Certain uses in particular could be good for this type of borrowing. “This type of loan makes sense for projects you need to pull money for when needed—extensive home repairs and maintenance—or college tuition payments each term,” say Rob Cook, Head of Marketing and Customer Experience for Discover Home Loans. Since a HELOC is secured by your home equity (vs. a credit card, which is an unsecured loan), rates are typically lower, which also makes a HELOC a possible solution for debt consolidation.
Sounds like what you need? Before you fill out your application, make sure you know the terms of a HELOC and understand it’s fundamental aspect—the draw period—to know if it’s right for you.
Understanding the beginning of your draw period
When you’re approved for a HELOC, you will also be approved for a credit limit based, in part, on how much equity you have in your home. You can use this line of credit during what is called the “draw period.” This is the amount of time you have to draw funds from the HELOC. The draw period typically lasts for a fixed amount of time. It can vary between lenders but the period usually can last up to ten years. Each lender could also have different requirements, like minimum draw amounts or when you need to start making repayments (more on that coming up!). Be sure to look into the specific details of each lender you consider.
During the draw period you typically can make interest-only payments on what you’ve borrowed. But you can also pay back the principal amount if you choose. You also don’t have to withdraw the entire amount. But it’s available if you need it. Here’s an example: If you have a $90,000 HELOC, you can borrow up to that amount. If you only use, say, $25,000 of the line of credit, you will only pay interest on that $25,000, not the $90,000 maximum value of the line.
“HELOCs are a good option for those looking for a source of revolving credit that can be managed in the same way as a credit card,” Cook says.
Accessing your funds once you have them
Your lender will provide you with options for accessing your funds. Most allow you to withdraw cash by using online bank transfer or a HELOC account card (similar to an ATM card). If you get an account card, you can use it just like you would a debit card to purchase things or withdraw cash at an ATM. You also usually have a checkbook that goes along with the account.
Something to keep in mind is that there may be minimum draw requirements and fees. Your lender may also require an initial draw amount. But after that, you can take out as much or as little as you like. Also, says Cook: “Most HELOCs charge a maintenance or annual fee regardless whether you’re actively using a line of credit.”
So go ahead and start paying for college, planning your new kitchen, paying off high-interest credit cards or designing your in-ground pool. But, doing your homework is important as well. Lender terms can vary widely, so fully understanding all the ins and outs of your HELOC before entering into an agreement can be very important to your financial situation.
Preparing for the end of the draw period
When the draw period ends, the agreement continues in another form, called a “repayment period.” In this next phase you’ll need to pay back both the principal and interest. This can increase your monthly payments significantly and catch you off guard if you’re not prepared for it.
The repayment scenario can play out in a few different ways: Some lenders may want you to pay back all of the money at the end of the draw period; others could extend the repayment phase over decades. There’s also the possibility of keeping a credit line open and stalling repayment by looking for a new HELOC at the end of the draw period. In essence, by doing this you are refinancing your first HELOC so you can continue borrowing and also avoid a big increase in the minimum monthly payment. You can draw on that amount again when you repay what you initially borrowed.
Another thing to keep in mind is that some HELOCs have variable interest rates, meaning that your monthly payments can vary month to month. HELOC rates move with an index such as the prime rate. The prime rate is one benchmark used to set HELOC and credit card rates. So when rates are expected to lower, the variable rate on HELOCs will cause your payment obligations to lower, too, but they will increase if the prime rate goes up. Cook adds, “If you are concerned about your rate and payments rising or want to take advantage of the current rate environment, another option to consider is to refinance your HELOC by taking out a fixed-rate home equity loan or refinancing your primary mortgage.”
Here’s an example to get a better understanding of the process: If your lender offers you a 30-year HELOC with a 10-year draw period, how it works is you’ll pay interest only on the balance owed during the first 10 years of the draw period, then you’ll owe interest and principal for remaining 20 years of the 30-year term.
Since your rate depends on the prime rate—the lender will likely tack on a percentage point or two on top of this amount. So, it’s best to be conservative in your estimates in terms of how much you can borrow so that you’re not in a situation where you can’t make your payments or repay your loan at the end of the draw period.