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Home Equity Loan Basics

Home Equity Lines of Credit

You may have the option to borrow against a portion of the available Glossary Term: equity in your home if you own your home outright, or if the remaining Glossary Term: principal you owe on your home is less than its current value. For example, if you’ve been paying down the principal balance on your mortgage or the value of your home Glossary Term: appreciates, you may be able to tap into some of your accumulated equity. Two popular options for doing this are taking out a home equity line of credit or a home equity loan.

Here, we’ll talk about home equity lines of credit (also known as HELOCs).

What is a home equity line of credit?

A HELOC is a line of credit secured by your home that gives you a revolving credit line, in some ways like a credit card. The differences are that instead of borrowing from a credit card company, you’re borrowing from the available equity in your home, and the house is used as Glossary Term: collateral for the line of credit. But like a credit card, as you repay your outstanding balance, the amount of available credit is replenished. This means you can borrow against it again if you need to, and you can borrow as little or as much as you need, up to your pre-set limit. Typically you can draw money from your HELOC for 10 years, with a 15-year repayment period.

Home equity lines of credit are often used to consolidate higher-interest rate debt on other loansFootnote 1 (such as credit cards) or to pay for home improvement projects, including those intended to increase the value of your home.

Understanding the basics

Here are some basic things to know about home equity lines of credit:

Qualifying. In order to qualify for a home equity line of credit, you must have available equity in your home. In other words, the amount you owe on your home must be less than the value of your home. Most lenders will allow you to borrow up to 85% of the value of your home minus the amount you owe. Your lender will also typically look at your Glossary Term: credit score and history, employment history, monthly income, and monthly debts, just like they did when you first got your mortgage.

The index. A financial indicator used by banks to set rates on many consumer loan products. Most banks use The Wall Street Journal Prime Rate.

The margin. The margin is the amount added to the index, such as The Wall Street Journal Prime Rate, to determine the interest rate for your home equity line of credit.

The limit. Your lender will calculate your line of credit limit. Here is an example of the calculation:

Assuming the lender allows a maximum credit limit of up to 85% of your home’s value and your home appraises for $300,000, if you owe $150,000 on your current mortgage you may qualify for a credit line amount of up to $105,000. ($300,000 x 85% = $255,000 - $150,000 = $105,000)

The draw period. The “draw period” is the period of time during which you can pay for expenses with your home equity line of credit. Depending on the terms, the draw period will vary, but typically it will be up to 10 years. You’ll receive home equity line checks and/or a home equity line access card to pay for expenses. At Bank of America, Online Banking is another helpful way to access your home equity line allowing you to easily transfer funds to your checking account. When you pay for expenses and have borrowed against your home equity line of credit, you’ll receive a monthly bill with a required minimum payment, similar to the way you would for a credit card. It’s essential to make your payments on time, and highly advisable to pay more than the minimum (especially if that minimum covers interest only), so that you’re paying down your principal. This may not only reduce your overall debt more quickly, it may also help you save on the interest you pay.

The interest. You will be charged interest for any money that you borrow against your credit line. Because home equity lines of credit have variable interest rates, your interest rate may vary from month to month. Since it is technically a home loan, the interest paid on a home equity line of credit is usually tax deductible, so you could potentially save on the interest you pay (everyone’s situation is different, so you should talk to your tax advisor regarding interest deductibility for your personal situation). Be aware that lenders have the right to modify your credit line at their discretion by decreasing the amount of funds available. In such cases, they are obliged to inform their customers of these changes to their credit limits. Some home equity lines of credit have an option during the loan term to convert all or a portion of the outstanding variable rate balance to a fixed rate. Bank of America home equity lines of credit include this fixed-rate conversion option.

Homeowner tip:

If you are using your home equity line of credit to consolidate and pay off other debts, be careful not to overuse those other accounts again, or to open new ones. That could make it difficult to pay off your accumulated debts, including your mortgage and home equity line of credit, which could also have a negative effect on your credit rating and put your home at risk.

The repayment period. Home equity lines of credit have an “end of draw” date, after which you may no longer borrow against your home equity line of credit. On this date, the repayment period also begins, which is typically about 15 years. During the repayment period, you’ll be required to make the monthly principal and interest payments needed to fully pay off the home equity line of credit by the end of the repayment period.

Homeowner tip:

If you were to make interest-only payments during the draw period of your line of credit, you could find yourself with a large balance and unexpectedly large monthly payments when your repayment period begins. To avoid this payment shock, it’s recommended that your monthly payments during your draw period cover principal and interest so that you’re paying down as much of your principal as possible during the draw period.

The home equity line of credit checklist

While many lenders offer the same features in their home equity lines of credit, some features will vary. Comparing these points as you shop could make a difference in your payments:

  • Annual fee: Amount charged once a year during the draw period, and sometimes only charged when you do not borrow against your home equity line of credit.
  • Cancellation/early closure fee: Fee charged if the line of credit is closed before a certain date (if less than 3 to 5 years from the date opened, it could cost from $500 to $1,000).
  • Margin: The amount added to The Wall Street Journal Prime Rate to determine the interest rate for the home equity line of credit.
  • Minimum draw: The minimum amount a lender requires you to withdraw/ borrow.
  • Introductory rate: A temporary rate that may be in effect before The Wall Street Journal Prime Rate plus the margin takes effect (not offered on all lines of credit).
  • Up-front fees: Some fees are charged by the lender to set up your home equity line of credit like application/and or appraisal fees.
  • Automatic payment discount: Discounted interest rate offered by some lenders if you establish automatic payments from an account also held by that lender.

Is a home equity line of credit right for you?

Home equity lines of credit give you the flexibility to use your credit at any time for any expense; however, that flexibility usually comes with a variable interest rate.

So before you get a home equity line of credit, consider things like whether a variable rate suits your needs, how much you think you’ll need to borrow over what period of time, and whether you’ll be able to make the payments in full and on time in order to maintain your credit rating and keep your homeownership secure. Since your house is used as collateral for your credit line, it’s important not to fall behind in your payments and put your home at risk.

When borrowing from a home equity line, mortgage, credit card or any other credit product, it’s important to borrow only the amount that you can comfortably afford.