A home equity line of credit can be a great way to use your home’s equity to finance big ticket items such as home improvements, paying off high-interest debt, or buying a second home.
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What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is a type of second mortgage.The way a HELOC works is very similar to the way a credit card works. Your home’s equity is used as the collateral for the loan and you receive a line of credit from which you can draw money.
Benefits of a Home Equity Line of Credit
Using your home equity line of credit for home improvements, consolidating your high interest debts, or keeping a rainy day fund, is a better financial alternative than using your credit cards. Here are the top 4 home equity line of credit benefits:
How Does a Home Equity Line of Credit Work
- You get a lower interest rate than you would with your credit cards. That means you pay less interest over the life of the loan.
- You get tax advantages that are not available with credit cards. With a home equity line of credit, the interest is usually tax deductible. Interest on credit cards is not tax deductible. Refer to your accountant to determine what tax advantages are available to you.
- You get flexibility in your payment options. Lenders offer interest only options to help make your payments more flexible. With an interest only home equity line of credit, you have the option to pay only the interest for a pre-determined amount of time or pay interest plus as much or as little principal as you want.
- In some instances, you get much larger credit limits. This is a great option to have when making a large purchase, such as remodeling your kitchen or adding an addition to your home
How Does a Home Equity Line of Credit Work? A home equity line of credit has several unique characteristics. Here is a quick overview:
During the initial years of the loan, you are usually only required to make interest only payments and you only make payments if and when you draw money from your account.
After the initial years of the loan, the full balance is amortized and paid off over the remaining years. An initial minimum draw (taking money in cash) is sometimes required at closing.
Like any standard loan, the interest rate and annual percentage rate (APR) are calculated based upon your credit score and the combined loan to value ratio (CLTV). Generally, the lower the CLTV combined with a higher credit score, the better your chances are of getting a better rate.
Your interest rate adjusts as the result of an index plus a margin. The index, which can change, is the Prime Rate as published in the Wall Street Journal at the time of the adjustment period. The margin, which cannot change, will be determined at the time of your application. Many of the terms here can be researched in the glossary.
There some home equity programs which offer a fixed rate for the life of the loan.
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