What Is a Home Equity Line of Credit?

What Is a Home Equity Line of Credit?
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If you need to make a large purchase, invest money in something or even pay off bills, homeownership may offer a loan option beyond digging into your savings. A home equity line of credit (HELOC) allows a homeowner who has built up equity in their property to access some of that money through a credit line that stays open for a specific term. Unlike with regular loans, a HELOC doesn't provide you with a single lump-sum disbursement but works more like a credit card. Use this guide to understand how a HELOC works as well as learn about the uses, benefits, disadvantages and procedures for taking out one.

Understanding Home Equity Lines of Credit

When you apply for a HELOC, the lender lets you have a credit line up to a maximum amount based on your home's combined loan-to-value ratio (CLTV ratio) and their policies. Your home's CLTV ratio refers to the total of all existing mortgage balances, second mortgages and HELOCs on the property divided by the current appraised value of your home. Usually, a lender requires a maximum CLTV of no more than ​80 to 90 percent​ for a HELOC. For example, a $300,000 property with $150,000 of debt would have a 50 percent CLTV, and a lender could let you borrow a portion of the $150,000 in equity you have through a HELOC.

The credit line the lender offers you would have a loan term that's usually ​25 to 30 years​, with the length split into draw and repayment periods. The draw period usually lasts for ​10 years​ during which you can borrow against the credit line as you wish, and most lenders just require you to make monthly interest payments during that time. When the draw period ends, you'll normally go into the repayment period during which you make both principal and interest monthly payments until you've paid off the loan amount. However, some lenders may require a balloon payment.

You'll find that HELOC lenders will usually offer a variable interest rate versus a fixed rate that is common with home equity loans and mortgages. While your interest rate is based on factors like creditworthiness and market rates, the variable aspect means you can see your interest rate change periodically during your HELOC's life of the loan term. This can lead to a higher or lower payment depending on whether rates go up or down.

Why Get a HELOC?

Taking out a HELOC comes with a lot of flexibility that can appeal to borrowers who may need the money at different times and for different purposes. Your lender usually doesn't restrict how you use the HELOC, so you can spend it on home improvements, a remodel, debt consolidation or other purchases such as vacations or vehicles that fit your financial situation. Flexibility also comes with the fact you can use as little or as much of the offered credit line as you need during the draw period, so you don't have to worry about requesting a certain amount of money upfront.

Using a HELOC can also cost less than using alternatives like a credit card and may not even have closing costs. This type of credit line usually has a low interest rate to begin with, and even if your rate does go up during the term, you'll still usually pay less than a typical credit card would charge. In some cases, you can even find a lender that allows a fixed-rate HELOC so you can have predictable, low interest.

Some HELOC interest is tax-deductible, so you can also get additional savings in the form of a tax deduction on the interest paid on a HELOC when you use the money on a qualified expense. Some examples include money spent building onto your home or making a substantial property improvement.

What Are Some HELOC Considerations?

Similar to your mortgage, the HELOC works with your home as the collateral. So, you need to feel confident you can handle both your mortgage and HELOC to avoid problems like potential foreclosure. Having to make just small interest payments during your draw period can tempt you to use more money than necessary, so you'll need to carefully consider how the money borrowed will affect your total debt payments both now and during the repayment period. Otherwise, you could face payment shock if you end up having to start making large payments or even a balloon payment for which you're not prepared.

While HELOCs offer flexibility, be aware that the terms can change from the ones you had when you agreed to the credit line. For example, although you get a specific credit limit when you take out the HELOC, keep in mind lenders can later reduce that line if your property experiences a decline in value, so you may lose access to money you'd need. Unless you've got a fixed-rate HELOC, your initial lower interest rate could go up and add to your costs. You might also have to pay closing costs and other fees that could offset some of the interest savings compared to other borrowing options.

What Are HELOC Alternatives?

