Cable channels like HGTV and DIY Network are filled with TV shows about home renovation projects that document the ins and outs of bringing old, dilapidated properties back into the current century. “Love it or List it,” “Rehab Addict,” “Yard Crashers” and “Design on a Dime” are just a few examples.
It’s hard to watch these shows and not feel the urge to head to your local home improvement store and embark on your own DIY project. If you are a homeowner and you’ve got a major home improvement project on your to-do list this summer, a Home Equity Line of Credit or HELOC may be a great financing option for you – especially as the real estate market continues to stabilize.
Let’s take a closer look at how a HELOC works and whether it might serve as a good option for you:
What is a HELOC?
By and large, HELOCs work the same way as credit cards. One difference is that your home will be used for collateral. 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 also takes into consideration how much equity you have in your home.
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 along with interest and any fees that may apply.
- To access your HELOC, you can use checks that are linked to your loan or use your online banking to transfer money to your checking account.
How can I determine how much equity I have in my home?
Your HELOC borrowing limit is typically set by subtracting the balance you owe on your mortgage from a percentage of the appraised value of your home (usually about 90 percent). The lender will also consider how much you want to borrow and your ability to repay the loan.
For example: Let’s say you purchased your home for $300,000 and now owe $250,000 on your mortgage. Your home currently appraises at $400,000. If the lender uses a standard 90 percent guideline, you could receive a credit line of $110,000.
If you’re considering if a HELOC is right for you, get an estimate of the cost of the home improvement project. Then compare this to the estimated equity in your home to see if a home equity line of credit makes sense as a financing option.
If the equity in your home isn’t sufficient, you may want to consider other financing options such as a credit card, personal loan or a line of credit that does not rely on home equity. These may be a good choice for smaller projects.
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 without going through the application and approval process each time. You only advance what you need, when you need it, up to your approved credit limit.
Some banks – like MidWestOne – also offer fixed rate repayment options for HELOCs. This allows you to lock the interest rate, repayment period and payment amount on the amount you advance. The advantage of this is that you will have predictable monthly payments that stay the same for the repayment period you choose. As you repay on the fixed amount, the principal portion of your payments is added back to your available credit limit. Also, even though you lock in a certain amount, you can still make advances on the remaining line of credit up to your approved limit.
While HELOCs come with many benefits, there are some risks to be aware of.
Unless your HELOC has a rate lock option, HELOC rates are variable and based on the prime rate or other publicly available index, plus a margin. This means a HELOC’s interest rate usually rises when the Federal Reserve increases rates to stem inflation making your monthly payment amount increase. These increases can come quickly when rates are rising.
Finally, your home may decrease in value while you’re borrowing more money. When it comes time to sell the house or you want to refinance your loans, you may find that the equity that you had counted on has disappeared. To help avoid this problem, make sure that the total amount of your home loans doesn’t equal more than 80 percent of the house’s market value.
Getting behind on payments can lower your credit score. Worse yet, failure to repay the amounts you’ve borrowed, plus interest, could mean the loss of your home.