Table of Contents
- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
Introduction to HELOC
A lot of people know what home equity is and many of you might have taken advantage of your home equity for many different reasons.
But for few who want to know about that is a HELOC (Home Equity Line Of Credit) and how does a HELOC work, this post is exactly what will help you understand that.
What is Home equity?
Before understanding how the HELOC work we will see what is home equity. In simple terms, home equity is nothing but your investment.
Share in your own property after deducting the mortgage or any other liens on the house.
We will take an example here to understand which we can take as a use case for this post purpose.
In the below example the Equity equals to Value of the House – Mortgage balance:
Property Value = $300,000
Mortgage Balance = $200,000
Equity = Property Value – Mortgage Balance
Equity = $300,000 – $200,000
Equity = $100,000
How Does a HELOC work?
HELOC is one of the financial tools used by many borrowers to remodel the house, pay off debts, have higher education, and many such purposes. A home equity line of credit is a loan given against the equity on the house.
The functionality of HELO is just like credit cards. The lender will approve a limit of a certain amount from the equity as HELOC to the borrower.
The borrower is only responsible to pay for the amount he is used from the set limit with the interest. Usually, the interest rate charged on HELOC is higher than any other mortgage loan in the market.
Concept of LTV
Loan to value ratio that tells a borrower how much they can get compared to the value of your house. In the example that we have taken the loan to value ratios is calculated as :
LTV = Mortgage balance /Property Value
$200,000 / $300,000 X 100 = 66.66%
This means that 67% of your property value is owed on the mortgage.
Let us say that the lender is ready to provide up to 80 % loan to value including your HELOC.
This means the lender can provide up to 80% of your home value including your current mortgage balance.
In our example, the HELO that the lender can grant you would be $40,000.
Now, many people think that they get this $40,000 all upfront like a mortgage. Well, it is like a credit card where you would get a limit of $40,000.
You can use whatever portion of the $40,000 that you require and you pay interest only the portion that you use.
How is the interest rate charged on HELOC?
When it comes to HELOC it uses a concept called average daily interest. The reason why HELOC uses average daily interest is that you can take the money out of the HELOC and pay it back. It is calculated in the below form.
Daily HELOC balance / 365 x interest rate.
Your interest rate may vary every day depending upon the amount that you borrow.
How is HELOC different from Mortgage?
HELOCs are considered NON-QM loans. Mortgages in general are heavily regulated by government guidelines.
When it comes to HELOCs, it is not as regulated as mortgages. This means that the lender could sort of dictate and that have the freedom to customize and change the features of the HELOC.
This means that not all HELOCs are created equal. In case of the mortgages, all the lenders and banks have to follow the same guidelines.
Hence there are very few chances of you getting any different features in mortgage from different lenders.
HELOC Requirements
The requirement for HELOC is not different from that of a mortgage, but you do need to understand that HELOC is a bank product.
The basic requirement for getting a HELOC is equity. The banks usually can get the HELOC for up to 85% LTV.
But this could depend on the lender to lender and your cash flow, DTI, and other parameters.
Conclusion
Though the HELOC is available at your disposal, you need to have a very firm reason to use it. Budget your expenses and access your line of credit accordingly.
As failure to make the payments might end up in foreclosure. In such cases you might want to sue other options like a home equity loan, cash-out refinance, or a personal loan.
