How Does a Home Equity Line of Credit Work?

If you own a home and have made sufficient payments to produce equity, you may find it appealing to turn some of that equity into cash. One way is to take out a second mortgage, but that idea is not always appealing. There is another alternative. When you’re laying out your financial budget, it’s good to understand the particulars regarding how does a home equity line of credit work. A home equity line of credit can be a readily available source of money.

What Is a Home Equity Line of Credit?

To help you answer the question of how does a home equity line of credit work, you should appreciate the difference between two similar home equity options. A home equity line of credit is not the same as an equity loan. When you secure a home equity loan, it is essentially a second mortgage. The biggest difference in answering how does a home equity line of credit work is the distribution method of the money.

A loan is exactly that, handed to you at one time. An equity line is a source of money, usually a preset amount. You can tap into it in case of emergencies, or other unplanned expenditures. The loan will usually have a fixed interest rate, with a predetermined payment structure. An equity line of credit is money you use when you choose.

How Does a Home Equity Line of Credit Work?

An equity line of credit can have a fluctuating interest rate, depending on when you secure the money. You can use this feature to borrow against your home’s equity when interest rates drop. This way, you will get the most for your money. Here is how to set up an equity line of credit and credit details you should consider. Also, you will find useful information regarding how repayment works, and especially how to avoid a lump sum payment at the payoff.

How to Establish an Equity Line of Credit

The first step in establishing a line of credit on your home in which you can borrow against is to find the appraisal value of the property. This is imperative. First, you must secure a fair appraisal of the market value of your home. Then, you can calculate how much equity you have.

The equity that you can borrow against will be a predetermined percentage of that equity as per lending institution guidelines. These guidelines will vary. However, it is rare that any bank or finance company will allow a homeowner to generate a financial obligation that exceeds 80% of the total appraised home value.

First, one needs to determine the amount of equity involved. Then, you will then need to present all required financial records to the lending entity of your choice. One thing to pay close attention is your debt to income ratio. It is the same factor that is important in securing a standard mortgage and becomes even more critical with equity loans and equity lines of credit.

an illustration of a house on a pile of money on a gray background

Equity Line of Credit Details and Specifics

There are some details surrounding aspects of how does a home equity line of credit work. Here is a list of details and specifics to consider before accepting the terms of an equity line of credit.

1: Continuing Costs

Even if you do not incur closing costs to secure an equity line of credit, your lender may have continuing fees associated with the equity line. These are somewhat similar to interest rates on credit cards.

Frequently, fees are generated whether you take any money out of the equity or not. Be vigilant when discovering all fees associated with your borrowed money. This is a critical aspect of how does a home equity line of credit work.

2: Refinancing Unpaid Balance

This could become critical if you encounter a loss of employment or other life circumstance that creates a reduction in your earnings.

If you are able to refinance any unpaid balance on your equity line, it could be helpful in an emergency. You can also work the financial system with this option, refinancing balances to secure better interest rates.

3: Repayment Terms

Know the payment terms in detail. The specifics of how the interest and principal are repaid will determine how and when you choose to borrow against the equity.

When you address the specifics about how does a home equity line of credit work, repayment terms are critical. One important question to ask is discussed below in lump sum or balloon payments.

Lump Sum, or Balloon Payment

One huge consideration when understanding how does a home equity line of credit work is to know what the payment structure is at the end. Some equity loans can incur a substantial final lump sum fee added to final payment. We’re talking about both second mortgage type and equity lines of credit. Sometimes these are akin to closing costs posted at the end of an extension of credit.

Make absolutely certain you understand the percentage and what the final lump sum payment is before you accept the terms with your signature. These costs may still be appealing if they are less than the amount of money you would spend on high-interest credit cards, or other types of unsecured debt.

Final lump sum payments may also be unavoidable if one needs the money to meet an emergency expense. There are also situations where early repayment of the money may generate an early termination fee. Be aware of all fees before you agree to an equity line of credit, especially any end-loaded lump sum payments.

How Does an Equity Line of Credit Work in Relation to Purposes and Uses of the Money?

One of the most important considerations surrounding how does an equity line of credit work involve how you can use the money. A loan on the equity will customarily have far more rigidly established guidelines on how you can use the money. It is not the same situation when you consider how does an equity line of credit work.

Equity lines of credit are monies that you can access whenever you need them. They quite similar to having an open credit card, but the interest rates will be substantially less. You can use the money you draw out for just about anything you want.

Fix something in your home, or make a long-awaited purchase. Maybe you want to use your equity for something really special. For instance, you may want to take a family vacation without having to incur high-interest credit card debt. However, frivolous spending using your home’s equity value should always be guarded against.

Pros of an Equity Line of Credit

  • The number one advantage of setting up an equity line of credit using your home’s value is having a security blanket in case of an emergency. When wisely used, equity lines of credit can help reduce financial stress.
  • If you’re laboring trying to erase high-interest debt such as credit card balances, an equity line of credit can erase these balances at a far lower interest rate. Be aware that you don’t exhaust the equity in your home, and then rebuild an enormous amount of high-interest
  • If you’re using the equity line of credit to make improvements to your home, you can pay as you go to defer large cash outlays for the work. This can be a productive way to use an equity line of credit since many upgrades to your home will frequently increase the equity.

Cons of an Equity Line of Credit

  • The Federal Trade Commission states that your home’ value secures equity lines of credit. You can be foreclosed on according to state laws. Know your rights before securing monies through either option.
  • Do not be tempted to incur more debt than you can meet financially. This money will have an appealing interest rate. Therefore, you may be prone to spend more than what might be otherwise frugal fiscal management.
  • In the same light as borrowing beyond your limits, equity lines of credit can also spur you to make frivolous, unnecessary purchases. While a family vacation may produce lifelong memories, taking a world travel excursion on the equity value of your home may not be wise.

Bottom Line

Home equity lines of credit are like a financial security blanket. So, you should only use them when needed, or when you feel like investing in something special. Make sure you thoroughly understand all fees, charges, especially if there is a lump sum payment due after your final payment.

It’s true that putting your home up as collateral against the money you use is taking a risk. Still, as long as you stick to your financial budget, equity lines of credit are an excellent source of cash.

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