Introduction: What is HELOC?


If you own a home, then you are familiar with terms such as mortgage and equity; however, if you are like others, as soon as people start throwing acronyms around, the “word jumbles” go straight over your head. Unless you are in the finance or real estate business, you shouldn’t be expected to know the HELOC definition or even have heard of the acronym before.

This article will answer the following questions: What is HELOC? What is a HELOC loan?

We will also discuss the questions on every consumer’s lips: What does HELOC stand for? Is HELOC interest tax deductible?

In addition, this review will give you a solid review of HELOC loans as well as when to use them and when not to use them. In this way, the next time you come across this acronym, you will at least have a good understanding of what is being discussed.

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What Does HELOC Stand for?

Have you ever, while reading the paper or financial blogs online, seen the word “HELOC" and asked yourself, “What does HELOC stand for?” Quite simply put, HELOC (pronounced hee-lock) stands for home equity line of credit.

This is not to be confused with a home equity loan, which is simpler to understand but not as effective as a HELOC loan. In order to define HELOC and understand which loan is best for you, you have to understand that there is a difference between the two.

A home equity loan is where you can borrow 80% of the value of your property minus your mortgage, so you borrow the equity that you have created in your home. This equity is created through paying your mortgage down or a rise in home value in your area. The money that you borrow is given to you in a lump sum, and you pay interest on it from the beginning of the loan.

Many of the same principles can be applied to a HELOC loan. However, this description does not actually define HELOC in its entirety.

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Image source: Bigstock



What Is a HELOC Loan?

A HELOC loan is a form of revolving credit. Where a lender agrees to lend you an amount of money, which you pay back within an agreed time frame (called a term), you use your home as collateral. To add additional clarity to the HELOC definition, the money that is borrowed is not handed over as a lump sum. It sits in waiting for when you need it, and you only pay interest on the money that you touch.

In this way, a HELOC loan is best compared to a credit card with a lower interest rate due to using your home as collateral. It is a pot of money that you can draw on as needed. As opposed to an equity loan – which is paid to you in a lump sum and creates interest for you from the beginning – you only pay interest on what you spend with a HELOC loan.

When consumers ask, “What is a HELOC loan?” they really want to know how this type of loan works. Just like the home equity loan, a lender will only lend you 80% of the market value of your home, but that money is there for you to use whenever you need.

You have access to it whenever you want; however, it is not given out in a lump sum, so you don't pay interest on any of the money borrowed until you draw on it. Customers are generally given a debit card or a check book to access the funds available to them.

Take a look at our case study to get a better understanding of the answers to questions like, “What is HELOC?” and “What is a HELOC loan?”

Maggie and George have a house with a value of $375,000.

Their mortgage balance is $195,000.

Step 1: Calculate the loan-to-value (LTV) ratio.

$375,000 (house value) x 80% (max LTV %) = $300,000 max LTV amount

Step 2: Calculate the total allowable HELOC amount.

$300,000 (max LTV amount) – $195,000 (mortgage balance) = $105,000 (allowable HELOC)

In this case study, the maximum amount of HELOC you could access from your loan is $105,000. However, this number cannot exceed 65% of your home's value, so there is one more calculation to do.

Step 3: Calculating if HELOC is under 65% of the home value.

$105,000 (amount of allowable HELOC) / $375,000 (house value) = 28%

In this case study, the $105,000 HELOC only amounts to 28% of the house value, so you would be able to access the full amount.

Hopefully, this example has made clear the answers to questions such as “What is a HELOC loan?”

As you can see from the example above, depending on the equity that you have created in your home, there can be a substantial amount of money available to you. These funds are often used for home improvements and renovations, tuition, and medical costs.

 However there is an increasing trend to use this type of loan to buy investment property. So, another way to answer the question of what is a HELOC loan is to say that it is a second mortgage used and utilized to buy an investment property.

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Is HELOC Interest Tax Deductible?

The next big question on consumers’ lips is, “Is HELOC interest tax deductible?” When talking about lines of credit, like auto loans, credit cards, and personal credit finance, the interest rate is quite high. With a HELOC loan, the interest rate is lower because your home is used for collateral. However, the biggest selling point is the fact that the interest that you pay is tax deductible whereas the interest that you pay on other lines of credits is not.

