A home equity line of credit, also referred to as a HELOC for short, is a loan where the collateral that is used is the borrower’s equity in his or her property. Homes are a valuable asset and usually the most valuable asset many people own, so this type of loan is used for major purchases such as for education, home improvements or medical bills. Unfortunately, home equity lines of credit loans were taken out recklessly in recent years and contributed to the subprime mortgage crisis.
A HELOC works differently from other loans. The borrower does not receive the entire sum up front. Instead, he uses the maximum allowed amount as a credit line but can’t borrow more than the equity allows. It can be compared to a credit card. There is a “draw period” in which borrowers can take out funds. This is usually 5 to 25 years.
There is usually a minimum monthly payment and it is often an interest only payment. This means that the borrower will only make a payment that is equal to the interest that is due on the principal and nothing more. The full principal amount is due to be repaid at the end of the draw period. This can be paid in a lump-sum or paid according to the terms of the loan and amortization schedule.
Another important characteristic of this type of loan is that is that the interest rate is variable. The interest rate is based on an index – usually the prime rate.