What is a HELOC?
A home equity line of credit or “HELOC” is a line of credit secured by your property that turns the home’s value into cash. HELOC loans are a great way to access the equity you’ve built up in your home without having to sell or refinance. If you’re considering a HELOC, here’s what you need to know.
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How does a HELOC work?
Home equity lines of credit work a bit like credit cards; they are revolving lines of credit that have a maximum spending limit. You can draw on the line, up to your credit limit, whenever you need cash. As you pay down the balance (with interest) your available credit is replenished.
But HELOCs have some key differences compared to credit cards. First, you can only draw from the credit limit for a set amount of time (known as the “draw period”), after which you can no longer borrow money and must repay the outstanding balance. Second, HELOCs are “secured loans” backed by your home’s value.
The fact that HELOCs are secured loans means borrowers get lower interest rates than they would on credit cards or personal loans. But the downside is that, as with a traditional mortgage, you could face foreclosure if you don’t make loan payments. So consider both the pros and cons before choosing a HELOC.
HELOC interest rates
HELOC interest rates are generally higher than standard mortgage rates but lower than home equity loan rates. However, like credit cards, HELOCs typically have variable rates. These interest rates rise and fall based on a public index such as the prime rate or U.S. Treasury bill rate. As the rate fluctuates, so will the cost of your credit. That can make it harder to budget for a HELOC than a fixed-rate home equity loan or cash-out refinance.
Using and repaying your HELOC
HELOC draw periods typically last 10 years. During the draw period, interest-only payments are required on any amount you’ve borrowed from the line of credit. If you want, you can pay more than the interest-only minimum on your HELOC and start paying down the principal. This will replenish the available funds and reduce how much you owe in interest.
After the draw period on your HELOC ends, you’ll enter the repayment phase. During this time, you won’t be able to draw additional funds from your line of credit. You’ll begin repaying any outstanding withdrawals plus interest on a monthly basis.
Most HELOC terms allow you repay the balance over a period of 10 to 20 years. This is a good thing because, unlike a traditional 30-year mortgage, the shorter term means less interest. But your monthly payments will also be proportionally higher.
How much can you borrow with a HELOC?
With a HELOC, you will have a credit limit that is based on your available home equity. Banks and lenders typically allow you to borrow up to 85 percent of your home’s value, less any outstanding mortgage balance.
For example, let’s say your home appraised for $300,000 and you have a $200,000 balance on your current mortgage. If you’re approved to borrow up to 85 percent of your home’s value, your total mortgage balances (first mortgage plus HELOC) can go up to $255,000. Since you have a $200,000 balance remaining on your first mortgage, the amount you can obtain for a HELOC would be $55,000.
Example of HELOC loan amount calculation:
- Appraised value: $300,000
- $300,000 x 85%: $255,000
- Current mortgage balance: $200,000
- HELOC amount available ($255,000 - $200,000): $55,000
Additional factors that lenders take into consideration include your debt-to-income ratio and your credit score.
How to qualify for a HELOC
Qualifying for a HELOC is similar to qualifying for a traditional mortgage. Your lender will require financial documentation and good credit scores that demonstrate your ability to repay. Income documents such as paystubs, W-2s, and tax returns are some of the documents you’ll need to have ready for your lender.
Lenders have varying credit score requirements for a HELOC. Generally, a minimum score of 620 is required. Credit scores over 700 are preferred and typically result in better terms and interest rates.
Your DTI, or debt-to-income ratio, is the amount you owe on monthly debt payments such as your mortgage, auto loans, and credit cards, against your monthly income. Your lender will factor in your debt ratios to make sure a new HELOC payment won’t exceed your ability to pay back what’s owed.
How to get a HELOC
When you are ready to apply for your HELOC, here are the steps:
- Determine the amount of cash needed based on your reasons for borrowing. Common reasons to take out a HELOC include debt consolidation, medical expenses, home improvements, wedding expenses, tuition costs, and more
- Draft a budget to make sure you’re comfortable with the monthly payments
- Compare lenders by shopping around and getting estimates. Be sure to not compare only interest rates but also repayment terms, fees charged, and eligibility requirements
- Get your documents in order and make application. Most lenders have online HELOC applications to make this process fast and convenient. Be prepared to submit your income asset documentation at the time you’re applying
- Get a home appraisal. After the underwriter verifies your credit and income, your lender will contact an appraiser to verify your home’s current value. This helps determine how much you can borrow on your HELOC. The appraiser will contact you to schedule the appraisal inspection
- Close the loan. Depending on where you live and your lender, a HELOC closing may be scheduled either at their office, an attorney’s office, or possibly at your home
- Get your cash. After closing and your right of rescission period has passed, you’ll be able to access your funds. You’ll be able to access your funds when needed by either writing a check, making an online transfer to a different account, or with a credit or debit card associated with the HELOC
The entire HELOC process, from when you apply to when you receive your funds, can take two to four weeks. The need for a home appraisal and full underwriting means HELOC loans can’t close instantaneously. However, some lenders are faster than others so it pays to shop around and ask lenders about their estimated closing times.
A HELOC is a type of mortgage loan. A HELOC is a second mortgage, meaning it’s taken out in addition to your primary home loan. The two loans will have separate terms and payments. The main difference between a HELOC and a traditional mortgage is that a HELOC is typically taken out after you’ve bought your home and accumulated equity.
A HELOC is repaid to your lender in a couple of different ways. Most lenders require interest-only monthly payments during the initial draw period. Once the draw period is over (typically 10 years), you will begin to make monthly payments that include principal and interest. If you sell your home and have a balance on your HELOC, the balance of your first and second mortgage will both be paid in full using the sale proceeds.
Like any other type of loan, a HELOC isn’t without risks. However, they can be a great option when you need to cash out equity but don’t want to lose the low fixed rate on your existing mortgage. Another HELOC benefit is that you may be able to deduct HELOC interest charges if you use the funds to buy a home or improve your existing home.
When you make an application for a HELOC, your lender will pull your credit. Credit inquiries have the potential to temporarily lower your credit scores, although the impact is small — usually 5 points or less. On your credit report, a HELOC will show up as a revolving line of credit, like a credit card. If you have too much debt, as well as too many open lines of credit, this can have a negative effect on credit scores. On the flip side, making HELOC payments on time and in full can help boost your credit score in the long run.
HELOC loans have a draw period and a repayment period. Funds are borrowed during the draw period, which is typically 10 years. Once the 10-year draw period ends, the outstanding balance converts to a principal and interest loan for a 20-year repayment period.
Is a HELOC right for you?
Understanding how a HELOC works, how much of your home’s equity you can access, and what qualifications are necessary can help you decide if a HELOC is right for you. When you’re ready to take the next steps, talk to a mortgage lender to discuss your options.