As U.S. homeowners have built up a record amount of equity—about $15.5 trillion, according to Statista. One option is a home equity line of credit (HELOC). Here we’ll walk through how HELOCs work, including how you access and repay the funds, and also look at an alternative solution.
What is a home equity line of credit?
A HELOC is a form of revolving credit secured by your home, i.e., your home serves as collateral. While this means interest rates will be lower than those of an unsecured loan, like a credit card or personal loan, it also means that falling behind on your loan payments could mean the loss of your home.
How can you use HELOC funds?
Generally, you can use the funds from a HELOC however you wish. Many homeowners take out a HELOC to cover big-ticket expenses, such as major renovation projects, college tuition costs, or medical bills. You can also use the funds to pay off other debts or simply have the line of credit open to help cover unforeseen emergencies.
Getting started – applying, establishing your credit limit, and understanding the costs
HELOCs are available from traditional brick-and-mortar banks, credit unions as well as other financial institutions. It often takes several weeks to complete the entire process and gain access to the funds. Lenders will look at your credit score, the equity you have in your home and your debt-to-income ratio to determine if you qualify for HELOC.
To establish how much you would be able to borrow, lenders look at your combined loan-to-value ratio (CLTV). Your CLTV equals your current mortgage balance plus your potential credit limit, divided by the value of your home. For example:
Value of home = $400,000
Potential credit limit = $100,000
CLTV = ($200,000 + $100,000) / $400,000 = 75%
Lenders typically target a CLTV between 75-90%. In the example above, if the lender allowed a CLTV of 80%, your potential credit limit would increase to $120,000.
Your credit limit may also be adjusted depending on your credit score, payment history and your other debts relative to your income.
There are generally costs associated with setting up a HELOC, which typically total 2-5% of the loan. These commonly include an application fee, appraisal fee, and closing costs to cover attorney fees, title search, title insurance, and taxes. Altogether, you could end up paying several hundred dollars to establish the line of credit. Once the HELOC is established, there may also be an annual or maintenance fee or a transaction fee each time you draw on the line. Some lenders also charge a penalty if you close the line of credit early.
Using a HELOC – accessing funds and making payments
The life of a traditional HELOC is typically divided into two phases: the draw period and the repayment period.
Draw period
During the draw period, which is usually the first 5 to ten years of the loan, you can access funds using the special checks or designated debit or credit card provided by your lender. Lenders often have terms and restrictions surrounding withdrawals, such as a cap on your initial withdrawal and minimum required amounts for subsequent withdrawals.
During the draw period, some HELOCs are structured so that your monthly payment only includes interest on the amount you’ve borrowed. Others are structured so that you repay principal as well as interest each month.
If your HELOC has interest-only payments, you can still choose to repay some or all of your balance. For example, say your credit limit is $100,000 and your current balance is $25,000. You have access to $75,000 in available funds. If you repay $5,000, your balance declines to $20,000 and your available funds increases to $80,000.
While some lenders offer fixed-rate HELOCs, most are structured with variable interest rates, which means the interest rate can periodically change in relation to an index. Your payments would increase or decrease accordingly. Variable interest rates are typically based on a benchmark rate—such as the prime rate—plus a margin.
For example, say your interest rate equals the prime rate plus four percentage points. Currently, that totals 9%. If you have a balance of $25,000, your monthly interest payment would be $188. If your rate rises over time to 12%, your monthly interest payment would increase to $250.
The prime rate is closely linked to changes in the target rate managed by the Federal Reserve, which is widely expected to continue rising. As such, variable-rate HELOCs are likely to become more expensive for homeowners.
Generally lenders are required by law to have a cap (ceiling) on how much your rate can increase over the life of the loan. Many lenders also incorporate terms covering how much your rate can increase each year and what the lowest possible rate is.
Repayment period
The repayment period follows the draw period. You can no longer make withdrawals during the repayment period. During this phase, which typically lasts 10 to 20 years, you start paying back principal and interest. If you were only paying interest during the draw period, your monthly payment will likely increase significantly as you begin to repay the amount you borrowed.
A new way to borrow against the equity in your home
If you’re considering tapping the equity in your home, it’s wise to examine all your available options. While a HELOC may have features that are beneficial for certain homeowners, it might not be the best fit for your individual situation. It’s important to consider what you’re looking to use the funds for and the longer-term impact on your finances and bottom line.
At Figure, we took traditional HELOCs and made them better. Our unique home equity solution has a fixed interest rate1navigates to numbered disclaimer and gives you full access to your funds up front, while still enabling you to make additional draws once you’ve repaid your balance. Plus, you can get approved in five minutes and funding in five days2navigates to numbered disclaimer.
