As a homeowner, if you've paid down your mortgage loan or your home has increased in value, you could have built up substantial equity that you can use for other purposes. You might need funds for debt consolidation, to pay down some medical bills, tackle home renovation or home improvement projects, pay for education expenses or refinance some high-interest debts, such as credit cards.
If you do need money to cover large expenses, a home equity line of credit might be the answer.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is a loan that uses the equity in your house, based on the appraised value of your home, as collateral. The amount is based on a percentage of the equity and is available on a revolving basis, like a credit card. The interest rate on HELOCs is usually variable and fluctuates as the baseline interest rate changes. The good news is that home equity loan rates are usually significantly lower than higher interest rates on credit cards and personal loans.
The interest rate that the lender charges is affected by your credit score. Higher scores get lower interest rates.
Read More: Home Equity Line of Credit: What You Need to Know
How Does a HELOC Work?
A HELOC has two stages: draw period (drawdown) and repayment.
You can borrow as much or as little as you want during the drawdown period up to the credit limit of your HELOC. If you pay it down, you can borrow against it again as long as you're still within the drawdown period. You make minimum monthly payments for interest only. You're not required to make principal payments. Most draw periods last for 10 years.
After the draw period ends, you begin to repay the outstanding balance. You cannot borrow against the credit line while in the repayment period. You make monthly payments during the loan payment period that include principal and interest. Most repayment period loan terms are for 20 years.
What Are the Qualifications for a HELOC?
Generally, these are the qualification factors for a HELOC:
- Credit score: The lowest credit score that most lenders accept is a FICO score of 620. Some lenders require a credit score of at least 680 or higher.
- Debt-to-income ratio: The debt-to-income ratio (DTI) is found by dividing the total of your monthly fixed payments by your monthly gross income. In most cases, lenders will not accept a debt-to-income ratio over 40 percent.
- Amount of equity: Most lenders set a maximum loan-to-value ratio (LTV) at 85 percent of the appraised value of your home.
For an example of this last point, suppose your house has a market value of $400,000, and you still owe $300,000 on your mortgage. Your bank will lend you a total of 85 percent of your house's value or $340,000 (85 percent times $400,000). The maximum line of a HELOC would be $40,000 ($340,000 minus $300,000 balance of first mortgage).
What Are the Risks With a HELOC?
Although the rates on a HELOC are attractive, they do come with risks. A HELOC may not be suitable for you if any of the following scenarios apply.
You need money for basic expenses. If you plan on using the funds from a HELOC to cover day-to-day expenses, you should get your budget in shape before assuming additional debt, especially since a HELOC acts as a second mortgage in that it is secured by your house.
You can't afford the payments if interest rates go up. All HELOCs have a lifetime maximum interest rate specified in their terms and conditions. While you may have qualified at the time of your initial application at a lower interest rate, could you make the monthly payments at the highest possible rate allowed? If you can't afford that payment with the higher interest rate, you should probably not take the loan.
Read More: Fixed Rate vs. Variable Rate: What You Need to Know
You don't need to borrow much. Lenders charge closing costs that can add up to several hundred dollars for setting up a HELOC. Paying these considerable upfront costs only makes sense if you're borrowing several thousand dollars. Otherwise, you might be better off exploring other loan options or applying for a credit card with low introductory rates.
You don't have a stable income. Because HELOCs come with variable interest rates, you might be faced with making larger payments as a result of rising interest rates at exactly the same time your income takes a dip. A failure to make these payments could result in a foreclosure on your home.
Read More: What Is HELOC vs. Home Equity Loan?
What Is a Home Equity Loan?
Unlike home equity lines of credit, a home equity loan is more like a conventional loan. In this case, you borrow a lump sum that you pay back in equal monthly installments over a period of years. Home equity loans usually come with fixed interest rates, so your payments won't be affected by a sudden rise in interest rates, which could happen with a HELOC.
Read More: What Happens When You Default On a Home Equity Loan?
What About a Cash-Out Refinance?
Another way to borrow against the equity in your house is to do a cash-out refinance of your first mortgage. For example, suppose your first mortgage has a balance of $300,000, and based on a current market value of $400,000, you're able to refinance it into another first mortgage of $340,000. You could use the proceeds to pay off the balance of the first mortgage and have $40,000 cash to use as you please.
How to Get a Home Equity Line
Before applying for a home equity line, you should do your research by contacting several home equity lenders and finding out the terms and interest rates they're offering. In some cases, you might be able to speak with a loan specialist at the lender to get an initial review of your home's market value, mortgage balance and your income to get an indication of your chances for approval. They may also have a FAQs page for your reference.
After selecting a lender, here are the next steps for an application:
- Complete the application. Applications will ask for your current and past home addresses, employment information and a summary of your assets, such as vehicles and bank accounts. You also need to disclose the purpose of the loan and state the loan amount requested.
- Submit documentation. The lender needs documentation that verifies your income, balance on mortgage and the property value. You also need to submit proof of insurance.
- Review your credit report. Get a copy of your credit report and look for any mistakes or anything that needs correction before the lender pulls a hard copy. Be prepared to answer questions about any negative issues on your credit report.
- Get an appraisal. The lender will request a current appraisal for your property. An estimate from Zillow will not suffice.
Gathering the documentation and going through the underwriting process can take several weeks. Have funds available to pay closing costs and be ready to sign more paperwork before you can access your HELOC.
- Bank of America:What Is a Home Equity Line of Credit (HELOC)?
- Bankrate: The Bankrate Guide to Home Equity Lines of Credit (HELOCs)
- Federal Trade Commission: Home Equity Loans and Credit Lines
- Internal Revenue Service: Interest on Home Equity Loans Often Still Deductible Under New Law
- Forbes: What Is a Home Equity Line of Credit and How Does It Work?
- Consumer Financial Protection Bureau: Requirements for Home Equity Plans
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.