How a HELOC Works

A home equity line of credit (HELOC) is a type of second mortgage that gives the borrower a revolving credit line similar to that of a credit card. Instead of distributing the loan in one lump-sum, the lender allows the borrower to draw from the funds whenever he chooses.

HELOC loans are known for offering high limits with low-interest rates. Since HELOCs are technically home loans, many state and federal laws make HELOC interest tax deductible.

It is important to note that HELOCs are secured loans that use the borrower’s house as collateral. If the borrower defaults on the loan, the lender may force foreclosure proceedings to recoup its loss. If the foreclosure does not generate the full amount due, the lender may seek a deficiency judgment requiring the borrower to pay back the additional funds.

Here’s how the typical HELOC process works:

Step 1 – The borrower applies for the HELOC. In order to qualify for a HELOC, the borrower must have accrued equity in his home (i.e. there must be a difference between the amount the borrower owes on the home and the current value of the property). The bank will also look at the borrower’s credit score, his debt-to-income ratio, and his employment.

Step 2 – The lender awards the loan and sets the HELOC limit. Because the HELOC uses a borrower’s home as collateral, the credit limit is determined by the value of the property. The limit will be set by subtracting the balance the borrower owes on their first mortgage by a percentage of the appraised value of the home (usually about 80%).

For example: A borrower purchases a home for $300,000 and now owes $250,000. His home currently appraises at $400,000. If the lender uses a standard 80% guideline, the borrower will receive a credit line of $70,000.

Step 3 – The loan enters the draw period. The “draw period” is a span of 5-10 years during which the borrower can withdraw money whenever he chooses. The borrower will usually be given a checkbook or a special credit card to use for withdrawals. When money is taken out, the borrower will receive a monthly bill and must make a minimum payment (sometimes interest-only). When no money is withdrawn, the borrower will not be charged.

Whenever the borrower has withdrawn money, interest accrues. Because most HELOCs have adjustable interest rates, the percentage the borrower is charged for interest will vary from month to month.

Step 4 – The loan enters the repayment period. During the 10-20 year “repayment period” the borrower cannot make any more withdrawals from the line. To determine the monthly bill, the total amount withdrawn is divided by months allotted for the repayment phase.

For example: A borrower receives HELOC with a $100,000 credit limit and a 10-year repayment period. By the end of the draw period, he has withdrawn $80,000. That amount will be split between the 120-months in the 10-year repayment period. His monthly payment for the next ten years will be $666.66 plus interest. ($80,000 / 120 months).

Although the general process is the same for most HELOCs, individual loan terms vary. Some HELOCS eliminate the repayment period and make a single balloon payment due at the end of the draw period. Some HELOCs use different methods of determining the borrower’s credit line. Before signing application papers, ask your lender for the specific terms of your HELOC.

Next: Is a HELOC Right for You?

HELOC Vocabulary

Collateral – Property pledged by the borrower to secure a loan. Should the borrower default on the loan, the lender may place a lien on the property or foreclose.

Draw period – A span of time (usually 5-10 years) during which the borrower may withdraw money from his home equity line of credit.

Repayment period – The span of time during which the borrower must pay back the money withdrawn from his HELOC (usually 10-20 years).

Revolving credit – A line of credit that can be used to a certain limit and paid down repetitively.