When you need cash to pay off debt, to make home repairs or for an unforeseen expense, a home equity line of credit, or HELOC, is one way to tap into your home’s equity.
A HELOC works like a credit card: You can borrow from the credit line as the need arises, then pay it off in installments. However, the interest is often much lower than you’d find on credit cards, so many homeowners turn to HELOCs when they need large sums of cash.
“Say you get a $50,000 equity line. As you pay it down through the years, that $50,000 is still available to you. So you could use it, pay it off or pay it down, and a lot of people like that feature,” says Josh Moffitt, president of Silverton Mortgage in Atlanta, Georgia. “You’re only paying interest on what’s used. It’s a nice way to have access to the equity in your home when you need it, versus trying to go get a loan every time.”
“A line of credit can be a valuable tool for a homeowner looking to take advantage of the value built up in their home,” explains Valerie Saunders, executive director of the National Association of Mortgage Brokers. “The approval process is typically less invasive on a HELOC so necessary funds can be obtained more quickly.”
How HELOC rates work
While home equity loans have fixed interest rates, HELOC interest rates are variable. HELOC interest rates track the prime rate, which has remained relatively low. That means you can still find a low HELOC rate — even if that rate fluctuates over the term of your HELOC.
However, keep in mind that your rate won’t necessarily be the prime rate. Your personal rate equals the prime rate plus a fixed margin, which is determined by your credit score and the amount of equity in your home. A higher credit score equals a lower margin and therefore a lower monthly rate.
How to get the best HELOC rates
Searching for a HELOC can be a daunting task. It’s important to shop around with different companies, as your estimate may be different depending on the provider. The lender that holds your current mortgage or the bank where you keep your checking or savings accounts are good places to start, since those financial institutions want to keep your business and might offer you a good deal on a HELOC (if they offer them).
As you shop multiple lenders, keep in mind these tips for getting the best HELOC rates.
1. Maintain good credit
When applying for a HELOC, you’ll need to be ready for a similar approval process as when you first applied for your mortgage.
“A HELOC is still a loan. In most instances, the same information is required,” Saunders says.
Just like the mortgage application process, a lender considers your FICO credit score to determine your interest rate. Before you apply for a HELOC, check your credit reports from the three major credit bureaus (Equifax, Experian and TransUnion) to confirm there are no errors or old “zombie” debts on your record. These negative items can lower your credit score.
Be careful not to close a credit card or take on new debt before seeking a HELOC, as those moves could lower your credit score even further.
2. Have enough equity
The amount of equity you have in your home determines the size of your home equity line, and it also influences the HELOC rate you’re able to get. The more equity you have, the less likely that you’re overloaded with debt against your home, and the better you look to a lender.
Having a decent amount of equity also means you’ll have a lower combined loan-to-value ratio, or CLTV. The CLTV is determined by adding up your current loan balance and your desired line of credit, then dividing by the appraised value of your home. For HELOCs, lenders typically prefer CLTVs below 85 percent.
To get an idea of how much home equity you have, find an online estimate for the value of your home and subtract the balance owed on your mortgage.
3. Consider different types of lenders
While your current lender may offer you a good deal on a HELOC, don’t stop there. Compare estimates from other players, including national banks, smaller community banks, credit unions and online mortgage lenders. Each type of lender has its own advantages. For instance, online lenders generally have lower operating costs, which can mean lower rates, while local banks and credit unions may have a better understanding of your market and offer you more personalized service.
4. Ask about rate changes
When you think you’ve found a great HELOC rate, find out how long it will last and how it might change over time. A HELOC typically comes with an adjustable rate during the initial draw period that fluctuates in sync with the prime rate. However, some lenders may fix your rate for an initial period or offer you a competitive introductory rate. Inquire about your introductory rate, how long it will last and what your rate will be after the introductory period. A lower rate during a year-long introductory period may not be worth it if your rate skyrockets after.
“Ask questions,” Saunders says. “Once the transaction has closed, it’s too late.”
Note also that during the first stage of a HELOC, you can draw from your credit line and pay only the interest on the amount you draw as your minimum monthly payment. At the end of that draw period, which can last five years or more, you must pay both interest and principal.
5. Look for rate caps
Some HELOCs offer rate caps as a safeguard against rising interest rates. If you select a HELOC with a low rate cap, you’re protected from paying more than your maximum, even if the prime rate spikes. If there is no cap, you run the risk of your interest rate pushing your monthly payment beyond what you can afford.
6. Factor in fees
Don’t be so enticed by a low HELOC rate that you miss hidden fees. Some lenders will charge up-front fees, third-party fees or an annual fee, or require you to draw a minimum amount of credit to avoid a fee. Some even charge inactivity fees, which can negate any benefit you may receive from a low HELOC rate. A trusted mortgage lender or banker can help you understand all of the fees involved.
7. Watch out for balloon payments
Getting a low monthly rate may seem like the most important factor when choosing a HELOC, but sometimes those low rates come at the expense of what’s called a balloon payment. A HELOC with a balloon payment requires you to pay off your remaining balance at the end of your term in a lump sum — a potentially huge unexpected payment if you’re not prepared for it.
The bottom line
Lenders determine your HELOC rate based largely on your financial profile, taking into account your credit score and home equity. However, when searching for the best HELOC rates, make sure to keep an eye out for things like rate caps, introductory periods and balloon payments. All of these will have an effect on what you’ll pay each month.