Home Equity Line of Credit (HELOC): What Is It And How Does It Work?
One of the best benefits of homeownership is the ability to build equity over time. With equity, you can secure low-cost funds in the form of a second mortgage, either through a one-time mortgage or a revolving home equity line of credit (HELOC). There are advantages and disadvantages to each of these forms of credit, so you should understand their strengths and weaknesses before proceeding. You may also have other choices that are worth exploring.
What Is A Home Equity Line Of Credit?
A home equity line of credit or HELOC is a type of second mortgage that lets homeowners borrow against their home's equity and receive that money as a line of credit. You can use HELOC funds for various purposes, such as improving your home, paying for education, and consolidating credit card debt.
Equity Loan Basics
Home equity loans and HELOCs use the equity in your home—the difference between the value of your home and your mortgage balance—as collateral. With the equity value of your home as collateral, home equity loans offer highly competitive interest rates, usually similar to those of a first mortgage. For the same loan amount, you'll be paying less in financing fees than in unsecured borrowing sources, such as credit cards.
There is, however, a downside to using your home as collateral. The home equity lender will place a second lien on your home if you fail to make payments, giving them rights to your home along with the first mortgage lien. The more you borrow against your house or condo, the more you are putting yourself at risk.
Is There A Limit To How Much You Can Borrow With Equity Loans?
Banks underwrite second mortgages similar to other home loans. They each have guidelines that dictate how much they can lend based on your creditworthiness and your property's value. It is expressed in a combined loan-to-value (CLTV) ratio. In this ratio, all loans secured by the home, including first and second mortgages, are compared to the home's value.
Let’s have an example. Suppose you work with a bank that offers a maximum CLTV ratio of 80%, and your home is worth $300,000. If you already have a first mortgage balance of $150,000, you may be able to get an additional $90,000 in the form of a home equity loan ($300,000 x 0.80 = $240,000 - $150,000 = $90,000).
Qualification Requirements For HELOCs
Qualifying for a home equity line of credit is similar to qualifying for a mortgage refinance. You’ll have to meet specific requirements before you can get this type of loan.
HELOC requirements vary from lender to lender, but you typically need a:
- Reliable income: Many lenders will need proof of income to verify that you can pay off your loan payments.
- Good credit: You are more likely to be approved for a loan if your credit score surpasses the mid-600s. It is considered ideal to have a credit score above 700.
- Qualifying amount of equity in your home: A minimum of 15% – 20% home equity is required.
- Responsible payment history: Your lender may evaluate your previous payment history to ensure you have not made any late payments.
- Low debt-to-income ratio (DTI): Reduce your DTI as much as possible. You may be able to increase the likelihood of receiving a loan if your lender has specific requirements for DTI ratios.
The requirements for refinancing a mortgage are similar to those for a HELOC. Take the time to review each to get the best understanding of those available for you.
How Does a HELOC Work?
There are usually two phases to home equity credit lines. The first is a draw period, usually ten years, in which you can access the available credit at your convenience. A HELOC usually requires small, interest-only payments during the draw period, although you may be able to pay extra and have it applied to the principal.
You can sometimes request an extension after the draw period ends. If not, the loan enters its second phase, which is repayment. Afterward, you can no longer access additional funds and must make regular principal-plus-interest payments until the balance dissipates. After a 10-year draw period, most lenders require a 20-year repayment period. All borrowed money, plus interest, must be paid during repayment. Some lenders may offer borrowers different repayment options.
Many of the attributes of a HELOC make them different from a standard credit line, but they also have advantages over them. However, the interest-only payments during the draw period can almost double the repayment payments. An $80,000 HELOC with a 7% annual percentage rate (APR) would cost around $470 a month in interest-only payments. After the repayment period begins, that figure jumps to about $720 a month.
Unprepared HELOC borrowers can experience payment shock at the beginning of the new repayment period due to the sudden increase in payments. Those with financial hardships may even default if the sums are large enough. And if you fall back on paying, you may lose your home.
