How a home equity line of credit or HELOC works
What is a home equity line of credit? What is a HELOC?
A home equity line of credit is also called a HELOC. It is a revolving line of credit that allows you to borrow money against the available equity in your home. Depending on your credit score, credit history, and the amount of debt that you have, you may be able to borrow up to 85% of the appraised value of your home minus the amount that you owe on your first mortgage. If you have a good credit score and a low debt-to-income ratio, you might be able to access more of your equity.
A home equity line of credit allows you to borrow as much as you need at the time that you need it within your established credit limit. However, you are not able to exceed the credit limit or borrow funds beyond the draw period.
The draw period is a fixed time period during which you can make withdrawals from your credit line. Your lender may give you checks or a credit card to allow you to borrow money from your equity line. You only make payments on the amount of money that you borrow instead of on the full amount that is available to you.
A HELOC may have certain tax advantages. You may be able to deduct some of the interest that you pay on your income tax return. However, this type of credit line requires you to use your home as collateral for security, making it important for you to use the funds wisely.
Statistics
The number of people who are taking out home equity lines of credit is increasing. Through 2022, TransUnion estimates that 10 million people will take out HELOCs. The current volume of these credit lines is $67 billion.
According to the Federal Reserve, consumers have more than $342.7 billion in revolving home equity loans. While these numbers demonstrate the popularity of accessing available equity in homes, it is important for people to be careful when they draw funds from lines of credit and to make certain that they make their payments on time.
Home equity line of credit rates
These type of credit rates may be variable or fixed. A credit line with a variable interest rate may initially have lower monthly payments. However, during the repayment period, the payments can change and may increase.
If a fixed rate is offered, the payments may be slightly higher at first. However, the monthly payments will remain the same over the life of the credit line. When you compare APRs for a home equity line of credit rate, it is important that you understand that APRs do not take points and financing charges into consideration. Before you apply, make certain that you read the disclosures and understand how much the credit line will cost you.
HELOC fees
There are several fees that are associated with HELOCs, including the following types:
- Application fee
- Title search fee
- Appraisal fee
- Attorneys’ fees
- Closing costs
Some equity lines of credit have fees throughout their duration such as annual membership or participation fees. These are due whether you use your account or not. You might also be charged a transaction fee each time that you borrow money. All of these fees add to the cost of your line of credit.
Tax deductions for HELOCs
The Tax Cuts and Jobs Act changed how the interest on HELOCs can be deducted. Under the law, you are only able to deduct HELOC interest on your tax return if you use it to improve or renovate your home.
The deductible interest is limited to $750,000 for the tax years through 2025. If your loan started prior to Dec. 15, 2017, you may be able to deduct your interest up to $1 million.
How equity loans differ
While some people confuse home equity lines of credit and home equity loans, they have distinct differences. An equity loan is money that is given to you in a lump sum. It has a fixed interest rate on the amount that you borrow. You repay a home equity loan in equal monthly installments over a fixed period of time.
Home equity loan rates depend on your credit score, credit history, and the fair market value of your home. If you have a good credit score, you may qualify for better home equity loan rates.
If you fail to repay your home equity loan under its terms, your home may be foreclosed on by the lender. You are limited in the amount that you can borrow with a home equity loan to 85% of the equity in your home. The amount of the loan will be determined by your lender after it considers your income, credit history, and the market value of your home.
The fees on a home equity loan may include the following:
- Application or loan processing fee
- Document preparation
- Recording fee
- Origination or underwriting fee
- Lender or funding fee
- Appraisal fee
- Broker fees
Your lender’s fees may be included as interest rate add-ons, origination fees, or points. If these fees are added to your loan, you will pay more over time to finance them than you would if you paid them outright. Like a home equity line of credit, the interest that you pay for your home equity loan may be tax deductible as long as the money is used to improve your home. If you repay your loan in full before the end of its term, some lenders charge prepayment fees.
Home equity line of credit compared to a home equity loan
Home equity line of credit vs. a home equity loan
| HELOC | Home equity loan | |
|---|---|---|
| Funds | Draw money when you need it | Provided as a lump sum payment |
| Interest rate | May be variable or fixed | Fixed |
| Term | Up to 25 years with a repayment period of 15 to 20 years | 5 to 10 years |
| Prepayment Fees | No traditional prepayment fees, but may have early closure fees | May have prepayment penalties |
| Closing costs and fees | Similar to a mortgage | Similar to a mortgage |
| Deductions | May deduct interest up to $750,000 if the money is used for home improvements | May deduct interest up to $750,000 if the money is used for home improvements |
How to take out a HELOC
If you want to take out a line of credit against the equity of your home, it is important that you research and compare the variable rates that are offered by different lenders. Read and compare the terms of each product that you consider.
Check the limit on how much the interest rate changes at one time, which is known as the periodic cap. Look for the limit on interest rate changes throughout the term of the loan, which is known as the lifetime cap. Find out which index is used by the lender and how much and how often the rate changes. You can use a home equity line of credit calculator to figure out how much the loan might cost you.
Lenders use a prime rate or index to calculate how much to raise or lower HELOC rates. The amount that is added to the index determines the interest rate you will be charged, which is called the margin. Ask whether the variable rate loan is convertible to a fixed rate at some point in the future.
Before you sign the papers, read them carefully. Use a home equity line of credit calculator to determine whether the loan makes good financial sense for you. If the terms are not what you expected, do not sign any documents. You can negotiate changes or choose not to take the line of credit. After you sign the loan documents, you have the right to cancel it without penalty if you do so within three days.
