Learn all about HELOCs in this guide. Find out how it works and if a HELOC counts as a second mortgage. Know whether your clients need an appraisal to qualify
A home equity line of credit (HELOC) gives homeowners a way to access the equity in their property. It functions as a second mortgage that provides them access to funds based on the value of their home. Like a credit card, your clients can draw from a HELOC and repay all or some of it each month.
Many people choose this option because it lets them borrow money when they need it, without having to refinance their mortgage. In this article, Mortgage Professional America will discuss how a HELOC works. We will talk about its benefits and downsides as well as how your clients can qualify. Want to know if a HELOC requires an appraisal? Read on to find out.
How exactly does a HELOC work?
A HELOC lets your clients borrow against their home’s value. Unlike other loan options, a HELOC gives them a line of credit that they can use, repay, and reuse during the draw period. This can be a great strategy for some homeowners. Still, there can be some risks.
To make it easier for your clients to understand, you can tell them that HELOCs work a lot like a credit card. As homeowners repay what they borrow, they free up more credit to use again.
Length of draw periods
Most draw periods last between 5 and 10 years. Within this timeframe, your clients can take money out and repay it as they need to. They can also make payments on just the interest during the draw period. After the draw period, they move into the repayment period. This can last about 10 to 20 years. This is when your clients must start paying for both the principal and the interest every month.
Watch this video to learn more about HELOCs:
Nowadays, HELOCs are still in demand as homeowners tap into their home equity due to economic pressure.
Is a HELOC a second mortgage?
Yes, a HELOC is considered a second mortgage. It’s an additional loan, on top of your clients’ first mortgage, that allows them to borrow against the equity in their property. They’ll be using their property as collateral.
Unlike a home equity loan which provides a lump sum upfront, a HELOC offers a revolving line of credit. This means that your clients can draw funds as needed up to a predetermined credit limit during the draw period.
During this time, they often make interest-only payments. After the draw period ends, the repayment phase begins. This will then require both principal and interest payments.
HELOCs and interest rates
HELOCs usually have variable interest rates, which can fluctuate over time based on market conditions. This flexibility can be beneficial for borrowers who need access to funds over an extended period, such as for:
- home renovations
- repairs and maintenance
- other ongoing expenses
Remind your clients that as with any mortgage, failing to meet payment obligations can lead to foreclosure. As such, you should help them review their financial situation and repayment ability before deciding whether to get this second mortgage.
Does a HELOC require an appraisal?
Banks and mortgage lenders will often require an appraisal when a homeowner applies for a HELOC. This is to help them assess the current market value of the property, which is vital in calculating the available equity.
Watch this video to better understand how home appraisals work:
To calculate home equity, get the difference between the home's value and any outstanding mortgage balance. This will then serve as the basis for the credit limit offered through the HELOC.
Types of home appraisals
Appraisals can vary in form. Some banks and mortgage lenders might go for a full appraisal, while others might use an exterior-only appraisal. They can also choose to make a rental analysis or a Broker Price Opinion (BPO). Your clients' chosen mortgage provider will decide based on these factors:
- the bank, credit union, or mortgage lender’ policies
- your clients' credit profile
- home loan amount
How borrowers can qualify for a HELOC
To qualify for a HELOC, your clients need to have equity in their home. This means that their property must be worth more than what they still owe on it. Most banks and mortgage lenders will let your clients borrow up to 85 percent of the home’s value, minus the current mortgage balance.
Before being approved for a HELOC, home loan providers will mostly review the same financial details that they looked at when your clients first applied for a mortgage such as:
- credit score and credit history
- employment history
- monthly income
- monthly debts
While these are the basics of what mortgage lenders will check, there are other requirements for borrowers to get a HELOC. These are:
- good credit
- sufficient income
- reliable payment history
- low debt-to-income (DTI) ratio
- a minimum percentage of equity in the home
Visit our special report on top mortgage lenders in the US. Reach out to these companies to find out which ones offer the best HELOC deals.
Is having a HELOC a good idea?
Yes, having a HELOC can be a good idea for your clients. Below is a quick look at six things a HELOC is good for:
- withdraw for years
- interest on what your clients borrow
- freedom to use the money
- high loan limits
- low payments (at the beginning)
Here is a closer look at each:
1. Withdraw for years
One of the most attractive parts of a HELOC is the ability to access funds over a long period of time. During the draw period, your clients can take money out as they need it. This can usually last up to 10 years.
For example, they might withdraw $5,000 one month, repay it, and later withdraw another $20,000. This kind of setup can give your clients flexibility with their cash flow. It works well for ongoing or unexpected costs such as tuition fees, medical bills, and other recurring expenses.
2. Interest on what your clients borrow
With a HELOC, your clients only pay interest on the amount they use. If they have access to $40,000 but only use $15,000, they will only pay interest on that $15,000. This will help lessen the total interest cost over time.
