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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 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.”
A HELOC works like a credit card: You can borrow from the credit line as the need arises, and 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.”
Here are some tips for getting the best rate on a home equity line of credit.
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. You can also get a free credit report and score from Bankrate.
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.
2. Have enough equity
The amount of equity you have in your home determines the size of your home equity line, and it 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 how much money you want to borrow, either as a lump sum or a line of credit, and how much you owe on your mortgage. Typically for HELOCs, lenders prefer the CLTV be less than 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. Comparison shop
Shop for a low HELOC rate starting with the lender who holds your current mortgage or the bank where you keep your checking or savings accounts. Those financial institutions want to keep your business and might offer you a good deal on a HELOC (if they offer them).
Don’t stop there, though. 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 and caps
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.
“Ask questions,” Saunders says. “Once the transaction has closed, it’s too late.”
Inquire about your starting rate, how long it will last and whether there’s a cap on how high your rate might eventually go. If there is no cap, you run the risk of your interest rate pushing your monthly payment beyond what you can afford. 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. Beware of 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. A trusted mortgage lender or banker can help you understand all of the fees involved.