Understanding Home Equity Lines of Credit
For many homeowners looking to free up money for a home renovation, a vacation, a child’s tuition, or a business investment, a home equity line of credit can be a viable option. Borrowing against the equity of your home can be an effective way to make the most of the money you’ve already invested in your property. You will often see this type of loan referred to as a HELOC.
What is a Home Equity Line of Credit?
A home equity line of credit is a loan that uses the equity you already have in your home as collateral. The loan is secured by a lien, typically a second position lien, on your home. The second lien position (also called a second mortgage) is most common because most borrowers will already have an existing first mortgage. First or third lien position home equity loans are possible as well, but occur with less frequency.
Home equity loans can be either “closed-end” or “open-end”. The home equity line of credit is an open-end loan, while a home equity installment loan is a closed-end loan. An open-ended loan has characteristics similar to that of a credit card. A borrower has a predetermined credit limit and can withdraw funds at their own discretion using HELOC checks or a HELOC withdrawal card. A monthly payment is only required if there is an existing balance, in which case the borrower has the option to pay it off in full, or make regular monthly payments according to the loan terms. The borrower may use the funds for any purpose they choose.
Most lenders are willing to extend a line of credit worth as much as 80-90% of a home’s value, minus any outstanding mortgage amounts, to qualified consumers. This calculation is called the loan to value ratio (”LTV”). Let’s look at an example. Your home is worth $250,000 and you still owe $100,000 on a first mortgage. If a lender is willing to lend at 90% LTV, you would multiply the value of the home ($250,000) by 90% LTV (.9), which equals $225,000. Subtract the first mortgage balance ($100,000) from the maximum loan amount ($225,000), and you get $125,000. This is the maximum loan amount of the line of credit in this scenario. Before the credit market problems that roiled the mortgage industry in 2008, it was not uncommon to see financial institutions lend up to or even exceeding 125% LTV. Those days are largely a thing of the past. In today’s market, lenders have become much more conservative in their underwriting guidelines.
Who Uses Home Equity Lines of Credit?
Homeowners use equity lines of credit to fund virtually any expense. Homeowners may request this type of loan in order to:
For many homeowners looking to free up money for a home renovation, a vacation, a child’s tuition, or a business investment, a home equity line of credit can be a viable option Borrowing against the equity of your home can be an effective way to make the most of the money you’ve already invested in your property
