A home equity line of credit (HELOC) allows you to leverage your home equity, which is the percentage of your home’s value that you already own, using the home as collateral. HELOCs are attractive because they provide easy access to money for home improvements, debt consolidation, medical bills, and other expenses. However, there’s a catch: Because HELOCs are tied to home equity, your lender can freeze or reduce your line of credit if your home’s value drops.
Key points to remember
- A home equity line of credit (HELOC) is a revolving line of credit secured by your home.
- Lenders base the loan amount on your home equity, credit score, and debt-to-income ratio (DTI).
- HELOCs generally have two stages: a draw period and a redemption period.
- If the value of your home drops significantly, your lender may limit or freeze your line of credit.
What is a Home Equity Line of Credit (HELOC)?
A HELOC is a revolving line of credit much like a credit card, except your home secures it. Because a house acts as collateral, HELOC interest rates, which are variable rather than fixed, tend to be more favorable than credit cards and personal loans.
Your lender approves you for a certain amount of credit based on your home equity, credit score, debt-to-income ratio (DTI), and other factors. As long as you stay under your credit limit, you can borrow whenever you need money, drawing funds via online transfer, cash pickup at your local bank branch, or check, card ATM or credit card linked to the account.
HELOCs and home equity loans allow you to borrow money using your home as collateral, but they work differently. A HELOC is a revolving line of credit, while a home equity loan gives you an upfront lump sum payment. Both loans involve interest and fees.
How do you reimburse a HELOC?
HELOCs generally have two stages: a draw period and a redemption period.
The drawdown period is typically 10 years, during which time you can borrow up to your credit limit, pay it off, and borrow again as often as you like. During this stage, you pay interest on the amount borrowed or make a minimum monthly payment (according to your loan agreement). You may also be able to make payments on the principal of the loan, if the lender allows it.
When the draw period ends, the HELOC closes, meaning you can’t withdraw any more money, and moves into the redemption period. You’ll make monthly installments to repay principal and interest, usually over 20 years. The amount of your payment will depend on your outstanding balance at the end of the drawing period and the prevailing interest rate. Some HELOCs have a lump sum payment, which means that the full amount of the loan plus interest is immediately due at the end of the drawdown period.
HELOCs typically have variable interest rates, so your payments can go up or down over time.
HELOC and falling home values
As mentioned above, your HELOC credit limit is tied to the value of your home, among other numbers. Although your lender considers the value of your home when you apply for a HELOC, they assess your line of credit and your ability to make payments over the life of the loan. If something has changed drastically since you got the loan, your lender may reduce or freeze your HELOC.
If this happens, you won’t be able to draw the full amount of your line of credit (or part of it, in the case of a freeze). However, you will still be responsible for performing your loan agreement, including monthly interest payments. Some of the most common reasons a lender might reduce or freeze your line of credit are:
- Credit rating dropped
- Employment or income status has changed
- Overall indebtedness has increased
- Marital status has changed
- The value of the house has dropped significantly
Your lender must send you written notice within three business days of your HELOC being reduced or frozen. If the lender’s reasoning doesn’t make sense to you, ask for a detailed explanation and if there’s anything you can do to re-establish your line of credit.
You can appeal the decision if you think the lender made a mistake. For example, your house is worth more than your lender thinks because you recently made substantial improvements. Of course, your lender will expect an updated home appraisal if you want to appeal based on the value of your property. However, keep in mind that the appraisal fees will be your responsibility and, more importantly, an updated appraisal will not guarantee that your lender will approve your appeal.
If your lender does not restore your HELOC, you can check with other lenders to see their offers. You may be able to open a new HELOC and use some of the funds to pay off your original line of credit.
Can I use a HELOC to pay for anything I want?
Once you’ve pulled out of your HELOC, it’s up to you (not your lender) to decide how you’ll spend that money. Smart uses can include home improvements, debt consolidation, major purchases like a house, a new business, or medical bills.
Of course, it’s important to avoid using a HELOC to hide any financial troubles you might be having, such as maxing out your credit cards for unnecessary expenses. In other words, you shouldn’t use a HELOC to plunge yourself into a bigger financial hole. Instead, work on the factors that caused you problems in the first place and use the HELOC to help improve your financial situation.
How much does an assessment cost?
The average price for a single-family home appraisal is $375 to $450, according to Fixr.com, which provides cost guides, comparisons and information for home improvement, installation and repair projects. .
Can I deduct HELOC interest?
You can deduct the interest you pay on a HELOC only if you use the money to buy, build, or significantly improve the home that serves as collateral for the HELOC. However, the standard deduction has increased under the Tax Cuts and Jobs Act, so you might not be a winner by itemizing HELOC interest on your tax return.
Property values tend to increase over time. Yet rising mortgage rates, increased supply, falling demand, recessions, and other events can drive prices down. If your home’s value drops a bit, your lender probably won’t reduce or block your HELOC, as slight fluctuations in the market are normal. It’s when the value of your home changes significantly that your lender can take steps to limit their risk.