Paying Back A Home Equity Line Of Credit
A HELOC has two phases that separate borrowing from repayment, also known as the draw period and the repayment period. During both periods, you will need to make payments on the loan.
Phase 1: The Draw Period
Your line of credit is available for use during the draw period, which is the first phase. During this period, you’ll be allowed to use your line of credit as needed, paying minimum payments or possibly interest-only payments on the borrowed amount. Once you reach your limit, you will have to pay off some of your debt before you can borrow again.
You may have to refinance your HELOC if you wish to extend your draw period.
Phase 2: The Repayment Period
Once your draw period is over, you won’t be able to access the HELOC funds anymore. You will have to start making full monthly payments, including principal and interest during the repayment period. If you have been making interest-only payments up to this point, you can expect them to increase substantially.
Depending on the loan you get, both periods will last different amounts of time. You may decide that a 30-year HELOC with a 10-year draw period and a 20-year repayment period is perfect for you.
To keep your loan-to-value (LTV) ratio below a certain percentage, lenders will not let you borrow against all the equity you have in your home. The reason is that you’re less likely to default if you have any equity to lose.
HELOC Loan Disadvantages and Advantages
Although HELOCs can be valuable financial tools, they aren't ideal for every situation. Here are some of the most important disadvantages and advantages to consider before applying for a HELOC loan so you can choose wisely.
- Be prepared to pay upfront costs. You may need to pay application fees, home appraisals, title searches, and attorney fees before receiving a HELOC. These additional upfront costs may not be worth it if you do not need to borrow a large sum of money. If you need help paying off your mortgage, using a credit card may be a better option.
- Your house is used as collateral. It is always risky to take on debt, especially one tied to your home. You could lose your home if you fail to make payments on your HELOC, since it acts as collateral for the loan.
- Rates and payments may increase. Keep an eye out for changes in the market that may increase your rates or payments. Your finances could suffer a shock if your interest rate increases or your draw period ends, forcing you to make full payments instead of interest-only payments. Ensure that your finances can handle this unpredictability.
- It’s not always the most practical option. Paying for everyday expenses with a HELOC should also be avoided. While it might seem like a regular credit card, you’re trading valuable equity for the money you borrow from your HELOC. Generally, it is best to use your HELOC for things that will benefit you financially, such as boosting the value of your home or paying for college.
- It is possible to consolidate debt at a low-interest rate. HELOCs can be helpful if they allow you to pay off your debts at a lower interest rate. You only have to pay interest on what you are currently borrowing.
- You can use the money for anything. A HELOC can be used for any expense you need cash for, including medical bills, college tuition, or other bills.
- You can access a large amount of money through it. A home equity line of credit may be your best choice for borrowing a large amount of cash, especially for expensive home improvement projects.
- There is no limit to how much you can borrow. In addition to their flexibility, HELOCs allow you to borrow as much money as you need. You can use this if you do not know how much your project will cost over time. In this way, if a project ends up being under budget, you won't have to worry about paying excessive interest.
- Tax deductions may be available. You may be able to deduct the interest you pay on a HELOC if you use the funds to improve your house.
Calculate your estimated line of credit for a HELOC using the following formula:
Multiply: (The value of your home) ✕ (your lender’s LTV percentage) = maximum amount of equity you can borrow
Subtract: (Maximum amount of equity you can borrow) − (what you currently owe on your mortgage) = your HELOC credit limit
As an example, suppose a lender is willing to provide you with a HELOC with 80% LTV. Your house is worth $250,000, and you currently owe $180,000. You can find your credit limit on this HELOC by multiplying the value of your home by 80% and subtracting your current balance.
250,000 ✕ 80% = 200,000
200,000 − 180,000 = 20,000
Depending on the circumstances, you may be able to get a credit limit of up to $20,000.
HELOC Rates: What Can Be Expected?
