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A Home Equity Line of Credit (HELOC), a type of second mortgage, is a line of credit extended to homeowners who use their home as collateral.    The line of credit is based on the home equity. The homeowner may draw on the line of credit when funds are needed.  However, there is a specific period, known as draw period, where the borrower is able to make withdrawals.  There is a repayment period where the borrower must repay all funds that were withdrawn from the account during the draw period.

How is a HELOC different from a Home Equity Loan?

The difference is quite simple; while both loans are secured based on the existing home equity, the distribution of funds to the homeowner is different.  With a home equity loan the homeowner is given all the finds immediately, however, with a HELOC, the funds are not immediately withdrawn by the homeowner.  The homeowner withdraws funds as needed.  There are restrictions as to how much and when funds can be withdrawn.

What are HELOC loans typically used for?

While other loans, such as a traditional mortgage or car loan, must be used for specific purposes, a HELOC can be used for anything specified by the homeowner.   Many homeowners use HELOC loans for home renovations, starting a small business, taking a dream vacation, paying for college, etc.  Interest paid on a HELOC loan in some cases maybe tax deductible if the funds are used to make repairs or improvements to a home.  Consult with your tax professional to determine if you qualify for a tax deduction.

What are the advantages with a HELOC?

The advantages of a HELOC are as follows:
  • No closing cost – If your credit is good, you will pay no closing costs.
  • Low interest rate – HELOC interest rates is variable and based on the prime rate, which is relatively low when compared to standard interest rates.  If you can take a tax deduction on the interest, then the interest rate is even lower.
  • Interest rate caps – If the prime rate increases, your HELOC interest rate should have a cap on how high it can increase on a quarterly basis.  Most HELOC loans will increase by a half percentage point.
  • Pay it off anytime - Most HELOC loans allow you to pay off the balance at anytime with no fees.  Before you signup for a HELOC loan make sure this is the case.
  • Convert to a fixed-rate loan - If you HELOC interest rate jumps and a fixed-rate home equity loan is more attractive, you should be able to convert whenever you like.  Again, before you signup for a HELOC loan make sure this is the case.
What are the disadvantages with a HELOC?

The disadvantages of a HELOC are as follows:
  • Adjustable interest rates – All HELOC loans are adjustable rate and have a higher risk than ARMs.  Some HELOC loans do not have a guaranteed initial interest rate like an ARM that may have a fixed rate of up to 10 years.
  • Caps on interest rate – HELOC loans don’t have the same type of adjustment caps like ARM (Adjustable Rate Mortgage) loans.  As a result, HELOC interest rates my rise quickly.  ARMs usually have lower maximum rates than HELOC loans.  ARMs usually have a max rate of 5-6% higher than the initial rate; however, HELOC could have as high as 18%.


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