HELOC: Is this the home equity loan for you?

Dog and couple slicing apples together in kitchen.
OCCU  -  05.19.2017

Homeowners who are ready to consolidate debt, make home repairs, or who have big life events like a wedding, college or hospital bills they need to pay for, may be thinking about getting a home equity loan or home equity line of credit (HELOC). While both types of loans function as a second mortgage, there are significant differences in how these loans work. How do you know which one is right for your needs? Does it make more sense for you to have a credit union home equity loan in a lump sum, or the revolving line of credit that you get with a credit union HELOC? The answer depends on your personal situation.

HELOC vs. Home Equity Loan: What’s the difference?

When most people consider taking a second mortgage, they’re thinking about a traditional home equity loan. This type of loan is sometimes called a term loan or a closed-end loan because you are borrowing a one-time sum that has a repayment schedule and a fixed interest rate. You make the same payments each month and pay the total of the loan by the end of the repayment period. Once you have received your home equity loan, you won’t be able to borrow more on the loan than was originally agreed upon, and you will be paying on the principal as well as the interest from the very beginning.

A home equity line of credit (HELOC), on the other hand, is a revolving line of credit that is available to you for an amount of time that is set by the lender. You are not advanced the entire sum up front, as you are with a home equity loan. Instead, you are given a credit limit and you are allowed to withdraw money from your HELOC up to that limit as you need it, for the life of the loan. At OCCU, this ranges from five to 15 years. For most OCCU HELOCs you are only required to pay the interest during this “draw” period, but if you also pay on the principal, your credit revolves and you can use the money again, just as you can with a credit card. For instance, if you have a $20,000 line of credit, and you borrow $5,000, you have $15,000 remaining on your credit limit. However, if three months later you pay back that $5,000 toward the principal, you again have $20,000 in credit available to you. You can do this as many times as you need to over the draw period of the HELOC. It’s important to note, though, that HELOCs don’t have a fixed interest rate. While you can fix portions of your loan balance, the interest rates will fluctuate on any unfixed balance over the life of the loan, so your monthly payments will also vary. To see current home equity line of credit rates and other terms and conditions, visit the OCCU Home Equity page.

Understanding the phases of a HELOC

The first five to 15 years of an OCCU credit union HELOC are called the “draw period.” The length of the draw period depends on the HELOC you receive. During the draw period, you may borrow from your HELOC credit line as you see fit. You will be required to make a minimum monthly payment during this period. Depending on the type of HELOC you choose, the minimum payment during the draw period may be to cover only the interest accrued or 1% of the balance. Either way, you may, choose to pay more on the principal as well, in which case your credit will revolve and you can use that money again in the future, so long as you are still within the draw period.

When the draw period ends, it’s time to repay your loan. Now you will begin repaying the principal, as well as the interest on your loan. At OCCU, the repayment period on a HELOC ranges from 10 to 15 years. Because a HELOC has variable interest, your monthly payment will change over the repayment period, but your payments will be calculated so that the entire loan is paid in full by the end of the period.

How much $$ can I get on a HELOC?

Depending on which HELOC you qualify for, and factors like credit score and employment, your credit line at OCCU could be up to 95% of your home’s value, minus any balance you owe on your mortgage. For additional flexibility we even have a HELOC that doesn’t require any equity. For instance, let’s say you qualified for a HELOC that allows you to borrow up to 80% of your home’s value. Let’s do the math:

We’ll assume you have a great credit score and you’re steadily employed, with enough income to make your monthly HELOC payment. Let’s say your home is valued at $350,000 and you still owe $150,000 on your first mortgage. Eighty percent of your home’s value would be $280,000. Subtract the amount you owe on your mortgage to get your maximum line of credit limit. In this scenario, your HELOC would be $130,000 ($280,000 - $150,000 = $130,000).

Is a HELOC right for you?

There are a lot of advantages to a HELOC, starting with the fact that they’re more flexible than a fixed-rate home equity loan. This makes them ideal for life situations that bring about recurring costs, like college tuition that has to be paid each semester. A HELOC is also perfect for a project that will take several years, like a big home remodel in which you’re going to need access to your credit for ongoing projects.

Home equity loans also tend to have lower interest rates than many other forms of credit: for instance, a credit card. This makes either a home equity loan or a HELOC good ways to consolidate credit card or other debt that you’re paying higher interest rates on. The interest you pay on a home equity loan, whether it is a HELOC or fixed-rate loan, is also generally tax deductible, unlike credit card debt, saving you even more money. Consult a tax professional regarding your particular situation.

