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Friday 12/15/2017 Mortgage Rates

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Home Equity Line of Credit

Defining a HELOC

A home equity line of credit (HELOC) can create a lot of flexibility by converting your home's current equity to credit. Homeowners with an HELOC can pay their monthly dues interest-only within a "draw" period (5 - 15 years), or can choose to pay all of them at once in a lump sum at the end of this period.

If you don't know how home equity works, learn about it from our introductory article first. HELOCs are not to be confused with home equity loans. For a comparison between HELOCs and home equity loans, click here.

Unlike primary mortgages, an HELOC does not involve closing fees since it doesn't require processing of new documents.

Revolving Credit

The Benefits of HELOC

  • Open-ended: You can deposit your entire income into your HELOC and still be able to retrieve it like you would with a credit card. What remains in the line of credit will drive down your interest payments and minimize what you owe on your mortgage. In this way, your income has an immediate effect on your outstanding balance when deposited. 
  • Better than a credit card: Where a credit card charges you monthly regardless of its use, HELOCs charge you only following certain activity.
  • Interest-only low payments.
  • No closing costs: The same forms and paperwork used to close your mortgage will be used to activate your HELOC without incurring lender fees.
  • No mortgage insurance required: Even if you drive up the loan-to-value of your mortgage to a 100% by draining your HELOC flat, you won't have to pay any mortgage insurance - which would be the case had you applied for a mortgage with a 100% LTV initially.
  • Home appraisals are not vital to using your HELOC unless you want to measure the change in the home equity you've built with renovations or new upgrades over the years.
  • Time-saving: There is no need to process new documents, open a new account, or go through the hassle and costs of refinancing.
  • Can be better than refinancing: HELOCs can be used to pay off a mortgage within a much shorter timespan than refinancing your mortgage. To learn about mortgage refinancing, click here.
Income vs. Debt

Eligibility Requirements for an HELOC

HELOCs are not moderated by the government since they are private bank products. Most mortgages are insured by the Federal Government, as outlined by the underwriting guidelines of Fannie Mae and Freddie Mac. To qualify for using your HELOC, you will need to meet all the following criteria:

  • Sufficient income relative to debt.
    This is found by using the combined loan-to-value (CLTV) ratio - which adds all mortgage-related debt and divides it by the home's appraised value:(Debt of the original mortgage + debt of any other mortgage, if any) ÷ appraised home value = CLTV
  • You don't need a mortgage to qualify for an HELOC.
    You can tap into your home equity without having a mortgage loan and reap the rewards.
  • An ideal 90% LTV or less.
    Most lenders prefer a 90% loan-to-value or less. The lower your LTV is before and after using your HELOC, the less of a risk you will be to the lender and the more supportive they will be of you.
  • Proof of income.
    For your sake, make sure your debt-to-income is less than 33% before and after using your HELOC.
  • Good credit score.
    Anywhere between 680 and 719 is a "good" credit score.

The Drawbacks of Using an HELOC

The two main drawbacks of using your HELOC have to do with adjustable rates and discipline. In a situation where the rates of the economy are rising, you could suffer losses, but this is only in extreme cases.

A more notable disadvantage with an HELOC, however, does not have to do with the product itself as it does with the homeowner or borrower. For the most part, the problem with HELOC users is that they will misuse the readily available line of credit on asset reducing sprees. The smart thing to do with an HELOC is to invest in wealth generating projects such as home improvements, college fees, a second home, and what have you.

Illustrating Home Equity

How to Use Your HELOC to Pay Your Mortgage

HELOCs are "open-ended", which means the sum of your income and home equity used to drive down the outstanding loan balance is the same source of funds that can be used for other purposes.

Reducing the mortgage you owe using your HELOC is not just a matter of transferring any amount you wish from your line of credit to your mortgage, you should also consider your home's loan-to-value. A loan-to-value is simply the mortgage debt amount you owe in contrast with your home's appraised value. The higher your loan-to-value ratio, the higher the monthly interest costs that you will incur. The trick with allocating your HELOC towards your mortgage debt is to reduce your mortgage just enough without being charged with significantly higher interest.

Let's look at an example. Suppose your home's current appraised value was $150,000 and your current outstanding mortgage balance was $110,000. The $40,000 positive difference doesn't mean that you can put down $40,000 towards your mortgage because you have to keep into consideration the resulting loan-to-value. We need to put down just enough so that the loan-to-value ratio doesn't climb higher than 80% - which is the ideal LTV required by lenders when you take out a standard loan.

Calculating the current LTV is done like so: Current mortgage debt ÷ home's current appraised value = 110,000 ÷ 150,000 = 0.73, or 73%.

This means that you can issue 7% (the difference between your current LTV and the ideal LTV) of your home's current appraised value towards your mortgage debt without exceeding the ideal LTV ratio (80%). 7% of 150,000 works out to be $10,050.

You have $10,050 worth of home equity to spend on anything you like, whether it be paying off the mortgage, other debts, or anything you wish.

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