What is a HELOC (home equity line of credit)?

What is a home equity line of credit (HELOC)?

A home equity line of credit (HELOC) gives you the ability to leverage the ownership stake you’ve built up in your home. It  allows you to borrow and repay funds on an as-needed basis during a specified period of time. After that, you pay back the amount you borrowed in installments. Your home is the collateral for the line of credit, which means falling behind on payments puts your home at risk of foreclosure.

How a HELOC works

A HELOC is a revolving form of credit with a variable interest rate, similar to a credit card. When you’re approved for a HELOC, you’ll be given a credit limit based on your available home equity. Typically, you can borrow up to 85 percent of your home’s value, minus outstanding mortgage balances.

During the draw period, you can use funds from the HELOC using dedicated checks or a draw card. You’ll need to make monthly interest payments on the amount you borrow, but as you pay back your HELOC, the funds are replenished. This draw period typically lasts 10 years.

After that, you’ll enter a repayment period, during which you’ll no longer be able to access funds and instead need to repay the principal and any outstanding interest. Most HELOC plans allow you to repay the remaining balance over a period of 10 years to 20 years.

While you’ll only be on the hook for interest payments during the draw period, you can pay both principal and interest at this time if you choose. This can help keep your payments manageable when you enter the repayment term.

How HELOC interest rates work

You’ll almost always encounter variable interest rates with HELOCs, but a few lenders offer fixed-rate versions. The variable interest rate on your loan is partly determined by publicly shared indexes, like the U.S. prime rate. The prime rate is set by collective financial institutions and is influenced by fluctuations in the federal funds rate (the rate that banks charge other banks for short-term loans).

Because the prime rate is affected by market and economic conditions, your HELOC interest rate can increase or decrease over time. As a result, your monthly payment will change. However, there is a cap on how much your rate can increase over the HELOC’s lifetime.

Some lenders, however, offer the opportunity to lock in a portion of your HELOC balance under a fixed rate, essentially converting part of your HELOC into a home equity loan. Typically, you’ll repay that portion of the loan over a period of five to 30 years, though the balance must be repaid by the end of your normal HELOC repayment period. If you’re interested in this option, look for lenders advertising “hybrid HELOCs” or fixed-rate locks.

HELOC pros and cons

The pros and cons of a HELOC include:

Pros

• Flexibility: While you’ll be approved for a maximum HELOC amount, you don’t need to use all of it. This makes HELOCs an attractive option for paying for ongoing expenses, as well as a “nice to have” for unforeseen emergencies.
• Interest-only payments: During the draw period (the first 10 years), you’re only required to pay interest on what you use from the line of credit. This keeps your payments low, freeing up cash for other expenses or goals.
• Lower rates: HELOCs are backed by the equity in your home, which acts as collateral for the debt (in contrast to unsecured debt instruments, like credit cards or personal loans, which aren’t backed by anything). The presence of collateral makes a loan less risky to a lender. Because of this lower risk, HELOCs and home equity loans tend to have lower rates than these other types of financing.
• Potential tax deduction: If you use the funds from a HELOC to make home improvements, you might be able to deduct the interest on your tax return.
• Fixed-rate options: HELOCs come with variable rates, but some lenders offer a fixed-rate option that allows you to convert some of what you borrow to a fixed rate, protecting your budget from fluctuating rates.

Cons

• Variable rates: HELOCs have a variable interest rate, which means the rate can go up or down depending on the economy and prevailing market rates. If your rate goes up significantly, you might no longer be able to manage the payments.
• Secured by your home: A HELOC is tied to the equity in your home, so if you default on your payments, it could be foreclosed on by your lender.
• Repayment structure: You might be able to afford your HELOC payments during the interest-only period, but once the repayment term kicks in, the combination of principal and interest payments could squeeze your budget.
• Possible fees: You might need to pay for an appraisal to obtain a HELOC, as well as an application fee and then an annual fee to keep the line of credit open. If you close your HELOC early or prepay, there might be a fee for that, too.

HELOC requirements

Each lender has its own requirements for getting a HELOC, but there are some general criteria most lenders look for:

• Equity level: Most lenders require homeowners to have at least 15 percent to 20 percent equity.
• Credit score: Homeowners with credit scores in the mid-600s and higher have the best chances of being approved for a HELOC. If you’re approved with a lower credit score, you’ll likely have a higher interest rate.
• DTI ratio: Many lenders want to see a reasonable debt-to-income (DTI) ratio of 43 percent or less. However, a lender might approve you with a DTI ratio of up to 50 percent.

How to get a home equity line of credit

Applying for a HELOC is a lot like applying for a traditional mortgage. Lenders will review your credit history and current financials, and will appraise your home for its worth — all to determine if you qualify for a line of credit and, if so, how much you can borrow.

1. Review and strengthen your credit. A strong credit score, ideally in the 700s, will allow you to qualify for the most favorable rates and terms. To improve your credit, make all payments on time — catching up any past-due ones — and try to settle or at least pay down any outstanding balances. Review your credit report to correct any errors. Do all this several months before you actually apply for anything.
2. Find a HELOC lender. Make sure you shop around and compare offers. Even a small difference in interest rates can save you thousands in the long run. You should also learn whether your loan will include annual maintenance fees or early closure fees.
3. Apply for the HELOC. Nowadays, you can do this in several ways: in person, by mail, over the phone or online. However you apply, you’ll need documentation — lots of documentation. Lenders will assess your financial life thoroughly. Be prepared to provide your residence history, income and employment information with printed proof: W-2s, tax returns, bank/brokerage statements, to name just a few. You’ll need to verify your identity and give permission for the lender to access your credit reports as well.
4. Hurry up and wait. Some lenders may get back to you with preapproval or an initial decision within days; others require you to wait until the whole underwriting process is done. They may ask for additional info. At some point, they will do an appraisal of your home, to determine its current value (they may want to arrange for an in-person visit for this). The appraiser’s assessment determines how much equity you have available, which in turn sets the size of your HELOC balance.
5. Close on the loan. After the appraisal, you’ll receive final approval. The lender will arrange a closing date with you. You’ll be sent more paperwork to sign, finalizing the financing and officially opening the HELOC. You generally have access to the HELOC funds starting on the fourth day after closing.

How much can you borrow?

You can usually borrow up to 85 to 90 percent of your home’s value, minus any outstanding balances (like the amount still owed on your mortgage).

To calculate your maximum HELOC balance, you can multiply your home’s value by the percentage of equity you’re tapping and subtract your mortgage debt.

Say your bank allows you to draw up to 85 percent of your home’s equity, and your house is worth $460,000. You still owe $250,000 on your mortgage. That means you could get a HELOC of $141,000 maximum ($460,000 x 0.85 – $250,000 = $141,000).

Of course, this is a generic example. Factors such as your credit score, financial situation, and bank policies could also affect how high a balance gets set.

Is it better to get a HELOC or a home equity loan?

A HELOC could be better than a home equity loan if you want a flexible line of credit you can access on an as-needed basis. This offers the ability to only pay interest on the amount you borrow. With a home equity loan, you’ll be responsible for interest on the entire loan balance, even if you don’t use all the funds.

If you’re planning to cover a significant expense in the near future and want to have a pool of cash readily available, a HELOC might also be the better choice. That’s only if you don’t mind a variable interest rate, however (unless the lender offers otherwise), and a fluctuating monthly payment.