Home Equity Defined

Home equity is the difference in your home’s current market value versus the remaining mortgage balance on it. For example, if your home is worth $125,000 and you owe $75,000 on your mortgage, your total home equity is $50,000. A HELOC would allow you to take out credit against that $50,000 in this case.

You can spend the HELOC on whatever you want. Most homeowners use the credit to pay for expenses related to home renovations, car, college tuition, debt consolidations, emergency medical bills or anything else important. Just make sure you don’t make too many leisure or unimportant purchases because your home equity will suffer for it if you do.

Banks will usually approve you for a HELOC because your home equity is the collateral for the credit. The high value of the collateral is why the interest rates on HELOCs are so much lower than on traditional loans and credit cards. Of course, you’ll still have to make your mortgage payments every month and pay interest on them too.

However, your home equity grows as you continue to make your mortgage payments and pay down the principal. And since real estate appreciates in value, it creates even more equity. Then you’ll have the opportunity to borrow more credit against the added equity of your home.

Most lenders won’t let you spend more than 65% on the value of your home. So, if you ever paid off your mortgage entirely, you wouldn’t be able to take out a HELOC that is 100% of the home’s value. The most you would get approved for is 65% of its value.

Making Interest Payments on HELOC

A line of credit is different from a loan because you don’t receive the entire amount upfront. Having a line of credit means you have been pre approved for X amount of dollars and can spend it whenever you want. You don’t pay interest on the total pre approved amount of the line of credit. Instead, you only pay interest on the credit you use to make purchases.

There are no fixed interest rates on HELOCs. The lender will attach a variable interest rate to your HELOC. Since variable interest rates can change by the day, they could increase much higher at any time. You could end up paying more interest at any time without much notice.

Variable interest rates are based on the prime rate, which is influenced by the lender and the federal funds rate. When the Federal Reserve lowers the federal funds rate, it will often lower the prime rate. That, in turn, reduces the variable interest rates in many cases.

However, the lenders still have the final say over the variable interest rates on their issued mortgages and HELOCs. That is why HELOC variable interest rates are usually higher than mortgage variable interest rates. It is at the lender’s discretion to change the formula of how the variable rates are calculated.

How to Calculate the Amount of Your HELOC

The Office of the Superintendent of Financial Institutions is the federal government agency that regulates the rules of HELOC. They have determined that a homeowner can borrow up to 65% of their home’s value. There is also a restriction on when you can start spending on the equity of your home.

When you add the mortgage balance and HELOC balance together, the total cannot be greater than 80% of the value of your home. For example, if you owe $80,000 on your mortgage and the home’s value is $100,000, that leaves you with $20,000 in equity. If you add the $20,000 to the mortgage balance, you get $100,000.

Adding the mortgage balance and home value gives you 100% of your home’s value. You wouldn’t get approved for any HELOC in this case. You’d have to wait until your property appreciates or your mortgage balance goes down.

Here are the formulas for making these critical calculations:

House Value * 80% (Maximum Loan-to-Value Percentage) = Loan-to-Value Amount

Loan-to-Value Amount – Mortgage Balance = Allowable HELOC

Allowable HELOC / Home Value = (Must be 65% or less)

Here is a scenario where you would have allowable HELOC:

Suppose your mortgage balance is $200,000 and your home’s value is $400,000. Let’s plug these numbers into the formulas to determine the amount of the allowable HELOC.

$400,000 (home value) * 80% = $320,000 Loan-to-Value

$320,000 – $200,000 (mortgage balance) = $120,000 Allowable HELOC

$120,000 / $400,000 = 30%

The rule states the HELOC cannot be over 65% of the home’s value. In this case, we see it is only 30%. That means it is acceptable.

Not all HELOCs are the Same

Do not assume all HELOCs are the same. Every lender offers different features for their HELOCs. Here are some of the features to watch out for:

Min / Max Amounts

Each bank sets the minimum HELOC amount allowed at their institution. Some banks don’t even have HELOCs.

Revolving Balance

HELOCS are called revolving lines of credit because you technically “borrow money” each time you spend on the credit. New loan documents don’t have to be written up for it. The line of credit is also revolving because the credit limit rises when the home equity increases.

Sub-divide Lines

Some banks let you split the HELOC into different sub-accounts for various spending purposes. For instance, perhaps you want to put money into a retirement account or brokerage account. You could take credit from the HELOC and put it into these accounts to benefit from the tax advantages they offer.

Convert to Fixed Rate

Your lender may let you convert some of your HELOC to a fixed interest rate, similar to a mortgage.

Second Position HELOC

A second position HELOC is when you hold a primary HELOC at one bank and then take out a second HELOC at another bank on the same house. You would usually get a second position HELOC if the home has a second mortgage, but it is possible to take a second position on a primary mortgage too.

You can expect the interest rates to be much higher on second position HELOCs because the lenders consider them to be a greater risk. If you default on your mortgage, the bank holding the second position cannot get reimbursed until the primary HELOC has been satisfied.

Contact a Mortgage Specialist Today

Do you have further questions about HELOCs and how they work? Contact our mortgage specialists at Mortgage Zilla Group to learn more about your options.