So, when answering the question of what is a HELOC loan, it is important to factor into the equation the benefits of being able to claim deductions on the interest that you pay at tax time, just like on your primary mortgage, of up to 1 million dollars.

However, if you use money from the HELOC for anything other than renovations or home improvement, you can only claim interest on a loan up to $100,000. If you are planning on consolidating debt with this type of loan, using the HELOC tax deductions is a definite plus because you will save on the interest rate to begin with, but you will also be able to claim deductions on the interest that you pay.

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Image source: Bigstock



Review – When to Use HELOC and When Not to Use a HELOC

The question, “What is a HELOC loan?” is often asked when consumers also want to know when to use a HELOC and when to use another type of loan. You have to be savvy about answering questions about HELOCs because, often, consumers ask the same questions for different reasons and, in turn, expect different answers.

As with any type of loan or, in fact, any decision that you make in life, there are positives and negatives. Here, we will describe some of the positive and negative aspects of a HELOC that you might be wondering about.

Positives

If you know that you are going to need a substantial amount of money and that you are going to access it over time, then a HELOC loan has benefits that will suit you. These benefits include:

  • Lower interest rate on credit due to house collateral

  • Only paying interest on the money that you use

  • Having tax deduction options on the interest that you pay

  • Revolving door of finance: as you build more equity in your home, your HELOC can increase

  • Not having to draw up new loan documents every time you need to access the money

Further benefits to a HELOC loan are:

  • The upfront costs are relatively low, and if the interest rate is high enough, you may not have to pay any at all.

  • Although HELOC loans generally have variable interest rates, HELOC loans can be converted to fixed-interest rate loans at the time of drawing. This is useful if you are planning on taking a large sum of the HELOC at one time.

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Negatives

Everything in life has a downside, so after you have asked the question, “What is a HELOC loan?” and you understand the inner workings completely, it is important to take into consideration the negative aspects of this type of loan based on your personal circumstances. Things that may impact you include the following:

  • The interest is based and calculated on your credit score.

  • The cost of setting the loan up. Yes, it will be less than setting up your initial mortgage; however, the cost is still structured the same way, and you need to be aware that there are upfront costs to this type of loan that are very similar to your original mortgage.

  • HELOCs have a minimum amount that you need to withdraw every year. This is to ensure that the interest that you pay on this money will rise each year.

  • You are putting your home up as collateral. Ensure that you are doing it to invest in some kind of future for yourself and your family.

  • It is a variable interest rate and is prone to change. Any interest rate change will affect your loan immediately.

  • It isn't a good idea to use a HELOC loan if your income is unstable. If you don't meet your monthly repayments, then the lender can force you out of your home.

  • A HELOC loan also may not be suitable if you don't need to borrow much money. The upfront cost may outweigh the benefits of the HELOC tax deductions and other positive factors.

  • You shouldn't use it to fund your day-to-day needs. It isn't worth the risk.

An important aspect to remember when taking on this type of loan is that there is still the three-day rule, where you can change your mind about the loan within three days. The three-day rule starts when:

  1. You sign the credit contract

  2. You get a Truth in Lending disclosure form with the key information

  3. You get two copies of a Truth in Lending notice explaining your right to cancel

So, if you are ever asked the question, “What is HELOC?” you can use this article to answer with confidence.

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Getting a HELOC loan can make a lot of sense; the HELOC definition allows you to be comfortable in the knowledge that you are using the equity in your home to fund your needs.

In other words, you know that you can pay the loan back because you are borrowing equity that you have created. If your financial situation can weather the possibility of rising interest rates, you are also safe in the knowledge that you won't lose your home due to missed payments. However, as with any question we ask ourselves, it is essential to study our situation and make comparisons before diving in.

So, when we ask ourselves, “What is a HELOC loan?” the biggest question we are asking is, “Is a HELOC loan the right decision and loan for me and my situation?” Whether you want to complete your home renovations, pay the tuition for your kids’ education, consolidate debt, pay medical bills or buy an investment property, a HELOC loan is definitely worth looking into and considering for your financing needs.

However, if you simply need to fund your day-to-day expenses, we would recommend researching different financing options as the cost and risk to your lifestyle may not be worth it.

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