Is a home equity line of credit right for you?

If you’re trying to decide if a home equity line of credit is a good idea for you, then consider the following. 

Home equity line of credit basics

A home equity line of credit (HELOC) is a form of revolving credit in which your home serves as collateral for the loan. It is more commonly known as a “second mortgage.”

Because your home is likely to be your largest asset, you might consider a home equity line of credit for the purchase of major items such as education, home improvements or medical bills, and not for day-to-day expenses.

With a home equity line of credit, you will be approved for a specific amount of credit — your credit limit. Your credit limit is the maximum amount you can access at any one time.

Since you can get approved for an amount of credit now, and not access the funds until you need them, a home equity line of credit is a good choice if you simply want the ability to access cash as you need it and not pay interest until you take an advance.

Think about these key questions

Is your income stable?

Typically, HELOCs have adjustable rates, and the payments can change up or down as the market fluctuates. You will want to evaluate your financial status when looking at any mortgage loan. Looking at your current income and future income potential is central to evaluating your income stability.

In evaluating your income you will want to look at your Debt-to-Income ratio (DTI).

A DTI is one way lenders measure your ability to manage the monthly payments to repay the money you have borrowed.

How to calculate your DTI

To calculate your DTI, add up all your monthly debt payments and divide them by your gross monthly income.

For example, if you pay $1,500 a month for your mortgage and another $100 a month for an auto loan and $400 for the rest of your debts, your monthly debt payments are $2,000. ($1,500 + $100 +$400 = $2,000).

If your gross monthly income is $5,000, then your DTI is 40 percent ($2,000/$5,000 = 40%). Typically, lenders use 43-45 percent as the maximum debt ratio. However, this varies by lender. Check with your lender to determine the maximum debt ratio.

Can you afford the upfront costs?

When you take out a home equity line of credit, there may be costs associated with your request. These can include:

  1. Closing costs — Usually a title search, appraisal or property valuation document, recording fees and other miscellaneous fees. Not every lender requires all of these expenses, so be sure to ask about closing costs before you commit to the loan. In some instances the lender will pay some or all of the closing costs depending on the amount borrowed.
  2. Annual fee — Most HELOCs have an annual fee. This fee is usually charged on the one-year anniversary of the loan and continues annually as long as the line of credit is open for draws. It is usually waived for the first year.

Can you handle fluctuating payments?

A HELOC is like a credit card: the more you advance – or borrow – the higher your minimum payment will be. Typically, these payments are interest-only during the draw period – a period of time during which you can take advances on the available funds in your account.

A HELOC also has a variable interest rate, meaning the interest rate will rise and fall with the changing conditions of the market. If you need a set payment every month, you should consider a home equity loan instead of a line of credit.

Does your home have enough equity?

You will want to check with your lender to determine the amount available to you based on your home’s equity. Many lenders will allow financing up to 80 percent of the home’s value, and some – including Oregon State Credit Union – allow financing up to 90 percent. Equity is the difference between what your home is worth and how much you owe on it. As you make payments on your home and reduce what you owe, or the value of your home grows because of favorable market conditions, your equity increases.

In the following example, our homeowner’s home is worth $200,000. The balance on his first mortgage is $150,000, leaving him with equity of $50,000.

Example: $200,000 (value of home) – $150,000 (balance on mortgage) = $50,000 (equity in home)

Getting a HELOC for the right reasons can make a lot of sense, especially if you’ve carefully considered the pros and cons. Armed with this knowledge, you can make a rational and informed decision and be confident you are making a smart choice.

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