Home Equity Line of Credit: What You Need to Know

Home Equity Line of Credit: What You Need to Know
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Whether you want to fix up your house, buy another property or even pay off other debts, having real estate that has built up substantial equity can work in your favor and help you qualify for a home equity line of credit based on the value of your home. This type of credit line gives you access to a set limit for the life of the loan, a period that usually extends several years. During that time, you can borrow money as you need it within the available credit.

However, qualifying will require having enough equity per your lender's rules as well as meeting other financial criteria. Take a look at all you need to know about HELOCs to get many of the FAQs you may have about this option answered.

Understanding Home Equity

Before looking into types of home equity borrowing options like a HELOC, you need to understand how home equity works and determine how much you might have. Simply, your home equity is your home's appraised market value minus your remaining mortgage balance. So, if you have a home with a current appraised value of ​$250,000​ but still owe ​$170,000​ on it, then your home equity is ​$80,000​. This number is important, since it determines the actual financial interest that you, the owner, have in your property after all the payments you've made over time.

Your home's remaining mortgage balance and current appraised value are also important for lenders, as they use the information to determine your home's loan-to-value ratio as a risk assessment tool for offering a loan or line of credit. This ratio is your current loan balance divided by the current appraised value. Continuing with the example, this would be ​$170,000​ divided by ​$250,000​, which works out to ​0.68​, or ​68 percent​. This means you'd have ​32 percent​ equity in your home.

Exploring HELOC Basics

When your loan-to-value ratio is low enough to satisfy the lender, which often means no more than ​80 or 85 percent​, then a HELOC can help you gain access to a revolving credit line for a term that often ranges from ​10 to 20 years​. The lender looks at your home's value and current mortgage and usually lets you borrow against a portion of the equity you've built up. In exchange, the HELOC lender uses your property as collateral like with a mortgage, and you have to make payments to avoid possibly losing your home.

While the credit line is open for the term offered, you can freely borrow up to the maximum funds offered to make purchases and pay off debt, and the money doesn't have to be used for your home. In fact, you could even use HELOC funds to make a down payment for a new vacation home, pay for your child's college or buy a vehicle. Your lender considers your creditworthiness alongside your home equity information to determine what your HELOC limit will be. You can use an online calculator to get an idea of your potential access.

While you're borrowing this money from the credit line, the lender has you make interest-only payments. While traditional mortgages often have a fixed interest rate, you'll likely deal with variable rates with a HELOC, and this can mean paying a much higher rate than you do for your mortgage, especially if your credit isn't ideal.

You'll deal with the principal once the draw period has closed and you're in the official repayment period. You can sometimes get the lender to extend the HELOC term if the draw period is closing and you still need access to the money.

A HELOC vs. Other Borrowing Options

While a HELOC offers a very flexible way to access funds based on your home's equity, it's not the only borrowing option available. You can also consider a home equity loan or cash-out refinance, but these work differently than a HELOC.

When you take out a home equity loan, there's not a revolving line of credit with a draw period, but rather your lender provides a one-time disbursement of money to you. Loan-to-value limitations are still in play, and your home is the collateral backing the home equity loan. However, you pay full interest and principal payments over the whole term that often ranges ​10 to 15 years​, and the interest usually is fixed rather than variable.

On the other hand, a cash-out refinance is actually a full replacement for your original mortgage that allows you to take out a higher mortgage than your previous one. The lender considers your home equity and adds a certain amount over the mortgage balance you had remaining and gives you access to some of the equity-based funds in cash. You can use that money for various purposes and potentially get a better interest rate than HELOCs and home equity loans. But you can face costs like private mortgage insurance, and you can risk losing your home if you can't keep up with the refinanced mortgage payment amount.

The Benefits of Getting a HELOC

Here are some benefits you can gain from taking out a HELOC:

  • Flexibility​: With a HELOC, you get flexibility in that you can use the funds for anything you want and can borrow as little or as much as you want within the limit offered.
  • Low payments initially​: Since the draw period comes with interest-only payments, you can find these easier to budget and have time to prepare for the full payments once the draw period ends.
  • Potentially lower rate than credit cards​: Although HELOC interest rates vary, you may get a better rate than you would with a credit card, especially if you need the money for something like medical bills or an emergency repair. You can also do some price shopping for the best terms.
  • Tax benefits​: As long as you itemize and use your HELOC funds for certain home-related expenses, like major improvements or construction, the interest qualifies for a tax deduction. Under current IRS rules, there's a ​$750,000​ mortgage limit for most taxpayers (halved for married filing separately) for when such interest is deductible.

