What is a HELOC?
HELOC stands for Home Equity Line of Credit. In basic terms, home equity is what your home is worth minus what you owe on the property.
Let’s say your home value is $200,000. And let’s say you owe a hundred thousand dollars as a mortgage. Consequently, your equity is a hundred thousand dollars.
How Does a Home Equity Line of Credit Work?
In this case, you’re using a line of credit to borrow against your home equity. The line of credit portion essentially takes your home equity and turns it into something like a credit card.
So going back to the early example you have a hundred thousand dollars of equity. If you get a line of credit on that hundred thousand dollars, you essentially get the ability to use that hundred thousand dollars sort of like a credit card. You can use up to a hundred thousand dollars. You borrow up to a hundred thousand dollars and pay back whatever you’ve used. Then you can reuse it all over again just like a credit card.
Understanding Loan to Value (LTV)
An important concept to understand is the concept of LTV, which stands for loan to value. Essentially, loan to value is how much you can get in terms of your loan in comparison to your home value.
Going back to our example. You have $200,000 of home value in this case and $100,000 of money still owed. As it stands, you have what is called a 50% loan to value. Meaning 50% of your total home value is being owed on a mortgage.
How Loan to Value Affects Your HELOC
Let’s say a bank offers you a 90% loan to value for your home equity line of credit. What that means is you can borrow up to $180,000 out of $200,000 because $180,000 is 90% of $200,000.
Since you still owe $100,000 of your mortgage, you are already at 50% of your loan. So, you can only use 40% of the $200,000 value towards your home equity line of credit.
Second Position Home Equity Line of Credit
In this case, this is called a second position home equity line of credit because your mortgage comes first. Your mortgage is considered the first position. It comes before this new home line of credit using the 90% loan to value. Thus, you now have an $80,000 home equity line of credit as the second position.
What can you use a HELOC for?
You can use whatever portion of that $80,000 for whatever you like. However, why not use the home equity line of credit to either pay off your mortgage? Or to pay off your debt? Or to acquire real estate properties that can help you make more money?
You do not typically get the $80,000 upfront. You can choose to if you write a check against your home equity line of credit. Then, you get it all up front however that is not strongly advised. Instead, your HELOC is comparable to getting an $80,000 limit credit card.
In other words, potentially you could have the same amount of leftover money as if you sold the property, but you don’t actually have to sell it. Now, you can use that $80,000 to invest in real estate. Maybe you use it to buy a lower price, blue collar home in your area. Maybe use it as a down payment on an apartment building. Or maybe you use it as the capital needed to offer your next real estate deal. The possibilities are great if you use your HELOC wisely.
Types of Line of Credit
There are different types of line of credit.
Personal Line of Credit
There’s a personal line of credit which doesn’t use a home equity line of credit. The difference between a personal line of credit and a home equity line of credit is it essentially uses your home equity as the portion that you can use for your line of credit.
Business Side Line of Credit
There’s also business side credit. If you have a business, typically you can get a line of credit. If you have a legitimate business, it works very similar to a home equity line of credit. Again, the difference is that it is not attached to any specific home equity.
Are interest rates higher than a mortgage on a Home Equity Line of Credit?
Yes. The interest rates are higher than on a mortgage. Typically, home equity line of credit interest rates are higher than your mortgage. However, the way that the interest is calculated and applied on a home equity line of credit is completely different to how a mortgage and the interest rate is calculated.
How Interest is Calculated and Applied for a HELOC – Average Daily Interest
When it comes to Home Equity Line of Credit, it uses a concept called average daily interest. The reason why HELOC uses average daily interest is because you could take the money out of the HELOC and pay it back.
The way to calculate the interest is it takes whatever balance that you have on that day divided by 365 days, times the interest rate. That is what’s called the average daily balance.
How Average Daily Interest Works
Today, you may have zero balance on your home equity line of credit. That means you are not going to owe anything on your interest.
But tomorrow you may spend let’s say $5,000. Which means that you now have a balance of $5,000 divided by 365 days, times the interest rate. That’s the amount of interest that you owe on that particular day.
The next day, you may spend even more money. Let’s say you spent another $2,000. Thus. Now you have $7,000 of balance. Right now it’s $7,000 divided by 365 days, times, whatever interest rate you owe on the HELOC.
Every day your interest may vary. You may have a different amount of interest on one day and the next day. That’s why if used properly, the home equity line of credit is a much more efficient and effective tool when it comes to paying off any debt.
HELOCs vs Mortgages
What’s the difference between a HELOC and a mortgage?
Mortgages by definition are regulated heavily by the government. The government sets regulations and standards as to how banks issue out mortgages and how they give out mortgages.
HELOCs on the other hand are considered non QM loans. When it comes to the home equity line of credit, it’s not quite as well regulated. It is not as regulated as a mortgage. What that means is that the banks sort of dictate it. Banks have the freedom to change and customize the features of the HELOC.
So not all HELOCs are created equal. Banks may have a different set of features and different types of interest rates depending where you go. Each bank is going to have different types of setup, different types of features and different types of fees. It’s really important that you read the fine prints as well as the disclosures when you’re being presented with the heloc offer by a bank.
Whereas in a mortgage, wherever you go, it’s generally the same. They may offer different types of interest rates or different types of fees. But generally, almost all mortgages are operated the same way they’re offered in the same manner wherever you go.
Do Your Research When Shopping for Home Equity Line of Credit
There’s so many different types of features that are out there for the home equity line of credit. Be sure to research thoroughly about where to get a HELOC and what the conditions for each line of credit is before making any decisions.