Truth in Lending Act (TILA)
The Truth in Lending Act or TILA mandates lenders to disclose the terms and costs of a loan or home equity line of credit at the time that you apply. This includes the HELOC or home equity loan interest rates, the payment terms, and the charges associated with opening or using the account such as the appraisal, credit report, and attorneys’ fees. Lenders must also give you a brochure that describes the overall features of the home equity plan and any features of the variable rate.
The Truth in Lending Act protects you from account term changes before the start of the plan, not including a variable rate feature. If you decide against a plan because of a change in its terms, all of the fees that you have paid must be returned to you.
Once you open a home equity line of credit and comply with its terms, your lender cannot terminate it. Your lender also cannot accelerate the payment of your outstanding balance or change the terms of your account. The lender may stop credit advances on your account during any period in which the interest rates exceed your agreement’s maximum rate cap if the contract permits.
The three-day cancellation rule
Federal law allows you to cancel a signed credit agreement within three days. You are able to cancel your account for any reason if your principal residence serves as the collateral for the loan.
The three-day cancellation rule gives you a right to cancel your HELOC contract within three business days of its signing. If you cancel, you must do so no later than midnight of the third day. The start of the first day begins after you sign the contract, receive a truth in lending form that contains the contract terms, and receive two copies of a truth in lending notice that explains your right to cancel.
For cancellations, the three days include Saturdays. However, Sundays and legal public holidays are not included in the calculation. During the waiting period, the activity related to the contract cannot occur.
If you decide that you want to cancel during the three-day waiting period, you must inform the lender in writing. You must mail, deliver or electronically file your notice to the lender within the previously described time period.
If you cancel the contract, you will not be liable for any amount. The lender will have 20 days to return all of the money or property that you paid as a part of the transaction. The lender will also have to release any security interest that it has in your home.
If you cancel your contract within the three day period and have received property or money from the creditor, you are allowed to hold it until you receive proof that your home is no longer being used as collateral and the lender has returned any money that you have paid. Then, you must offer to return the lender’s property or money. If the lender does not claim it within 20 days, you are allowed to keep it.
If you have a personal financial emergency such as storm damage to your home, you can waive your right to cancel and eliminate the three-day waiting period. To waive your right, you must give your lender a written statement in which you describe the emergency. Your statement must include a declaration that you are waiving your right to cancel. You and everyone who shares ownership of your home must sign and date your written statement.
Repayments
Most HELOC rates are variable. This means that as you repay your loan, your payments may change. It is important for you to find out how often and how much your payments can change. Ask the lender whether you will be paying back interest only with a balloon payment in the future or if you are paying back both principal and interest.
Make certain that you understand the lender’s terms concerning late payments and default. If you are considered to be late by your lender and in default of the agreement, your lender can demand an immediate and full payment of your balance.
If your HELOC credit line includes a large balloon payment at the end of its term, it might be a good idea for you to try to renegotiate the terms of repayment with your lender. Ask about the conditions of renewal, refinancing your unpaid balance, or extending repayment times at the time that you take out your credit line. Make any negotiations in writing so that you have a record of them.
Closing a HELOC
If you pay off your HELOC balance early, you may have the ability to close your line of credit or to keep it open for more borrowing. You might want to consider closing it if your lender charges an annual fee.
If you want to sell your home or want to take out a second mortgage, you must close your HELOC. The lender of has a lien against your property that must be closed before you can make any additional transactions involving your home.
Obtaining and keeping a good credit score is important. If you owe nothing in your account, your average credit history length will be increased each month that it remains open. The average length of your credit history comprises 15% of your FICO score. The amount that you owe makes up 30% of your score, including how much of your total credit line is being used. Keeping your HELOC open even though it does not have a balance can help you to obtain a good credit score. If you already have a good credit score, keeping your account open can help it to improve even more.
Borrow money with M1 Finance
While a home equity line of credit can allow you to flexibly borrow money against the available equity in your home, it has some drawbacks since you must use your home as collateral for the loan. M1 Borrow may be a better alternative to a line of credit.
M1 Borrow is a flexible portfolio line of credit that allows you to borrow up to 35% of the value of the securities in your taxable brokerage account. When you borrow funds with M1 Borrow, you will be charged a low-interest rate of 3.50%, which is among the lowest available on the market.
To access M1 Borrow, you must have a minimum of $10,000 in your taxable brokerage account. Once you borrow the funds, you can repay them according to your schedule. With M1, you enjoy instant access with no additional paperwork, no credit checks, no loan officers and no denials.
M1 Finance has a strong reputation as a trustworthy brokerage. It offers the simplest way to borrow money at the lowest cost. You can use the money that you borrow with M1 Borrow to repay expensive debt. The portfolio line of credit is more tax deductible than most HELOCs.
You can open an account with M1 Finance today and customize your own portfolio by selecting your securities and assigning weights to each one. You can instead opt for an expert-created portfolio from among more than 80. The expert portfolios have been created to reach different financial goals during the time periods that people have to invest. Make diversification super-simple and ensure you’re always fully invested with M1.
The investing platform that is offered by M1 Finance was designed intuitively so that investing is easier. You are able to have access to the automation and investment tools from anywhere with your smartphone through mobile investing. The platform uses automated reinvestments and dynamic rebalancing to help you to build your savings effortlessly.
Margin Disclosure: Using margin involves risks: you can lose more than you deposit, you are subject to a margin call, and interest rates may change. To learn more about the risks associated with margin loans, please see our Margin Disclosure. M1 Borrow available on margin accounts with a balance of at least $10,000. Does not apply to retirement accounts.
Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.