The Downsides of Getting a HELOC

To make a well-informed borrowing decision, be aware of these HELOC downsides:

  • Temptation​: While a HELOC can help you improve your home or pay off debt with higher interest rates, having the credit line available might also tempt you to buy things you don't need. This can lead to payments you can't afford and get you deeper in debt.
  • Variable interest rate​: Subject to a lifetime interest rate cap, HELOCs usually have interest rates that rise over time, and this can cost you more than a fixed-rate loan would. While some borrowers can benefit from low interest rates such as ​3 percent​, if you have mediocre credit, you could experience a much higher rate that can top ​21 percent​.
  • Risks to home​: HELOCs come with two risks to your home. First, you can risk losing it if the lender decides that foreclosure is necessary. Second, using the credit line means eating into your home's equity, and you could end up with an underwater loan if your house ends up losing value.
  • Fees​: Interest might not be your only expense since HELOCs often have various closing costs alongside potential annual fees and penalties if you pay the HELOC off early.

Looking at HELOC Qualifications

Like with mortgages and home equity loan options, lenders require that you go through a comprehensive application and review process to qualify for a HELOC. This often means that you need to meet the following requirements to move forward:

  • Good credit score​: While some lenders may accept the minimum ​620​ credit score often needed to get a conventional mortgage and just charge you a higher interest rate, others may have more stringent credit requirements when you're trying to get a HELOC. Experian suggests a credit score of ​680 or higher​ and explains that scores in the ​700s​ can help with getting a better interest rate. Having declared bankruptcy can make it harder to get a HELOC as well, unless it's been discharged for ​three years​ or more.
  • Acceptable debt-to-income ratio​: After adding up your monthly debt payments and dividing them by your gross income each month, the ratio shouldn't go above ​43 percent​ for the best shot at getting a HELOC. If you've already got a heavy debt load, consider working on paying off high-interest debts so that you'll improve your chance of HELOC approval and face an easier time paying all your bills each month.
  • Sufficient home equity​: If you've just started paying your mortgage and didn't make a substantial down payment, it can be hard to qualify for a HELOC unless you wait for several years. That's because lenders usually need to see ​15 to 20 percent​ equity before they're willing to let you borrow against part of that amount. At the same time, they'll combine your current mortgage and new HELOC to make sure that the total doesn't exceed typically ​90 percent​ of what your home's worth.
  • Money for upfront costs​: While some lenders like Discover don't make you pay cash for closing costs to take out the HELOC, other lenders may require it. You'll need to have money set aside in those cases, and this typically is ​up to 2 percent​ of your HELOC credit limit.

Applying for a HELOC

To proceed with applying for a HELOC, you'll need to do your research to find suitable lenders and see what terms they could offer you. It helps to speak to loan specialists at different financial institutions and bring documentation for your home's value, mortgage and income to assess your chance of approval.

Once you've decided on a lender, here are the steps you can expect during the application process:

  • Fill out the application​: While many lenders now have online applications, others will provide paper HELOC applications. In either case, these forms will ask for personal information about your current and past residencies, employment situation, real estate owned, financial assets like vehicles and bank accounts, and the purpose and amount requested for the HELOC.
  • Submit documentation​: Along with your HELOC application, the lender will need documentation you provide that backs up your income, property value and mortgage amount. You may need to submit bank statements showing funds for any HELOC closing costs as well as verify you have homeowners insurance on the property.
  • Have a home appraisal​: A lender will often request a home appraisal to verify that your home's value hasn't changed substantially from the most recent valuation in the public tax records.
  • Complete the closing process​: Underwriting can take several weeks, but once that finalizes, you'll have more paperwork to sign to complete closing and get access to your HELOC.

Handling Your HELOC Responsibly

Once you've gotten approved for your HELOC, you enter the drawing period determined by your lender. While this gives you access to your credit limit to spend money on what you and your family need, the same benefit can lead to issues if you spend more than you can afford to pay back. For example, it can be tempting to borrow more money when you know you only have to worry about paying interest on that money for several years. But keep in mind that you'll eventually need to pay back the full principal as well.

When you're in the repayment period, you need to keep making your payments when they're due and preferably pay a little extra when you can. However, you'll want to check with your lender if you decide you'd rather pay the home equity line of credit off in a lump sum within a few years, since you might end up with extra costs in the form of prepayment penalties.

In any case, you want to avoid default since a HELOC is secured like a mortgage is, and this could mean facing foreclosure if you stop paying for long enough. While Investopedia mentions that foreclosures don't usually happen quickly with HELOCs due to the equity already available in the home, you can still face other collections issues as well as see your credit score fall. Your lender will usually help if you contact them, and options can range from a temporary payment pause to HELOC modification.