New Way to Improve Your Home and Pay Off Debt (Together)

what is a heloc and how does it work

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Home is one such asset that requires a constant care. Whether it is the leaky faucet to something big like demolishing a part/whole house. From time to time, our house requires small pampering to keep its resale value high. A smart move, if we can say, considering the recent increase in the housing market.

Frugal moves say – do it yourself, yes you can if the situation calls for it. But when it comes to big changes like remodeling your master bedroom or flipping down your house into a new one, you can’t, because 1. You were not trained for it and 2. You have your own job to take care of. So, instead of DIY, you hire workers, but did you know, recent studies have shown that a median cost of upgrading your house is $15,000, thanks to a shortage of labor and rising prices for materials.

So how can you squeeze out those extra bucks? If you are also in the same dilemma, allow me to answer your question. HELOC or Home Equity Line of Credit is your option. Not just for house improvement, you can also use HELOC to pay off your other financial troubles considering its low-interest rate. Read below to find out how.

What is HELOC?

HELOC or Home Equity Line of Credit is a line of credit as simple as that.

Let me take the example of a credit card, in credit cards you have a certain line of credit, till which you can borrow money and then eventually pays it at the end of the month. HELOC works in the same exact manner, but the only difference is its extent of the taking-out-money period. In, home equity line of credit, you get up to 10 years.

The only thing that makes both the things different is that credit card is an unsecured debt while home equity line of credit is a secured debt with your house as collateral.

How Does It Work?

In HELOC, you are borrowing money from the bank with your home as collateral. You do the same as you have been doing with a credit card, you are given a line of credit (pool of cash from which you take your needed amount), just like a credit card bill you pay your balance and draw it down again.

A HELOC has 2 time periods. One is the “draw period” which is usually up to 5 to 10 years in which you take out the cash you need and payback for the interest rate only. After you draw period ends, comes your “repayment period” where you pay both the principal and interest until your loan is paid off, that last for 10 to 20 years.

If you are still scratching your head. Let me explain you with numbers. Suppose a home equity line of credit has a line of credit of $20,000 for 10 years, you borrow $5,000 and pays $4,000 toward the principal in 2 years. Now you have $19,000 which can be used for the rest 8 years.

How to Use HELOC?

As mentioned, the home equity line of credit is used for home remodeling but a savvy move is to pay off your first mortgage of higher interest or any other debt.

  • Pay off your student loan.
  • Pay off your medical debt.
  • Consolidate your other debt.
  • Act as an emergency fund when you have no other option.
  • Buy a car

The real question comes that how much you can borrow from the bank when taking a home equity line of credit. Typically a HELOC gives you around 75% – 85% of your home value excluding your mortgage balance.

Line of credit = 75% – 85 % (Your Home’s Value) – Your Debt

I think that sums it all. The above equation is not going to give you the exact estimated amount, your home equity line of credit also depend upon how much you can pay which means that before the final verdict, the bank will look at your income, credit score, previous debt.

A HELOC has a variable interest rate which is tied to The Wall Street Journal Prime rate. Which means that as the prime rate goes up and down so does your HELOC interest rate. But fortunately, there is a limit up to which your interest rate can go which is known as ceiling or cap. For example, if your HELOC is having a cap of 15% then even if the prime rate goes beyond 15%, your HELOC interest rate will remain stagnant.

Advantages

1. Tax Deduction

A bonus of using HELOC is its tax deductible interest rate since HELOC is treated as a home loan, which most of the credit card and home loan doesn’t have.

2. Low Interest

HELOC is a secured loan which gives you the advantage of lower interest rate over any other debt as you are using collateral.

3. Flexibility

HELOC gives you a drawing period of almost 10 years which gives the liberty to take out as much as you want, at any time, and also gives you double the years to pay back what you own.

Let us assume that you take out $8000 for your trip, you can break that down into as many monthly installments as you want with a better interest rate.

4. Right to pay early

No matter what your installment payments are, you can pay your full loan at any time you want.

5. No Payment when there is no balance

Your HELOC can have two things, either to carry a minimum balance or no balance and if you fall into the latter category you are no longer require any amount until you draw next, if you have made a full payment to your previous draw.

6. A Chance to back out

Even if you went with the flow and opt for a HELOC and realize later that you no longer need it or have found a better option or better lender, you have 3 days to cancel your home equity line of credit and pay nothing. All you need is to inform the lender in writing and it will cancel your loan and pay back any fees that you have already paid.

Disadvantage

1. No Renting

HELOC doesn’t let you rent your place. So, if you are a constant mover, it is advisable not to apply for HELOC as you will have to pay the full balance at once.

2. Risk of Foreclosure

The biggest risk while opting for a HELOC is by any chance you were not able to pay off your debt, your house is in the danger of a foreclosure.

3. Risk of Credit Line Frozen

If bank founds out that your income has deteriorated and is not sufficient to pay off your debt or that your house has lost its value, your line of credit of credit could immediately freeze and you will be asked to pay your loan or else bank will seize your house.

4. Uncertain rate

Your home equity line of credit’s interest rate is totally dependent upon the prime rate, which put you at a risk of high monthly interest rate every month. That can be a problem if your budget is tight but thankfully there is a limit to which your interest rate can go but still, there will be variation every now and then because of the prime rate.

Final Thoughts

The Home equity line of credit is often termed as a second mortgage, as you might have already had a primary mortgage either on your house or something else. HELOC is risky, as your house is on the line, so you have to consider all your cases before you decide on anything. All the other loans come with its pro and cons and HELOC has its merits too, so look thoroughly because if you don’t, you will have another debt on top of the other.

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