Eli5: what are HELOCs and how do they actually work?

77 viewsEconomicsOther

I’ve heard of them and am interested in more info just wanted to see if someone had a briefing before I went in depth?

In: Economics

2 Answers

Anonymous 0 Comments

First, you have to understand what home equity is.

Home equity is the “value of the home” minus “the amount you owe in mortgage.”

So if your home is valued at $500K and you have a $400K mortgage your home equity is 500-400 or $100K.

If you home is valued at $500K and you’ve been paying your mortgage for years and only have $75K left to pay, then your home equity is 500-75 or $425K.

Got that? Okay, so now that you have equity in your home, you can use that equity as collateral. There’s two ways to do that:

A Home Equity Loan (also known as a “second mortgage”) is where you use the equity in your home as collateral to take out *another* mortage loan. Banks usually only provide a loan for a portion of the equity, so if you have, say, a $500K home with a $400K mortgage — meaning you have $100K in equity — you might be able to get a home equity loan for $50K. You take out the loan, the bank gives you a lump payment of $50K, and then you can use that cash for whatever you want … but you now still owe the $400K of your first mortgage and you now *also* have to pay back the $50K home equity loan.

A Home Equity Line of Credit (HELOC) is similar, but instead of a loan you can think of it like a credit card with your equity as collateral. (Almost literally. Sometimes a HELOC comes with a Visa card attached to the HELOC.) You have a credit limit determined by your equity (so, same example as above, your HELOC credit limit might be $50K), but instead of getting a chunk of $50K cash up front like you do with a loan, you can use that $50K line of credit like a credit card, and spend what you need when you need it. You’ll still have to pay it back, of course, but — just like if you have a credit card you don’t use, you don’t have a monthly credit card bill — if you don’t *use* the HELOC, then you don’t have anything to pay back.

Home equity loans are usually better if you need a big chunk of cash immediately for something like a home renovation or to pay a big medical bill.

A HELOC is useful to have as an “emergency back-up” of sorts. E.g. if you wreck your car and don’t have the cash on hand to buy a new one, you might use the HELOC to buy that sexy 2014 Kia Soul you were eyeing.

Anonymous 0 Comments

A HELOC, or home equity line of credit, is a line of credit where the collateral is the equity in your home.

Now what does all that mean? A “line of credit” means that someone agrees they will loan you money up to a certain amount, but the agreement doesn’t say beforehand exactly how much they’re going to loan you. A credit card is a great example of this. When you use a credit card, you’re borrowing money from the credit card company. You can borrow money up to the credit card’s limit, and you have to pay that money back.

Now, what’s collateral? Collateral is basically a guarantee when you take out a loan, saying “if I don’t pay back this loan on time, you can take this”. So, if you don’t pay off the money you take out of your HELOC on time, then you lose the equity in your home.

Now, what’s the equity in your home? When you buy a home, you typically have a mortgage. This means that you got a loan from the bank using your house as collateral. But, due to down payments and as you pay off your mortgage, the value of your house will be greater than what you owe on your mortgage. This difference is your “equity” in the house. Basically it can be thought of as the part of your house that you own completely no matter what, as opposed to the part that the bank owns if you fail to pay your mortgage.

Put all this together again, and what do you have? You have something kinda like a credit card, but if you don’t pay it off, they take your house like a mortgage would, so the interest rate is much lower than a credit card. You can get a HELOC for something like 60-80% of however much equity you have in your home (your home’s value minus what you still owe on the mortgage). People use this typically for big expenses, especially home renovations since those will increase your home’s value, and thus your equity.