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- A home equity line of credit (HELOC) is a variable-rate form of financing that allows you to cash in on the equity you have in your home.
- HELOCs are a revolving line of credit, similar to a credit card in that you can borrow what you need, repay it, then borrow again, during a set draw period.
- HELOCs are often used to pay for home improvements, but the funds can go toward any expense.
What is a HELOC?
A HELOC is a revolving form of credit with a variable interest rate, similar to a credit card. The line of credit is tied to the equity 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’ll 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 does a HELOC work?
When you’re approved for a HELOC, you’ll be given a credit limit based on your available home equity. Well-qualified borrowers can tap up to 80 percent of your home’s value (sometimes as much as 85 percent), minus outstanding mortgage balances.
During an initial draw period, you can spend the funds using dedicated checks, a draw debit card or online transfer. You’ll need to make monthly interest payments on the amount you borrow, but as you pay back your HELOC, the funds will be 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 to calculate your HELOC borrowing limit
When considering your HELOC application, lenders look at the equity you have in your home. Equity is the value of your home minus what you still owe on your mortgage.
Say your home appraises at $375,000 and you still owe $150,000 on your mortgage. Your total equity, then, would be $225,000 ($375,000 – $150,000).
You can also determine your level of equity by calculating your loan-to-value ratio, or LTV. Simply divide $150,000 by $375,000, then multiply by 100 for a percentage. In this case, you’d have a 40 percent LTV ratio. This means you’d have 60 percent equity (or $225,000) in your home.
With a HELOC, you can usually borrow up to 80 percent of your combined LTV (CLTV). The CLTV takes into account the value of your home and what you owe on your first mortgage, plus what you’re borrowing through the HELOC.
Say your lender allows up to an 80 percent CLTV. Using the above example:
$300,000 – $150,000 (balance of first mortgage) = $150,000
Why HELOCs are popular in 2023
Home equity financing is having a moment. HELOC originations were up 7 percent from the second quarter of 2022 to the second quarter of 2023, according to credit bureau TransUnion. Their fixed-rate counterparts, home equity loans, are up even more — 24 percent in the same period.
The cause is mainly the rise in mortgage interest rates, which have doubled since their mid-pandemic lows. For many, the rapid rise has eliminated the advantage of a cash-out refinance, once the go-to way to tap a homeownership stake. Hence the appeal of home equity loans and HELOCs; while their rates have risen, too, they remain cheaper than other forms of debt, like credit cards.
Plus, Americans have plenty of equity to tap: The average mortgage holder had $199,000 available as of August 2023, according to Black Knight.
There’s no one-size-fits all set of requirements to qualify for a HELOC. That said, the criteria commonly include:
- Amount of home equity: Lenders typically require homeowners to have at least 15 percent to 20 percent equity.
- Credit score: Homeowners generally need a credit score in the mid-600s to qualify 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 debt-to-income (DTI) ratio of 43 percent or less. However, certain lenders might approve you with a DTI ratio of up to 50 percent.
How to apply for a HELOC
- Review and strengthen your credit. A strong credit score, ideally in the 700s, will get you the most favorable rate and terms. To improve your credit, make all payments on time — catching up on 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.
- Find a HELOC lender. Shop around and compare offers. Even a small difference in interest rate can save you thousands in the long run. Learn whether the HELOC lender charges annual maintenance or early closure fees.
- Apply for the HELOC. Depending on your lender, you can do this in several ways: in person, over the phone or online. However you apply, you’ll need to provide your residence history and income and employment information. You’ll also need to verify your identity and give permission for the lender to pull your credit reports.
- Hurry up and wait. The lender will order an appraisal of your home to determine its current value. The appraiser’s assessment determines how much equity you have available, which in turn helps set the size of your line of credit. Your lender might get back to you with a preapproval or an initial decision within days; others require you to wait until the whole underwriting process is done.
What are the pros and cons of a HELOC?
The pros and cons of a HELOC include:
Pros of HELOCs
- 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 some 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.
Cons of HELOCs
- 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.
- Sudden repayment shock: You might be able to afford your HELOC payments during the interest-only period, but once the repayment term kicks in, the new monthly amount you owe, a combination of principal and interest payments, could squeeze your budget.
- Sensitive to the real estate market: A significant decline in home values could cause your lender to reduce or freeze your credit line (during the draw period).
Home equity line of credit FAQ
It depends on your goals. A HELOC could be better than a home equity loan if you want a source of funds you can access on an as-needed basis. The line-of-credit arrangement also means you’ll only pay interest on the amount you borrow, at least initially. 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 but indeterminate 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.
Your lender will conduct a hard credit check when you apply for a HELOC, which can cause a slight, temporary decrease in your credit score. This type of credit check typically stays on your credit reports for two years, though it might only impact your credit score for up to a year. Apart from that, the way you use and repay your HELOC could impact your score. Borrowing against a HELOC can increase your credit utilization ratio, which factors into your credit score. A higher credit utilization ratio could result in a lower credit score. That said, paying down your HELOC over time could help you build credit,
The typical length of a HELOC is up to 30 years, with the draw period up to 10 years. Some lenders also provide the option to renew or refinance your HELOC once the repayment term ends.
A HELOC can work for many scenarios, including paying off high-interest credit card debt, tackling home improvements, paying for education or funding emergency expenses, such as a car repair or medical bills. Ultimately, there are several use cases. Just remember that your home serves as collateral, so it isn’t worth taking out the HELOC if you’re not confident you’ll be able to repay what you borrow.
You’ll almost always encounter variable interest rates with HELOCs, but a few lenders also offer fixed-rate versions. The variable interest rates on HELOCs are partly determined by benchmark indexes, like the U.S. prime rate. The prime rate is set by individual banks and influenced by fluctuations in the federal funds rate (the rate that banks charge other banks for short-term loans).
Some lenders offer fixed-rate HELOCs, which allow you to lock in a portion of your HELOC balance with a set, unchanging interest rate. This essentially converts part of your HELOC into a home equity loan. With a fixed rate, you won’t need to worry about your interest rate increasing over time.
The limit varies by lender. Generally, lenders allow well-qualified borrowers to tap up to 80 percent of their home’s equity. Some lenders allow up to 85 percent, or even 90 percent.
If you take out a HELOC with a $50,000 limit and draw the full amount, your monthly payment will depend on whether you make interest-only payments or interest and principal payments to start.
Say the HELOC has a 9 percent interest rate and you plan to pay it off in 20 years. You’d need to pay $453 per month to reach that goal.
If you want to explore a scenario of your own, use our HELOC payoff calculator.
There are two main alternatives to a HELOC: a home equity loan or cash-out refinancing. While a HELOC works like a credit card — giving you a maximum amount you can borrow with a variable interest rate — a home equity loan works more like your mortgage. You get a lump sum of money, and you repay it on a set schedule with a fixed interest rate. Likewise, a cash-out refinance replaces your current mortgage with a new, bigger one, allowing you to pocket the difference. Both types of loans take your equity into account when determining how much you can tap.