What is a HELOC?
A home equity line of credit, or HELOC, is a loan that uses the value of your home as collateral. The loan is approved as a line of credit, meaning you can borrow up to a certain amount and only pay interest on the amount you borrow. The interest rate is usually variable, meaning it can change over time.
HELOCs can be used for a variety of purposes, including home improvement projects, debt consolidation, or major purchases. Because the loan is secured by your home equity, it can often be obtained at a lower interest rate than an unsecured loan.
What are the Benefits of a HELOC?
HELOCs can be a good option for people who need to borrow money for a specific purpose, such as home improvements or consolidating debt. They can also be a good choice if you don’t have the cash on hand to pay for the expense and you don’t want to take out a traditional loan.
HELOCs can be a great way to finance home improvements or other major expenses. Because the loan is secured by your home’s value, HELOCs usually have lower interest rates than unsecured loans. And, since you only pay interest on the amount you borrow, HELOCs can be more affordable than traditional loans.
Types of HELOC
There are two main types of home equity lines of credit: one that’s combined with a mortgage, and one that’s a stand-alone product.
Combined HELOC with a Mortgage
Sometimes called a readvanceable mortgage, this type of revolving HELOC is tied to your fixed-term mortgage. It works similarly to a traditional mortgage, except you can draw on the line of credit at will and only pay interest on the amount you use while maintaining your regular mortgage payments.
A home equity line of credit (HELOC) that’s combined with a mortgage can be used to finance a maximum of 65% of the market value of your property.
Your HELOC’s credit limit will also rise as you pay down the principal on your mortgage, as shown in Figure 1. The part of your home that you’ve paid off through down payment and regular payments of principle is called equity. As your equity rises, so does the amount you may borrow with a home equity line of credit.
Figure 1: Home equity line of credit combined with a mortgage
Figure 1 – Source: Home Equity Lines of Credit, Financial Consumer Agency of Canada
You can see that your home equity line of credit didn’t increase in Year 25. This is because you had already reached the maximum credit limit for your home equity line of credit in Year 24.
Combined HELOC Sub-Accounts
A HELOC combined with a mortgage can include other forms of credit and banking products under the same credit limit, such as:
- personal loans
- credit cards
- car loans
- business loans
You may be able to combine your HELOC with a mortgage to create sub-accounts for these loans and credit options. These different debt solutions and credit cards might have interest rates and terms that are different from your HELOC. You can also use your home equity line of credit to pay off any debts you owe to other lenders.
This type of HELOC functions like a standard revolving line of credit. It’s a separate loan and not related to your mortgage, so you’re only paying interest on the amount that you use.
The maximum credit limit on a stand-alone home equity line of credit:
- can go up to 65% of your home’s market value
- won’t increase as you pay down your mortgage
You can apply for a stand-alone home equity line of credit with any lender that offers it.
HELOC Substitute for Mortgage
A stand-alone home equity line of credit can be used instead of a mortgage to buy a home.
Buying a home with a HELOC instead of a mortgage means:
- you’re not required to pay off the principal and interest on a fixed payment schedule
- there’s a higher down payment or more equity required (at least 35% of the market value)
Using a HELOC as a substitute for a mortgage can offer flexibility. You choose how much principal you want to repay at any time. You can also pay off the entire balance at any time without paying a prepayment penalty.
Home Equity Loans
A home equity loan is different from a HELOC. With a home equity loan, you receive a one-time lump sum payment of up to 80% of your home’s market value, and you pay interest on the entire amount.
The loan isn’t revolving credit, you must repay amounts on a fixed term & schedule that covers both principal and interest.
HELOC Interest Rates
Home equity lines of credit can have different interest rates depending on how they’re set up.
They usually have a variable interest rate based on a lender’s prime interest rate. The lender’s prime interest rate is set by a financial institution as a starting rate for their variable loans, such as mortgages and lines of credit.
For example, a home equity line of credit can have an interest rate of prime plus one percent. If the lender’s prime interest rate is 2.85%, then your home equity line of credit would have an interest rate of 3.85% (2.85% + 1%).
You can try to negotiate interest rates with your lender. Lenders will consider:
- your credit score
- income stability
- net worth
- your home’s price
Tell them about any offers you’ve received from other lenders.
Your lender can change these rates at any time. Your lender must give you notice if there’s a change. Any change in the prime lending rate will affect your home equity line of credit’s interest rate and your payment amounts.
Who Qualifies for a HELOC?
To qualify for a HELOC, you’ll need to have equity in your home. Equity is the portion of your home’s value that you own outright or the portion that you’ve paid off. For example, if your home is worth $200,000 and you have a mortgage balance of $150,000, you have $50,000 in equity.
To qualify for a HELOC, you typically need to have at least 20% equity in your home. This means that your home must be worth more than you owe on it. If you have less than 20% equity, you may still be able to get a HELOC, but you’ll likely have to pay private mortgage insurance (PMI)
Credit rating is also a factor to qualify for a HELOC. Lenders will look at your credit history and credit score to determine whether you’re a good candidate for a loan. If you have a high credit score and a strong history of making on-time payments, you’re more likely to qualify for a HELOC with a lower interest rate.
To qualify for a home equity line of credit at a bank, you sometimes need to pass a “stress test”. A stress test is to prove you can afford payments at a qualifying interest rate, which is typically higher than the actual rate in your contract.
Credit unions and other lenders that are not federally regulated may choose to use this stress test when you apply for a home equity line of credit. They are not required to do so.
The bank must use the higher interest rate of either:
- the interest rate you negotiate with your lender plus 2%
If you own your home and want to use the equity in your home to get a home equity line of credit, you’ll also be required to:
- provide proof you own your home
- supply your mortgage details, such as the current mortgage balance, term and amortization period have your lender assess your home’s value
If you’re looking for a lower-cost way to finance home improvements or other major expenses, a HELOC may be right for you. With competitive interest rates and flexible repayment terms, it can be an affordable option for many
The best way to find out if you qualify and what other programs are available to you, speak with a financial advisor today or Apply Online