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

Question

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

Answer 1

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.