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Finance From A to Z: Week 8 (H)

Finance From A to Z: Week 8 (H)

This week’s submission will dive into the intricacies of home equity lines of credit, AKA HELOCs!

H is for Home Equity Lines of Credit (HELOCs):

What is a HELOC?

A HELOC, also known as a home equity line of credit, is a form of home equity loan that enables you to borrow money as needed and repay it at a variable interest rate. In other words, you are only limited by your credit limit and can take out as much or as little credit as you need at any one time. HELOCs are, therefore, a type of secured credit where the lender uses the value of your property as collateral to ensure that you will repay the loan. The draw term, during which one actively draws from this line of credit, is distinguished from the payback period, during which one repays the borrowed funds.

How do HELOCs work?

HELOCs operate utilizing the equity that a borrower has in their home — that is, the difference between what is owed on the mortgage loan and the home’s current market value. With a HELOC, you can borrow money based on the equity you have in your home, and the house serves as collateral for the line of credit.

Similar to a credit card, HELOCs operate using a line of credit that you can draw funds from and pay back as needed with respect to a benchmark interest rate. As you repay your outstanding balance, the amount of available credit is replenished, allowing you to borrow against it again if necessary. Depending on the interest rate and how much money you have used, the subsequent payments will vary; however, compared to other common types of loans, HELOCs generally have significantly lower interest rates, which may also be tax deductible. That being said, it is nevertheless necessary to maintain a high credit score and a low debt-to-income ratio in order to see such interest rates in the first place. Additionally, HELOCs also benefit from unfixed payments— something that is not present in normal home equity loans. 

What can HELOCs be used for?

While HELOCs are generally best for people who need funds for ongoing home improvement projects or need more time to pay down existing debt, there are a wide variety of applications where HELOCs can be used effectively. For starters, if you have significant or ongoing medical bills and wish to benefit from low interest rates, a HELOC can be a suitable choice. Likewise, since HELOCs frequently have lower interest rates than student loans, they might be a good option to cover tuition and other educational costs. Additionally, HELOCs may be a desirable option for making significant purchases because they have longer repayment terms than many other loans.

HELOCs and Mortgages

By themselves, HELOCs can be very useful, but they can also be offered in combination with a mortgage. The majority of major financial institutions offer some version of this combination, including a HELOC and a fixed-term mortgage. 

Potential Disadvantages of HELOCs

As with any other form of loan, there are risks and disadvantages associated with HELOCs. By using your home as collateral, the inability to pay back the HELOC puts the borrower at risk of foreclosure. Additionally, while the variability of the interest rate may seem appealing at first, it may increase at the whim of the Federal Reserve. Given that borrowers are also at risk of overspending, the lack of guarantee that the borrower will be expected to pay off the loan at the same interest rate they took it out at may make for a particularly unpleasant scenario. Ultimately, however, it is up to the borrower to determine whether the advantages and various applications of a HELOC outweigh the potential hazards and disadvantages associated with it.

Thanks for reading this week's newsletter! 

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