When you take on debt, the interest rate you pay will depend on your financial situation and the current economy. In general, rates for second mortgages, like your HELOC, will be slightly higher than your main mortgage because the lender is taking on more risk but lower than the average credit card rate (sometimes even lower depending on your creditworthiness).
In addition, you should be aware that most HELOCs have variable rates, which means the interest rate you pay will change with market fluctuations. It is possible to get a HELOC with a fixed rate that allows you to convert fro m a variable rate to a fixed rate, but these loans may have restrictions on how many withdrawals you can make and the maximum amount you can withdraw each time.
Depending on your lender, you may also have to pay additional fees, such as an annual fee for the cost of having the account or an origination fee that covers the cost of setting up your loan.
If you decide to get a HELOC, shop around and compare costs among multiple lenders to guarantee you get the best deal. If you can't find an attractive lender, you might want to consider working on your credit first, then shop around again once you've improved your score. You should also familiarize yourself with the current refinance rates if you are still considering refinancing options.
What Can You Use A HELOC For?
HELOCs were designed to be a flexible way to leverage the equity in your home. You are not required to use the funds for any particular purpose, so you can use them however you like depending on your needs. Let’s go a little more in-depth about some things you might be able to use a HELOC for.
Home Improvement Or Repairs
If you plan to use the funds to improve or increase the value of your home, it can make sense to tap into your home’s existing equity using a HELOC.
Some improvements are more worthwhile than others. A full kitchen renovation may seem like it will give you a dollar-for-dollar return on your investment, but that is not always the case. You will likely get more bang for your buck with something that increases the square footage of your home, such as finishing your basement.
Likewise, you may reap many benefits by making changes to the exterior of your home to increase its curb appeal, such as upgrading the landscaping around your house.
Having a lot of high-interest debt, such as credit card debt, can make it challenging to consolidate all your debt into a single loan. However, lower-interest HELOC may be able to help by saving you hundreds of dollars in interest costs.
Nevertheless, don't forget that when you use a HELOC to consolidate credit card debt, you'll replace an unsecured loan with one secured by your home. You could lose your home if you default on this loan.
It is common for medical bills to exceed thousands of dollars for even the most basic procedures and care. HELOCs can have lower interest rates than other financing options. HELOCs allow you to pay off medical bills in full and repay your line of credit at a lower interest rate, thereby saving you money in the long run.
Some people use the equity in their homes to pay for their own or their child's college education. While this can make sense in some situations, you should explore all your options.
If the student can get federal student loans, they may qualify for a lower interest rate than they would with a HELOC. Furthermore, federal student loans offer certain benefits, such as flexible repayment plans and protections.
Alternative To A HELOC
Even if you do not want to open a home equity line of credit, you still have a few other ways to take advantage of the equity in your home. A cash-out refinance is one of the easiest ways to access the equity in your home without taking out a new loan. It is important to learn more about this financing option.
How A Cash-Out Refinance Works
When you refinance your current mortgage with a cash-out refinance, you're replacing your old mortgage with a new one, while borrowing cash that you can use however you like. In a cash-out refinance, the new mortgage loan amount is higher than what you owe now, allowing you to pocket the difference.
Let's look at our first example again with your $250,000 home and $180,000 balance. With a cash-out refinance, you could borrow up to $200,000, use $180,000 to pay off your current mortgage, and then keep the other $20,000 (minus closing costs and additional fees).
Cash-out refinances have their own credit, LTV, and DTI requirements, like second mortgages and HELOCs. Generally, you'll need a minimum 620 credit score, a DTI of less than 50%, and a max LTV of 80%.
FHA and VA loans are exceptions. You can do an FHA cash-out transaction with a 580 median FICO® Score so long as you're paying off debt at a close. With VA loans, you can take cash out with a median credit score of 580 if you leave 10% equity in the home.