To see how a HELOC compares to other common loan and credit line options, take a look at the following:

  • Credit card:​ Of the options available, a credit card is similar since you periodically borrow against a given credit line. However, the money isn't secured by your home with this option, interest rates tend to run higher and your credit line may be much less than what a HELOC might allow for a home with substantial equity.
  • Home equity loan:​ Also backed by your home, a home equity loan involves borrowing a specific amount in a lump sum rather than through a credit line. This loan usually has a fixed interest rate, and you don't have an interest-only repayment period like with a HELOC. This home equity borrowing option has less flexibility but more predictability in what payments and interest will be.
  • Cash-out refinance:​ Best if you're interested in both changing your current mortgage's terms and using some cash built up in your home's equity, a cash-out refinance gives you a new mortgage to replace your current one, so you can choose a new term, interest rate structure and even loan program. You can get a certain amount of money left over after the closing step for the refinance and use that for other purchases.
  • Reverse mortgage:​ If you have your home paid off, then a reverse mortgage might allow you to borrow against home equity as the lender would give you payments. You get to avoid paying this money back until certain events like your death or the sale of the property.
  • Personal loan:​ Available from online banks like SoFi and most local financial institutions, personal loans are unsecured financial products that usually have shorter terms of up to ​seven years​ and limits of up to ​$100,000​. They can offer better rates than credit cards but may have origination fees.

Looking at How to Qualify

For a lender to give you a HELOC, you'll have to meet various requirements. Some seem similar to that of an initial mortgage, while a HELOC omits some typical mortgage requirements like a down payment and instead requires a reasonable amount of equity. Take a look at what you can expect to need:

  • Credit score and history:​ The minimum HELOC credit score will vary by lender, but a ​620​ on your credit report is a common minimum to show you have good credit. However, having a credit score of ​720​ or more can substantially cut your interest rate. As of publication, myFICO estimated that a borrower with a ​620​ credit score might pay an interest rate of ​10.86 percent​ on a HELOC versus ​7.86 percent​ with a ​670​ score or ​5.24 percent​ with a ​720​ score. Lenders will also look at your credit history in general to make sure you don't have negative items like a bankruptcy, collections account or missed payments that indicate a risk you won't be able to handle the HELOC.
  • Home equity:​ While a lender might offer a HELOC if you just have 10 percent equity in the home, a minimum of ​20 percent​ is more common. When the lender calculates your CLTV ratio to determine your equity, they'll also look at how the new HELOC amount will affect your debt load and limit your credit line accordingly. So, you'll find your lender calculates a maximum credit line that can significantly fall below your actual calculated equity beforehand.
  • Debt-to-income ratio:​ You'll find your lender looks for a similar back-end DTI ratio that they'd consider for a mortgage, and ​43 percent​ is a good rule of thumb. This number will include all current debt payments plus the potential HELOC payment. If you can't satisfy the lender's maximum DTI ratio requirements, you could get lenience if you have a lot of cash on hand, or you can increase your income or reduce your debt payments to fix the issue.
  • Home appraisal:​ Depending on the lender, determining your home's value for calculating equity might just involve looking at records, but the lender may want a new appraisal done in some cases. (There may be appraisal fees.) For example, if you have a high CLTV ratio, the lender may particularly want to be careful and get an official appraisal before extending you a HELOC.

Deciding on a HELOC

If you meet all the HELOC requirements and have built up enough equity to warrant a high enough credit line for your needs, this financial product may suit your needs as long as you accept the risks and feel confident about your ability to repay the money. A HELOC can serve as a good and flexible option for purchases ranging from paying off high-interest debt to investing in your home when you have a good enough credit score to get a competitive interest rate and choose a HELOC with minimal fees.

On the other hand, if you don't need the flexibility of the draw period and prefer predictable payments, then the home equity loan alternative might better serve your needs, especially if you like the convenience of having all the money at once. A lender can help you weigh the pros and cons of a HELOC vs. a home equity loan as well as discuss other loan and credit line options that might suit your needs better.

Going Through the HELOC Application

Before you start an official application for a HELOC, consider both using a HELOC calculator and requesting a preapproval. The HELOC calculator will use information such as the home's current value and existing loan balance to give you an estimated credit line based on your CLTV. The preapproval allows a lender to give you an initial response including the potential HELOC limit and interest rate so you can shop around for the right option.

When you go through the HELOC application process, you'll fill out a detailed application, and possibly application fees, similar to that of a mortgage, send in income verification documents and have a credit check done. The lender will consider your existing mortgage outstanding balance as well as check the home's value, either through records or a new appraisal, and calculate your DTI ratio. If you eventually get approved, the HELOC application moves to the closing stage with the final paperwork and any closing costs paid. Lenders will give you a three-day cancellation period during which you can change your mind on taking out the line of credit.

Your lender will provide information on accessing the HELOC, and you can begin using the money once the three-day period where you can back out expires. Usually, you can do online transfers as well as withdraw the money in person or write checks. You'll also get communications about your interest-only payments during the draw period and the due date for those.