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

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A home equity line of credit (HELOC) is a type of loan that allows you to borrow and repay money as you need it over a certain period of time. It essentially functions as a credit card secured by your home, since the funds are based on your available equity. Because of its flexibility, a home equity line of credit is a great option if you have ongoing projects like home renovations.

How does a HELOC work?

Unlike a home equity loan, which involves borrowing a fixed, lump-sum amount, a HELOC is a revolving form of credit. It functions much like 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 established draw period, you can draw funds from the account using dedicated checks or a draw card. You’ll need to make minimum monthly 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 will instead repay the principal. Most HELOC plans let you repay the remaining balance over a period of 10 to 20 years.

How to qualify for a HELOC

Each lender will have its own requirements for getting a HELOC, but there are some general criteria that lenders will consider when deciding whether to approve your application.

  • Equity in your home. Most lenders require homeowners to have at least 15 percent to 20 percent equity in their homes.
  • Good credit. Homeowners with credit scores in the mid-600s and higher have the best chances of being approved for a HELOC.
  • Debt-to-income ratio. Many lenders will look for a reasonable debt-to-income ratio, generally approving applicants with a ratio of 43 percent or lower. Be sure to calculate your debt-to-income ratio before applying.
  • Adequate income. Before you can be approved for a HELOC, a lender will evaluate your annual income to ensure that you can afford your monthly payments.
  • Responsible payment history. If lenders see a history of late payments, they are unlikely to approve your application because you may not make your new loan payments on time.

Types of interest rates on HELOCs

You’ll almost always encounter variable interest rates with HELOCs, but a few lenders offer exceptions.

Variable interest rates

Like credit cards, HELOCs come with a variable interest rate, which means that your monthly payment will vary depending on the current interest rate and how much you borrow at any given time.

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, it causes your HELOC’s interest rate to increase or decrease over time. As interest rates change and you draw on your HELOC account, the monthly payment that’s due will also change. However, there is a legal cap on how much your rate can increase over the plan’s lifetime.

Fixed interest rates

Some lenders 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. Companies that offer fixed-rate HELOC options typically let you 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. Companies may also let you have multiple rate locks in place at any given time.

Choosing to lock in a portion of your HELOC could be useful if interest rates are low and you don’t want to risk them rising over the course of your repayment period. If you’re interested in this option, look for companies advertising “hybrid HELOCs” or fixed-rate locks.

The bottom line

HELOCs are worth looking into if you want the freedom of borrowing as little or as much as you want, and doing so on your timeline. But keep in mind that HELOCs require discipline, and a variable interest rate makes them slightly more volatile than home equity loans. Still, if you’re looking for access to funds for ongoing projects or expenses, try getting quotes from a few lenders to see what they can offer you.

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