Thankfully, many of our clients are happy with their mortgages. The interest rate, the terms, the peace of mind — all are satisfactory and there’s no motivation to change or refinance. But what happens if there’s a need to use the equity in the home to finance a remodeling project, a large purchase or to just have a “safety net?” A home equity line of credit or “HELOC” can be used to meet these purposes, but should you get a HELOC and, if so, how do they work?
What Is a HELOC?
A home equity line of credit, or HELOC, is most often a second mortgage or junior lien, that “goes behind” your existing (first) mortgage. Unlike a traditional “closed end” mortgage that is fully-amortized, a HELOC usually allows the borrower to draw a balance on a line or limit, then pay it back and repeat the process again. So, where your typical mortgage may start at $400K, for example, and with every payment made will see its balance reduced a little further until completely paid off, a HELOC might have a limit of $50K. Our homeowner may “draw” $35K on the line to purchase a vehicle, then pay it back in the span of a few years and until the balance is at zero. Later, there may be another need for all $50K in order to remodel the kitchen of the home and our borrower could again write a check against the line for that amount. A good analogy for a HELOC is a credit card. You have a limit and you have a balance, and the balance can go both up and down depending on your use and repayment.
As the name would imply, a home equity line of credit allows the homeowner to access the equity in the home. What does this really mean? Let’s use an example. We’ll say our home is worth $500K. The owner has a first mortgage of $400K, so the loan-to-value (LTV) is 80%. The owner therefore has 20%, or $100K, of equity in the home. Some of our HELOC programs allow a combined loan-to-value (CLTV) of 90%, so in this case the homeowner could take a line of credit for $50K (10% of value and a CLTV of 90%). The HELOC now gives the owner access to some of the equity without having to do a cash-out refinance, which might be expensive or, in many cases, impossible.
How Do HELOCs Work?
Let’s first differentiate between a home equity line of credit (HELOC) and a fixed rate second mortgage. The latter is simply a junior lien of (usually) 10, 15 or 20 years that often has a fixed rate and is fully-amortized. You pay it down just like your first mortgage. But a HELOC, as explained above, works differently and as a result, usually has two distinct periods during its full term; the draw period and the payback period. A HELOC’s full term might be anywhere from 15 to 30 years, and some even have a balloon feature, so you have to ask every time. But let’s examine a common HELOC program we offer. It has a 30-year term. The first 10 years are the draw period. You can access the line electronically or with checks. Your payments during the draw period are interest-only, but you can pay the principal balance back as you’d like at any time. After the draw period, the HELOC will convert to a fully-amortized payment for the remaining 20 years and the draw feature ends. During the entire term, the interest rate is adjustable and tracks Prime Rate. The line of credit will have a margin over or under Prime and this combination (index + margin) is considered your fully-indexed rate or “FIR.”
Home equity lines of credit are the most common kind of second mortgage and they can serve many purposes. Because they allow access to the equity in a home without having to actually service any debt, we see many of our clients open a line of credit and save it for a rainy day. Others will use it to replace the roof on their home to assure a rainy day doesn’t end up inside the home itself. Either way, promoting an understanding of how HELOCs work is something we’re happy to share. Get in touch if we can help you unlock the mystery of a home equity line of credit.
Loc, stock and barrel,
Robert J. Spinosa
Vice President of Mortgage Lending
Marin Office: 324 Sir Francis Drake Blvd., San Anselmo, CA 94960
Berkeley Office: 1400 Shattuck Ave., Suite 1, Berkeley, CA 94709
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