What Is a Line of Equity Credit & How Does It Work?
Homebuyers build ownership in their homes by making down payments and mortgage payments. Ownership in a home -- the value of a home that exceeds the remaining balance on a mortgage -- is called home equity. A home equity line of credit (HELOC) is a common financial product that allows a homeowner to borrow against his home equity.
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HELOC Basics
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A home equity credit line is often considered a type of second mortgage. A traditional second mortgage involves borrowing a single lump sum against your home equity, while a HELOC gives you access to a credit line with a predetermined limit based on your home equity. You can borrow from that line of credit as needed. According to the U.S. Federal Reserve Board, many lenders calculate HELOCs by appraising a home's value, multiplying it by a certain percentage and subtracting your current mortgage balance. HELOCs typically have variable interest rates, meaning interest rates can change over time.
Benefits
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The main benefit of a HELOC is that it allows you to access large amounts of cash quickly when you need it. According to the U.S. Federal Trade Commission (FTC), HELOCs often have low initial interest rates, which can make them cheaper for financing purchases than other types of loans. A HELOC can be used to pay off higher interest debts, such as credit card debt, to save money over the long term.
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Drawbacks
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When you take out a HELOC, the equity of your home serves as collateral for the debt. just as it does with a traditional mortgage. This means if you miss monthly payments on a HELOC, your lender potentially can attempt to foreclose on your home. The U.S. Federal Reserve Board notes that you may incur fees when using a HELOC, including appraisal fees, application fees and closing costs. A HELOC can be a valuable source of cash in times of need, but relinquishing equity may result in debt that's costlier than a traditional mortgage as a result of variable interest rates.
Considerations
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There are safeguards in place to protect lenders against changes in terms when opening HELOCs. The FTC states that the Truth in Lending Act protects you against changes lenders make to the terms of an account before a credit line is opened. If you turn down a plan because of a change in terms before opening a HELOC, the lender is required to return all fees you have paid.
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