It’s a huge advantage compared to other loans that charge interest on the full amount right from the start, no matter how much your client ends up using.
3. Use the money however you want
There are no spending restrictions on HELOCs. Your clients can use the funds on home renovations and repairs. They can use the money they borrow to pay off high-interest credit cards and cover education fees.
Other homeowners spend the funds on things totally unrelated to their properties, such as consolidating debt or taking a vacation. They can even spend it on personal leisure, invest in landscaping, you name it! The freedom to use borrowed funds makes HELOCs a strong option for people with varied financial needs.
And since the credit line can be reused, it works much like a credit card. As your clients repay what they’ve borrowed, more credit becomes available to use again. This makes HELOCs a great choice for both planned and unplanned expenses.
4. High loan limits
A HELOC potentially offers access to large sums of money. There are banks and mortgage lenders that allow homeowners to borrow up to $500,000, depending on how much equity they have in their home.
This is often much more than what your clients can get through a credit card or unsecured loan. It’s also common for HELOCs to have lower interest rates than other credit options. Both the borrower’s credit score and home equity are major factors in how much they can borrow and what rate they receive.
5. Low payments (at the beginning)
During the draw period, most HELOCs only require interest payments. This keeps the monthly payments lower at first. This can be helpful for those who want to protect their cash flow. This feature is useful for your clients especially if they’re on a tight budget.
Once the repayment period begins, the client must start paying both the principal and the interest. In turn, don’t forget to remind your clients that their monthly payment amount will increase over time.
What are the disadvantages of a HELOC?
As mentioned earlier, getting a HELOC can have some downsides. To give you a better idea whether HELOC it is the right option for you, here is a quick look at five potential downsides:
- variable rates
- payment shock
- home as collateral
- potential prepayment penalties
- ongoing fees
Let’s take a closer look at each:
1. Variable rates
Most HELOCs come with variable interest rates. These rates are often tied to the prime rate. If the prime rate goes up, your clients' HELOC rate may rise too. If it drops, the HELOC rate could go down. This can make monthly payments less predictable.
When speaking with homeowners, you should explain that interest rates might shift several times over the life of the credit line. You can also suggest that they should plan for rate increases. This will help them avoid payment surprises and stay prepared for higher monthly costs.
2. Payment shock
During the draw period, your clients will make interest-only payments. While this keeps payments low at first, it can be a problem later. When the repayment period begins, they must start paying back both the interest and the principal.
If your clients borrowed a lot during the draw period, their new payment could be much higher. This sudden change in cost is called payment shock. Help your clients plan early so that they’re ready for the higher payment amounts when repayment starts.
3. Home as collateral
A HELOC is a secured credit line. Your clients’ home becomes the security for the loan. This allows banks and mortgage lenders to offer better rates and terms. But if your clients fall behind on payments, they risk losing the home.
That’s why it’s imperative to make sure that they understand the risk before deciding to go for a HELOC. Remind them that using home equity comes with responsibility and preparation. Advise them to never miss their payments and use their funds wisely.
4. Potential prepayment penalties
Some mortgage providers charge a fee if the borrower closes the HELOC too soon after opening it. These early closure fees often apply within the first two or three years. They might also ask your clients to repay any closing costs that the mortgage lender originally covered.
If your clients plan to move or refinance their mortgage soon, this kind of fee may be an issue. As such, advise your clients to always exercise due diligence and review all terms before they sign.
5. Ongoing fees
HELOCs often come with fees that apply each year or when making transactions. Banks and mortgage lenders might also charge inactivity fees if the borrower does not use the credit line for a long time.
Be sure your clients are aware of all possible charges. These extra costs can add up over time, even if your clients don’t borrow often.
Difference between a HELOC and a home equity loan
A HELOC and a home equity loan both let homeowners borrow against their home’s equity, but they work differently. A HELOC provides a revolving line of credit. This means that your clients can borrow as needed during the draw period, repay what they used, and borrow again. HELOCs usually have variable interest rates, so monthly payments can change over time.
On the other hand, a home equity loan gives the borrower a lump sum upfront. It comes with a fixed interest rate and fixed monthly payments. The borrower starts repaying both the principal and the interest right away.
Should your clients get a HELOC?
A HELOC gives property owners a way to use the equity in their home without changing their main mortgage. They can simply borrow what they need; once it’s been repaid, they can borrow again during the draw period. It offers more control than a fixed loan since it can be used for whatever expense your clients need funds for.
Still, there are risks. Payments may rise over time and the interest rate can change. And since their home backs the loan, missed payments could lead to serious trouble. That’s why before applying, help your clients assess their overall financial health. After that, they can decide if a HELOC is a good idea or not.
Curious to know more about HELOC and other similar loan types? Visit Mortgage Professional’s Guides section for expert resources and tips
