCs are similar to Home Equity Loans in that they use your “equity” in your home for you to use for many purposes. The difference with a HELOC is the way the loan works.

A HELOC has a maximum dollar amount that you are qualified for. This allows you to advance up to your qualified amount whenever you want. Many banks have both fixed rate and variable rate HELOCs. The payments are determined on how much you owe at the time of billing and there are even interest only HELOCs.

Advantages of HELOCs

One advantage of a HELOC is that you are able to pay down your loan, advance again, and pay down again as you have the funds to do so. This allows you to simply write a check to access your line of credit. Only borrow what you need, when you need it.

Some banks also offer fixed rate repayment options for HELOCs. This allows you to lock the rate, time period and payment of your loan.  The advantage of this is that you will have predictable monthly payments that stay the same for the life of your loan. Also, even though you lock in a certain amount, you still have the remaining amount on your HELOC available to you.

The Risks of a HELOC

Some financial institutions promote a feature on a HELOC that allows the minimum monthly payment need only cover interest costs. A loan amount of $30,000, for example, might only require a minimum payment of $200. This allows you to float the balance from month to month. This can create issues over the long run.  If you make only the minimum payment, you’ll never pay off any principal, and the loan will never go away.

Also – unless your rate is locked, interest rates on HELOCs are usually based on the prime rate, which tends to hover in the single-digit range. A HELOC’s loan rate is variable, however, and usually rises when the Federal Reserve increases rates to stem inflation. These increases can come quickly and may climb 2 percent or more.

Finally, your home may decrease in value while you’re borrowing more money. When it comes time to sell the house or refinance the loan, you may find that the equity that you had counted on has suddenly disappeared. Avoid this problem by making sure that the total amount of your home loans doesn’t equal more than 80 percent of the house’s market value.

About the author

Jeff Burkhart is Regional President at MidWestOne.

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