If you wish to have only one loan on your property and only one monthly mortgage payment, a cash-out refinance might be better than a home equity line of credit. A cash-out refinance is also typically associated with lower interest rates since it is a first mortgage, making it a less risky investment.
Home Equity Loans Vs. HELOCs
Home equity loans are similar to HELOCs in that they are loans offered by lenders based on your home equity. In addition, home equity loans use your home as collateral, so if you cannot make your monthly payments, you may lose your home. Home equity loans have fixed interest rates and preset monthly payments. In contrast to HELOCs, you cannot add loan funds to your home equity loan, so it's ideal if you know how much funding you need.
- You receive your loan in one go. It is helpful if you have a project with a fixed cost that you need to cover upfront, such as replacing your roof.
- There is a certain level of predictability. Generally, home equity loans have fixed rates and set monthly payments, making them more predictable. Home equity loans are a more reliable option if you know exactly how much you need and prefer to budget your income.
- You can pay off the loan early. Refinancing home equity loans at a lower rate can allow you to pay off the loan sooner and save on your monthly payments.
- You’re unable to receive more loan funds than the promised amount. If you’re planning on a significant home renovation on an investment property, unexpected costs may arise, and you may not know how much you’ll need to borrow overall. In these circumstances, home equity loans may not be the best option.
- Keep an eye on real estate value fluctuations. The market value of your home may also decrease if real estate values decrease. In this case, you may owe more than the value of your property. During this time, you may lose money in the process if you plan on selling your home.
Most Frequently Asked Questions About Home Equity Lines Of Credit
What is home equity?
Home equity is the difference between the value of your house and what you currently owe your lender. Each time you pay towards the balance of your mortgage, you are adding to the amount of your home that you own.
What is a line of credit?
The term "line of credit" refers to an account that allows you to borrow repeatedly, as long as you stay within the approved credit limit. As it is related to home equity, a line of credit is more flexible than a traditional term loan, where you borrow a fixed amount of money and pay it off over time with fixed payments. A line of credit allows you to get approval from your lender to borrow money up to a certain amount, and then repay the borrowed money all at once or over a period of time (with interest of course).
Can I pay off a HELOC early?
You can pay off a HELOC early. Prepayment penalties do not apply to these loans. During the draw period, you should pay off your loan's principal. You only need to pay interest during this time but paying extra toward your principal while in the draw period can help you avoid paying more during repayment.
Is there a difference between a HELOC and a home improvement loan?
One of the biggest differences between a HELOC and a home improvement loan is that a HELOC borrows against the equity in your home, whereas the latter does not. Due to this, home improvement loans have a lower borrowing limit. The interest rates on these loans can also be higher than those on HELOCs.
Furthermore, remember that the money from a HELOC does not have to go toward home improvements. Other uses include debt consolidation and major purchases.
Is The Interest On A Home Equity Loan Or HELOC Tax Deductible?
Tapping into home equity through a home equity loan or a HELOC could yield a tax benefit if you can write off the interest you pay. The Internal Revenue Service (IRS) allows you to deduct some of the interest on home equity credit as long as you itemize deductions and meet a few requirements.
Before the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers could deduct interest on up to $1 million of mortgage debt, and there were no restrictions on the usage for deductions. Through 2025, the TCJA established new limits and restrictions.
As of 2022, married couples can deduct interest on up to $750,000 of eligible mortgage debt (or $375,000 if filing separately). First mortgages, second mortgages, home equity loans, and HELOCs can qualify for deductions if the debt is used to "buy, build, or substantially improve" the home.
The Bottom Line
You may reach a point in your life when access to extra cash becomes a necessity. If so, a second mortgage can be an attractive option. Because it relies on the equity value of your home, lenders may be willing to offer rates lower than most other types of loans.
However, you should factor into your monthly budget the extra loan payment that comes with a home equity loan or a HELOC. Furthermore, if you fail to make payments, your home may be at risk of foreclosure due to a second lien placed by the bank.
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