Buying a home is an investment, and a home equity line of credit (HELOC) lets you tap into the return on that investment. Whether you’re funding a home improvement project or covering college tuition for your kids or yourself, a HELOC provides cash on hand to take on life’s next steps. But before you sign your name on an application, it’s important to know the details and implications of taking out a second mortgage on your home. Here’s everything you need to know about a HELOC.

What Is a Home Equity Line of Credit?

A home equity line of credit allows you to borrow against the equity you have built into your home. That equity is determined by subtracting the total you owe on your primary mortgage from your home’s total value. For example, if your home’s current market value is $400,000 and you owe $160,000 on your mortgage, your home equity would amount to $240,000.

When taking out a home equity line of credit, lenders may choose to approve you for up to a certain percentage of your home’s value. iTHINK Financial HELOCs allow you to borrow up to 90% of your home’s value, minus the amount you owe on your house. So, using the above example, if your home’s value totals $400,000 and you owe $160,000 on your loan, you could qualify for a HELOC of up to $200,000 ($400,000 x .90 = $360,000, $360,000 - $160,000 = $200,000).

Is a HELOC Different from a Home Equity Loan?

Both HELOCs and home equity loans allow you to access cash by drawing on the value of your home, but there are key differences to note.

A home equity loan takes a one-time equity draw and distributes it as a lump sum. This type of loan also typically comes with a fixed interest rate. Together, these two factors mean monthly payments will be the same over the life of your loan.

On the other hand, a home equity line of credit works much like a credit card. Once you’re approved, you can draw from your line as you need it and you only have to make payments if you owe a balance on your account. Unlike home equity loans, HELOCs often carry variable interest rates, but you’ll only pay interest on what you borrow. That also means your monthly payments may vary month to month, depending on the amount you borrow and interest rate fluctuations.
 

How a HELOC Works

Beyond understanding the basics of a revolving line of credit and variable interest rates, there are additional factors involved in a HELOC borrowers must consider.
 

Variable Interest Rates

As we covered earlier, HELOCs are variable rate loans. The interest rate on these loans may rise or fall as the prime lending rate goes up and down. Published weekly in the Wall Street Journal, the prime lending rate is the lowest rate available to bank borrowers. For HELOCs, the variable interest rate is often expressed as prime plus a margin, which is determined by the borrowers’ creditworthiness. For example, at iTHINK Financial, our HELOC rates are as low as prime plus .25%.

Draw Period

HELOC loans typically have a 20-year lifespan, with the first 10 years are known as the draw period. During this time, you may borrow from your line of credit as you see fit, up to your approved limit. Minimum payments due during this period are often interest-only, but any additional amount paid will go towards your principal.
 

Repayment Period

Once the draw period is over, HELOCs enter a repayment period during which the line of credit transitions into a fully amortizing loan for the remaining 10 years of your loan. At this time, your monthly payments will be calculated each month based on what will bring the loan to zero by the end of the 10-year amortization period.
 

HELOC Closing Costs

Like a primary mortgage, there are sometimes closing costs associated with home equity lines of credit which can range from 2% to 5% of the loan amount. These costs vary by institution and may even be waved depending on which bank or credit union you choose for your HELOC. Worth noting, iTHINK Financial covers closing costs on loan requests under $100,000.

Should You Apply for a HELOC?

Armed with everything you need to know about a home equity line of credit, the next question to ask is, “is a HELOC right for me?”

Just like with any other line of credit, you don’t want to take on more debt than you can handle. With a HELOC, your home is used as collateral for your loan, and if you are unable to pay back what you owe, you may be at risk of losing your house. That means a HELOC is not a good option to fund vacations, vehicles or other everyday purchases.

The most common reason homeowners take out a home equity line of credit is to tackle major home renovations or repairs. Not only do these projects typically add to the value of your home, the interest on HELOCs used for major improvements may even be tax-deductible. Paying for higher education or consolidating high-interest debt can also be good reasons to tap into your home’s equity.