What is a Home Equity Line of Credit?
HELOCs are a flexible way to turn your home into a source of cash, but they can come with fees and put your homeownership at risk. If you need financial flexibility, they’re a useful tool, but you should keep the costs and risks in mind.
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In most parts of the United States, a home can cost tens or hundreds of thousands of dollars, which easily makes a home the most expensive thing that most people ever own. Owning your home can provide a lot of peace of mind, but it can be difficult to have so much money tied up in your home when you might need it for other expenses.
However, as you pay down your mortgage, you build equity, which is the difference between the value of your home and the balance remaining on your mortgage. For example, if your home is worth $200,000 and you have a mortgage balance of $150,000, you have $50,000 in equity. Lenders offer specialized loans that are secured by the equity you have in your home.
Home equity lines of credit (HELOCs) are one such type of loan, offering flexible, long-term access to cash through the equity that you’ve built. This guide will cover common HELOC questions and how you can make the most of one.
Table of Contents:
- What is a HELOC & how does it work?
- Common HELOC terms
- What can a HELOC be used for?
- How large of a HELOC can you get?
- How does the HELOC application process work?
- What are the alternatives to HELOCs?
What is a HELOC & how does it work?
A HELOC is a line of credit secured by the equity you’ve built in your home, and it works a lot like a credit card. When you get a HELOC, you receive a credit limit and a variable interest rate. When you need some cash, you can borrow money from your HELOC, up to your credit limit.
If you do borrow money from your home equity line of credit, you’ll get monthly bills and have to make payments against your HELOC balance. Even if you already have a balance, you can continue borrowing money until you reach your credit limit—again, just like a credit card. If you don’t have a balance, you don’t have to borrow any money and won’t get monthly bills.
How does repayment work?
Some HELOCs are paid off like traditional loans, with a monthly payment toward your balance and interest. Interest-only HELOCs, however, have a draw period—where you are allowed to draw money from the home equity line of credit—and a repayment period.
During the draw period, you are only required to pay the accumulated interest on your monthly bills, though you may pay more if you’d like. After the five to 10-year draw period, there is a repayment period that ranges from 10 to 20 years. During the HELOC’s repayment period, you’ll get monthly bills for principal and interest until you pay off the full balance.
It’s important to note that your home serves as collateral for the loan. This means that if you don’t make the required monthly payments, you may forfeit your homeownership.
In some scenarios, the interest that you pay on a HELOC can be tax-deductible. According to the IRS, if you use the HELOC to “build or substantially improve the… home that secures the loan,” you may be able to deduct the interest payments on your taxes, though individual circumstances vary.
HELOC Terms and Fees
When you apply for any type of loan you want to make sure you understand all of the terms and fees that come with it. This is especially true for a loan as large as a HELOC usually is.
With a HELOC, the first thing to keep in mind is that you’ll probably have to pay some fees and closing costs when you first get the line of credit. Some lenders charge origination or annual fees for their HELOCs often reaching into the hundreds of dollars. The size of these fees is usually based on how much money you take with your initial draw on the HELOC.
HELOCs might also charge other fees, such as prepayment fees, and missed or late payment fees. All of these can add additional costs to your loan. Typical interest rates for HELOCs are lower than credit card and personal loan interest rates because your home serves as collateral for the loan.
Keep in mind that HELOC interest rates tend to be variable, which means the interest rate could increase over the life of the loan—this is in contrast to fixed interest rates, which do not change.
This is especially dangerous for interest-only HELOCs, as you only start paying down the principal balance after the draw period. If interest rates rise, your payments will rise over time, and you may wind up having to pay a large amount of interest during the repayment period.
What can a HELOC be used for?
One great thing about HELOCs is that they’re incredibly flexible. You can use the money that you borrow for almost any purpose. Because you can draw money from a HELOC as you need it, it makes the HELOC great for unpredictable expenses.
Some popular uses for HELOCs include:
How large of a HELOC can you get?
The top factors determining how much money you can borrow with a HELOC are the equity that you’ve built in your home and the overall value of your home. The relationship between the two amounts is know as the Loan-to-Value (LTV) ratio.
