What is a Home Equity Line of Credit?
Home equity lines of credit are also referred to as a HELOC. They are a revolving source of funds, similar to a credit card, that you can access when you choose. Unlike home equity loans, they tend to have few (if any) closing costs, and they usually feature variable interest rates—though some lenders will offer fixed rates for a certain number of years.
Due to the pandemic, you may have lost your job, need cash and have equity in your home. For you taking out a HELOC may be a good option right now.
You need to be cautious as HELOCs and Home equity loans can be rather too enticing and end up getting the borrower into financial troubles. It can be easy to spend available funds on nonessentials—or, during the global pandemic, on things you do need, but with no end in sight for your financial challenges.
The Phases of HELOCs
Most home equity credit lines have two phases. Firstly, a draw period, often 10 years, during which you can access your available credit as you choose. Typically, HELOC contracts only require small, interest-only payments during the draw period, though you may have the option to pay extra and have it go towards the principal.
After the draw period, you can sometimes ask for an extension. Otherwise, the loan enters the repayment phase. From here on out, you can no longer access additional funds, and you make regular principal-plus-interest payments until the balance disappears. Most lenders have a 20-year repayment period after a 10-year draw period. During the repayment period, you must repay all the money you’ve borrowed, plus interest at a contracted rate. Some lenders may offer borrowers different types of repayment options for the repayment period.
HELOCs have many attributes that make them different from a standard credit line and also offer advantages. However, the interest-only payments in the draw period mean payments in the repayment period can almost double. For example, payments on an $80,000 HELOC with a 7% annual percentage rate (APR) would cost around $470 a month during the first 10 years when only interest payments are required. That jumps to around $720 a month when the repayment period kicks in.
The jump in payments at the onset of the new repayment period can result in payment shock for many unprepared HELOC borrowers. If the sums are large enough, it can even cause those with financial hardships to default. And if you default on the payments, you could lose your home.
Difference between a HELOC and Home equity loan
Let’s start with the similarities between the HELOC and the Home equity loan, which is the way that they are secured, with the equity a borrower has in their home representing the collateral.
An obvious difference between the two is how you receive the money. With a home equity loan, you get a lump sum and with a HELOC you get a line of credit that stays open for 10 years and you can draw on it when you need it.
With a home equity loan, the amount of interest is fixed, whereas a HELOC would generally operate on a variable interest rate, so your payments can go down or up at any time. Repayment of the loans is also different as when you have a home equity loan you pay a set amount over a number of years and the payment combines principal and interest and doesn’t change. In the HELOC process during the draw period you can make monthly payments of interest only meaning lower monthly payments. However, when you move to the repayment period monthly payments will begin to include principle plus interest for any money borrowed. The monthly rate will therefore increase.
Both have their advantages and disadvantages and you should get advice from a financial advisor if you need to decide which route would best suit your family needs.