How does a HELOC work?

October 19th, 2015 Kathy Blackford
HELOC MidWestOne

As a homeowner, it’s more than likely that you’ve heard the term HELOC before. A HELOC, which stands for home equity line of credit, gives you the ability to access the equity you have built in your home as a line of credit.

This can be beneficial for you because it can serve as a convenient and often inexpensive way to borrow money for things like home renovations, education costs, medical expenses and many others.

Let’s take a closer look at how a HELOC works and whether it might serve as a good option for you.

HELOCs are similar to credit cards

By and large, HELOCs work the same way as credit cards. With a credit card, the bank establishes your credit limit based on your income and credit score. You can spend as much or as little as you want as long as you stay under that limit. HELOCs work under that same principle, but your credit limit is based on how much equity you have in your home. The limit is typically set by subtracting the balance you owe on your mortgage by a percentage of the appraised value of the home (usually about 90 percent).

For example: Let’s say you purchased your home for $300,000 and now owe $250,000. Your home currently appraises at $400,000. If the lender uses a standard 90 percent guideline, you will receive a credit line of $110,000.

There are other similarities between HELOCs and credit cards:

  • You are approved for a total line of credit, but you only have to pay interest on the amount you actually use.
  • Just like your credit card, you are only obligated to pay back the amount you have used.
  • To access your HELOC you can use checks that are linked to your account or use your online banking to transfer money to your checking account.

Important things to remember

While HELOCs and credit cards share a large number of similarities there are a few key differentiators that are important to understand.

  • If you don’t repay your HELOC you could end up in foreclosure. That’s because a HELOC is secured by your home equity.
  • The interest paid on your HELOC is often tax deductible, so it’s possible to save money on taxes. As always, you should consult a tax professional to discuss your unique situation and the deductibility of interest on your HELOC.
  • HELOCs are subject to underwriting standards, which means you’ll need to provide more information than when you apply for a credit card. As a rule, you’ll need to document your income and employment status, just like you would be if you’re refinancing your home.

Pay attention to interest rates

HELOCs have variable interest rates that are often significantly lower than credit card interest rates. Determine what the index and margin are for your HELOC. You can find them in the HELOC note you signed when you closed on the line of credit. Many HELOCs use the prime rate as published in the Wall Street Journal for their index.

Because of the variability it’s important you know when and by how much your interest rate might change before you borrow money. Can you afford the monthly payments if they go up? How much of an increase in interest rates can your budget handle? Will the things you want to purchase with your HELOC money still be worth it at a higher interest rate?

These are important questions to consider before you move forward with securing a HELOC.

If you have more questions about HELOCs, please don’t hesitate to reach out to our team of bankers at your local MidWestOne location.

About the author

Kathy Blackford is Retail Managing Officer at MidWestOne Bank.

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