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What is a HELOC and How Does It Work?

written by: Dale DeVries•edited by: Jason C. Chavis•updated: 4/28/2011

Do you know what your options are when it comes to borrowing on the equity in your home? You don't want to borrow all the available funds if you don't need it right now. However, you don't want to borrow too little and find out you need more later. A HELOC may be the answer.

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    What is a HELOC?

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    HELOC is an acronym for Home Equity Line of Credit. It is a line of credit secured by your home. A line of credit works like a credit card where you have a certain amount of money available but only use it when you need it. This is unlike the Home Equity Loan where you get all the money when you close on the loan. A HELOC is considered a mortgage. During a good market you can apply for as much as 125% of the value of your home. If the market is slow the money is harder to get and the maximum is normally between 80 to 90%.

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    How Does it Work?

    So, you may be wondering "how does a HELOC work", this will help get you started. To obtain a HELOC you would apply at a bank, mortgage company or other lending institution. The requirements for the line of credit may be a little more relaxed than a first mortgage because they base it more on the equity you already have in your home. It is important that you have been making the payments on your first mortgage on time. The amount you can receive will be determined by an appraisal done on your home and the current balance of your first mortgage.

    For example, if your home is found to be worth $200,000 and the lender will lend up to 80% of the value it would equal $160,000. If you have a $100,000 first mortgage you would be able to receive $60,000 on your HELOC. You may pay an application fee and appraisal fee out of pocket. All other expenses to the loan would be figured into the loan amount. After you have closed on the loan you will receive a checkbook where you can access your loan any time you like. You can write checks to pay someone or a bill. You can also write yourself a check for cash. In some cases you are also sent a debit card for the line of credit that you would use just like the one for your bank account. It can be dangerous to carry this card around with you as there are normally large balances on these lines that you wouldn't want stolen.

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    How is a HELOC Repaid?

    There are various types of terms associated with these loans. Most are based on the prime rate. If you have very good credit you may pay 1% over prime and if your credit is not so great it could be as much as 3%. These are commonly variable rate loans, however, there are fixed rate HELOCs. They are usually for 10 to 20 years with the first 10 being interest only payments. You can still pay on the principal if you want to, but it is not required. Some have balloon payments at the end of the term and some will amortize for the remainder of the 20 years. Anyone desiring a HELOC will want to investigate different lending institutions to find the best rate and terms for them.

    HELOCs can be a great way to consolidate debt and get rid of credit cards for a disciplined person. The rates are usually much better than that of the credit cards and by putting them all into one loan; you have one smaller monthly payment. However, you must be careful not to go out and charge up your credit cards again because the HELOC is and mortgage and if you can't make the payments your home can be foreclosed by the lending institution.

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    References

    mtgprofessor.com, http://www.mtgprofessor.com/a%20-%20second%20mortgages/what_is_a_heloc.htm

    Federal Reserve, http://www.federalreserve.gov/pubs/equity/equity_english.htm

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    Image Credit

    flickr/james.thompson