Again, you are only required to make the minimum payment, which could be only the interest accrued or 1% of the balance, during the draw period on a HELOC. During that time, your monthly payments can be very reasonable, allowing you to focus on what matters: getting that child through college, finishing that big remodeling project or working to improve your credit score.

Another advantage of a HELOC is the fact that if the balance on your loan is zero, you have no monthly payment. For people who need access to a credit line from which they can borrow money for a short period of time and can pay back the principal quickly, a HELOC makes a lot of sense. In this case, a line of credit might cost the borrower significantly less in interest than a fixed-term home equity loan would.

However, it’s important to understand your needs and your personality before you apply for a HELOC. This type of loan isn’t right for every situation, primarily because the interest rate on a HELOC changes with the prime rate. When the prime rate is low, your HELOC payments will be lower, and when the prime rate is high, your payments will be higher. This makes it difficult for some people to set a budget that they can work with. And of course, when the draw period ends, those variable monthly payments will go up considerably as you begin paying on the principal of the loan.

Similarly, there is a risk in using a HELOC to pay off credit card debt. Unless you are disciplined enough not to accumulate additional debt, either with your HELOC or the original credit cards, you could find yourself deeper in debt and unable to meet the minimum monthly payment when the draw period ends and the repayment period begins.

Remember also that the collateral underlying your HELOC is your house and property. It is important to know that if the worst case happens and you are unable to make payments the lender has the right to foreclose on your home.

For these reasons, there are many situations in which a standard home equity loan would be the better option. For instance, if you need a lump sum to make immediate repairs on your home, or to pay off a higher interest credit card, or to pay for the part of your hip surgery that your insurance didn’t cover—in other words, you know how much money you need, when you need it, and you don’t need to borrow more again soon—a home equity loan with a low fixed interest rate for the amount you need would save you money in the long run.

Getting a HELOC can be a perfect solution for the right borrower, so long as you have the ability to handle those changing interest rates and payments. Be sure to compare a HELOC to other loan options before you apply to make sure it’s the best choice for your situation. Ask yourself important questions like when do you need the money and for how long? How large of a monthly payment can you make and/or how many years do you need to comfortably pay off the loan? If you’re not sure which loan type makes the most sense for you, give us a call or stop by one of our OCCU branches. Our knowledgeable loan officers will be glad to sit down with you and help you determine the best option.

What happens if I can’t afford my HELOC payment when the draw period is finished?

If you’ve had a HELOC for 10 or 15 years, and you’ve been enjoying low payments of interest only, it can be a shock to see how significantly payments will go up when the draw period ends. If you still owe a lot on your HELOC, the repayment period can sneak up on you and become a burden you weren’t prepared for. Life throws curve balls sometimes; you may have had a good plan in place when you took the loan, but now you’re not able to meet the higher repayment amount. Fortunately, you have options. If your credit score is still good, you have built equity in your home, and you’re still adequately employed, you may be able to refinance your HELOC or take out a different kind of loan to pay off the balance.

The first option is to refinance your HELOC with a new one. This means you will again have the draw period in which the requirement payment is only the interest accrued, and you can make payments on the principal as you’re able. This option will stretch out the amortization period and still leave you with some credit options if you need them in the future. The downside of this refinancing route, of course, is that you will still have the variable interest rate that can go higher than you’d like. When the new draw period ends, you will again face a significantly higher repayment period.

Another option is to refinance the HELOC and your first mortgage into a new primary mortgage. This will allow you to lock in a lower fixed interest rate, and you could potentially stretch the loan over a longer period of time to keep payments down. You will have to take closing costs into account with this financing option, and it will be important to continue to build equity in your home. Additionally, you will not have a credit line with this fixed-rate mortgage.

And finally, you may qualify for a fixed-rate home equity loan that will allow you to pay off the HELOC. In this way you will lock in an interest rate that will remain the same for the life of the loan. As with a primary mortgage, you may be able to stretch out your payments over a longer period of time that will make monthly payment doable. Again, you will not have a credit line with a fixed-rate home equity loan.

If you believe a HELOC may be what you need to meet your life goals, or if you’re interested in knowing more about home equity loans in general, let’s connect.