The lower your LTV, the more that lenders will be willing to let you borrow. Most lenders will offer you a HELOC of 80% to 90% of the value of your home minus your balance.
For example, if you own a $250,000 home and have a $100,000 balance remaining on your mortgage, your LTV is 40%. If the lender is willing to lend up to 80% of that amount, you can borrow an additional $100,000 using a HELOC. This number is derived from taking 80% of the overall home value ($200,000), and then subtracting the $100,000 balance.
You can use our home equity loan calculator to estimate your borrowing limit and repayment costs.
Other things that affect your ability to get a HELOC and your HELOC’s credit limit include your credit score, debt-to-income ratio, and your annual income.
If you have good credit, it’s easier to qualify for loans and secure lower interest rates. A HELOC is less risky for lenders than unsecured loans, but most lenders still want to see borrowers with good credit. If you have a lower credit score, you might receive a lower credit limit.
Your debt-to-income (DTI) ratio measures how much debt you have compared to your income. If you have a lot of debt, lenders may worry that you won’t have enough income to make payments on a new loan, and will be wary of lending to you.
Lenders also want to make sure you have a way to repay a loan before offering one to you. You might have to provide proof of income, such as a paystub or last year’s tax return, when you apply.
How does the HELOC application process work?
Applying for a HELOC is a multi-step process.
- Check your credit and your home’s value to make sure you can qualify for a loan.
- Figure out how much you want to borrow.
- Compare lenders and choose one with whom to work. You can do this with our best home equity lines of credit page.
- Fill out an application. You’ll provide personal identifying information and financial information during this step.
- If you’re approved, review the documentation and make sure you understand any applicable fees, limits, and penalties.
- Double-check your budget to make sure you can afford the cost of the HELOC.
- Wait for final approval and sign the paperwork.
What are the alternatives to HELOCs?
HELOCs are a flexible way to get cash out of your home, but there are other ways to borrow money when you need it.
Home equity loans
Home equity loans let you turn the equity you’ve built in your home into a one-time infusion of cash. Like a HELOC, a home equity loan uses your home value and that equity to secure the loan, making it easier to borrow large amounts and secure a low interest rate.
The major difference between home equity loans and HELOCs is that you get the full lump sum of the loan when you first open a home equity loan—you can’t go back and borrow more money when you need it. That makes home equity loans ideal for one-time, large expenses, such as consolidating many debts or paying for a large home improvement project.
Additionally, home equity loans are available with fixed rates and variable rates, where HELOCs can only be borrowed at variable interest rates.
Want to learn more? Check out our guide on home equity loans or compare the best home equity loans rated by our Editorial Team. To better understand the difference between the two, check out our HELOC vs. home equity loan page.
Unsecured personal loan
Unsecured personal loans are smaller loans that don’t require any collateral. This means that they can be harder to qualify for than home equity loans or HELOCs, and they tend to carry higher interest rates. The benefit is that you don’t have to put your home at risk when you get a personal loan.
Typical personal loans let you borrow anywhere from $1,000 to $35,000 for a term of three to five years. Some lenders offer slightly longer terms and higher limits.
Personal loans usually work best when you have to meet a short-term, small expense, like an unexpected bill.
You can use our best personal loans page to compare unsecured options.
A cash-out refinance replaces your mortgage with a brand new one that has a balance roughly equal to the value of your home. You pay off your current loan and pocket the difference between it and your new one as cash. You can use the money you get from a cash-out refinance for any purpose.
One advantage of a cash-out refinance is that you only wind up with one monthly payment to make. Home equity loans and HELOCs add a second loan payment on top of your existing mortgage. The downside is that a cash-out refinance replaces your mortgage with a new one, resetting your loan’s term. That means that it will take longer to pay off your mortgage.
You can use our page to compare the best cash-out refinance companies.
A reverse mortgage is usually aimed at older homeowners who have a lot of equity in their homes. It lets them keep their home while turning it into a source of income that they can use during their retirement.
Typically, the lender gives the homeowner a lump sum or monthly payment. The homeowner makes no payments against the loan. Instead, when the homeowner passes away, sells the home, or moves, the full balance of the loan comes due. Often, the home is sold to cover the loan’s balance.
You can use our page to compare the best reverse mortgages.
Author: TJ Porter