The abbreviation HELOC stands for home equity line of credit. This is a type of loan where the creditor has agreed for lending a certain maximum amount within a specific agreed upon period (term). Here the collateral is the debtor’s equity in his or her home. HELOC abuse resulted in the subprime mortgage crisis. The subprime mortgage crisis refers to a persistent real estate and financial crisis due to a drastic increase in foreclosure and delinquencies in the United States.
How is HELOC different from a traditional home equity loan?
A HELOC is distinct from a home equity loan in the sense that the debtor is not given the total sum on an upfront basis, but he/she makes use of a line of credit for borrowing certain sums at regular intervals, which adds up to not more than the amount of credit limit, quite akin to a credit card. A HELOC fund is typically borrowed in the “draw period”, which is 5 to 25 years.
A HELOC also differs from a home equity loan in the interest rate which is variable. The interest rate is calculated on the basis of an index, like the prime rate. Homeowners looking out for a HELOC should note that the margin calculation (difference between the prime rate and the actual interest rate paid by the borrower) by each lender is different.
A HELOC may come with a minimum amount monthly payment structure. However, just like any credit card debt, a HELOC borrower may pay any amount higher than the minimum amount due. The total principal amount has to be paid at the end of the loan tenure either in the form of a balloon payment (lumpsum amount) or based on a specific schedule.
HELOC – advantages
A HELOC is useful in order to fund intermittent needs like repaying credit card debts, making home renovations and also paying for college tuition. This type of loan is flexible both in borrowing as well as in repayment terms. You have only got to pay interest on the amount that you have actually drawn. The repaying schedule is also determined on the basis of the borrower’s flexibility. Another reason for its popularity in the United States during the early 2000s was that the repayment of HELOC loans brought with it tax incentives.
Upfront costs of a HELOC loan are also comparatively low. Suppose you take a conventional loan of the amount $150,000, settlement costs may be between $2000 to $5000, unless the interest rate is high enough to take care of these costs. However, if you take a HELOC loan of the same amount, costs mostly do not exceed $1000, and in majority cases are borne by the creditor without adjustment in interest rate.
Rising interest rates make people apprehensive regarding their variable interest rate debts. A HELOC loan offers the flexibility of converting to a standard rate of fixed interest in such situations.
However borrowers of HELOC should be aware that this type of loan comes with certain risks. The underlying collateral is the home and default payments may give rise to foreclosure.