Definition of a Home Equity Line of Credit

A home equity line of credit is the perfect asset to have when you need emergency funds

A home equity line of credit (HELOC) is an extremely valuable financial tool. With a HELOC, you can access the equity in your home similarly to how you access credit on your credit card. However, because the balance due is leveraged against your home equity, you should only use the HELOC for emergencies or major purchases such as college education and home improvements.

Home Equity Line of Credit

A home equity line of credit can be viewed as a credit card balance leveraged against home equity. The funds are available for use when needed, just like a credit card. It's not a credit card, however, because once you access the funds, a home loan is put in force which becomes a mortgage against your home. As with any home loan or mortgage payment, if you default on the loan, you will lose your home.

How It Works

To get approved for a HELOC, you must complete processes similar to applying for a home loan. After applying, an appraisal is done to determine the market value of your home. The lender then compares the appraised value of your home to your existing mortgage to determine the amount of home equity that is available. If you qualify for a home loan equal to your home equity or a percentage of your home equity, you will be approved for the HELOC. Once you withdraw funds from your HELOC, a loan is created and you will pay principal and interest payments, or just interest payments, according to the terms of the HELOC contract.

Advantages

The primary advantage of having a HELOC is the peace of mind that comes with knowing funds are available when you need them, like having a credit card with a healthy credit limit. With the exception of the processing cost associated with obtaining the HELOC, you incur no cost until you access your line of credit. Also, since your HELOC is leveraged against your home equity, the interest rate tends to be significantly lower than credit card interest.

Disadvantages

The primary disadvantage is the risk of having the HELOC frozen, reduced, suspended or canceled during economic downturns. For example, in 2008, major institutions froze or suspended their HELOC contracts due to fallen home prices. The equity in the homes used to underwrite the HELOCs was evaporating. So homeowners were left in the cold, especially during a time when layoffs were at an all time high and people needed to tap their HELOCs to cover living expenses. Another risk is irresponsibility, where homeowners use HELOCs funds to purchase non-essential items that are not worthy of placing a mortgage on their home. Also, the interest rates you pay may vary over time.

Applications

The home equity line of credit is ideal for use as an emergency fund. Generally, a family should have three to six months of living expenses as emergency cash in the bank to handle the temporary loss of income due to a layoff. However, very few do and a HELOC can provide peace of mind in these emergencies. Homeowners also use their HELOCs for major purchases and expenditures such as college education, home improvements, or medical bills.

References

• U.S. Federal Trade Commission: Home Equity Credit Lines
• U.S. Federal Reserve Board: What is Home Equity Line of Credit