About a Home Equity Line of Credit

Homeowners in the United States have an inordinate number of choices when it comes to home financing. One of these choices is the home equity line of credit, or HELOC. These loans are traditionally obtained either with a first mortgage or after a first mortgage. While the process for obtaining a HELOC is similar to that of a first mortgage, the purpose of the loan is often different.

Identification

Home equity lines of credit are like credit cards in that they are revolving lines of credit. Borrowers can access part or all of a credit line, use the cash, repay the advance and re-borrow against the credit line. These loans, however, are secured by real estate. Therefore, defaulting on a HELOC can and will lead to foreclosure.

Features

Many HELOCs have variable interest rates tied to market indexes. Common indexes include the Prime Rate and the LIBOR (London InterBank Offered Rate). HELOC rates will often adjust based on the fluctuation of these rates. For example, if a HELOC has a rate of Prime plus two, a borrower would need to look up the current Prime Rate and add 2 percent to find his rate.

Uses

HELOCs are commonly used for home improvements. Since borrowers can take small, large or full advances, the flexibility of these loans lend themselves well to changing needs. Most HELOCs offer a credit card or checks that are used to access HELOC funds. These loans are also commonly used for large purchases--like tuition, appliances and home furnishings.

Benefits

Not only do HELOCs help borrowers with purchases and home improvements, they can also help borrowers avoid private mortgage insurance (PMI). PMI is lender-required insurance for properties with a loan-to-value (LTV) ratio higher than 80 percent. (To calculate LTV, divide a mortgage balance by the value of the property.) The cost of this insurance is passed onto the borrower. However, if a borrower obtains a first mortgage and HELOC at the same time, often the lender will not require PMI.

Warning

HELOCs are flexible and convenient. They can, however, get borrowers into trouble. Like credit cards, these loans require a minimum payment only each month. Borrowers can get quickly overwhelmed by a semi-large HELOC loan. Paying only the minimum payment will simply extend the repayment period and incur huge interest costs over the life of the loan.