Definition
A home equity line of credit, or HELOC, is an agreement between a homeowner and a lender whereby the lender agrees to provide the homeowner with access to funds, using the home as collateral for the loan.
Explanation
A home equity line of credit can be a useful source of inexpensive credit. With this type of arrangement, the borrower has access to the money they need by writing a check against the line of credit account held by the lending institution. A line of credit offers the borrower more flexibility than home equity loans or mortgages, which involve lump sums.
The amount of equity in a home is determined by taking the current market value of the home and subtracting all of the outstanding loans that are using the home as collateral. The lending institution will usually allow the borrower to take out a loan of up to 80% of the equity in a home.
Most home equity plans set a fixed time, known as a draw period, when the borrower can make withdrawals from their account. Since a home equity line of credit is a secured loan using a home as collateral, foreclosure is possible if loan payments are not made on time. Finally, the interest charges on a home equity line of credit are usually tax deductible.
Example
Sam's home is valued at $500,000, and the remaining principal on her mortgage is $300,000. Sam also took out a home equity loan of $12,000 to pay for a new roof on her home. The outstanding principal on the home equity loan is $10,000.
The lender has agreed to extend Sam a home equity line of credit; up to 70% of the equity in the home. Sam's line of credit would be calculated as:
HELOC = (Market Value of Home - Loans Using Home as Collateral) x 70%
= ($500,000 - $300,000 - $10,000) x 0.7 = $190,000 x 0.7, or $133,000
In this example, Sam would have access to a loan as large as $133,000, if her annual income supports an additional loan of that size.
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