What is a home equity line of credit (or HELOC) and how does it work?
Our HELOC guide walks you through your questions on what a home equity line of credit is, how it works, plus the advantages and disadvantages of taking out a HELOC.
Summary: What is a HELOC?
A home equity line of credit, or HELOC, is a form of borrowing that is secured by the equity you have in your home
The amount of equity you have accrued (that is, how much of your home you own versus the bank) will determine how much you can borrow, usually up to 90% of your equity
Home equity lines offer lower interest rates and repayment flexibility when compared with traditional lending options
HELOCs are rotating lines of credit, from which you can withdraw funds and repay, in a manner similar to a credit card
Lending institutions vary in loan terms, interest rates (variable versus fixed), and fees, so it is important to research the exact terms of any HELOC you chose
If you can't make minimum monthly payments, you risk foreclosing on your home
What is home equity?
Home equity refers to the amount of ownership or value that a homeowner has in their property. It is calculated by subtracting the outstanding mortgage balance from the current market value of the property. Home equity can increase over time as the home value appreciates and/or as the mortgage balance is paid down.
When you buy a house, you get some initial equity from the amount used as a down payment. With a larger down payment, you begin with a larger equity share in the home. As you make mortgage payments, your equity grows even more, because part of each payment goes toward reducing the amount you still owe.
Home equity is a valuable asset that homeowners can use as collateral to borrow money, which can be used to use for various purposes.
How does a HELOC work?
A home equity line of credit, or HELOC, is a revolving line of credit. Instead of receiving a one-time payment upfront, as you do with a traditional loan, you are given a borrowing limit (or credit limit). You can then withdraw money from the credit line as you would with a credit card, using only the amount you need when you need it. Interest is only charged on the amount of money you withdraw, not the full limit amount.
Your credit limit is based on your home's value, allowing you to borrow a percentage of what you own (usually 80-90%). Typically HELOCs are divided into two distinct periods: The draw period (usually around 10 years) and the repayment period (usually 20 years). During the draw period, you can withdraw funds and you only have to pay interest on the balance (and not the principal). After that, you typically cannot continue to withdraw funds and have to pay back both principal and interest.
How to qualify for a HELOC?
To begin with, in order to qualify for a HELOC you need to have sufficient equity in your home. This means that the amount that you owe on your home must be less than its current value. If your home has lost value due to current market trends or if you owe more than the value due to second mortgages and missed payments, you will not be able to qualify for a home equity line.
A lender will typically allow you to borrow and use up to 85% of the current value of your house minus the amount you owe on it.
In addition to evaluating equity, a lender will also look at other factors when determining approval, such as credit score, credit history, employment history, monthly income, debt payments, and debt-to-income ratio. These same factors will be used to determine the amount of your credit line and your interest rate.
The process of qualifying is similar to what was done when getting approved for a mortgage in the first place. Individual lenders have specific requirements. Research various options before applying so that you can be sure you meet their particular criteria before making a decision on if you should apply.
How much can be borrowed with a HELOC?
The amount you can borrow with a HELOC will vary based on certain factors such as the appraised value of your home and what percentage of that value the lender will allow you to borrow.
To determine how much you can borrow with a HELOC, you need to first calculate the maximum amount of equity that could be borrowed based on your current home value, followed by deducting any current mortgage balances.
First, multiply the current appraised value of your home by the percentage of that value the lender permits you to borrow against. This is usually 80-90% of the home value. This gives you a maximum amount of money in equity that could be borrowed from your home's value.
Then, subtract this maximum amount from any remaining balance on your mortgage to get an approximate total amount you will be able to borrow with a HELOC. For example, if your property is worth $300,000 and you have $200,000 left on your mortgage loan, and your lender allows up to 85% borrowing capability against your property’s value; then multiplying $300,000 by 0.85 equals $255,000 in equity that could potentially be borrowed leaving $55,000 in additional borrowing power.
How do HELOC interest rates work? Variable- versus fixed-interest HELOCs
The annual percentage rate (APR) that borrowers are offered is indexed at the current base prime rate. The lender then looks at the applicant's credit score, existing debt, and the amount they wish to borrow to make a final APR offer. This rate is calculated by adding a margin to the prime rate, based on the borrower's credit profile.
There are lenders that offer both variable rate and fixed interest rate home equity lines of credit. Variable interest changes as the prime rate is adjusted, which can be risky for long-term debt. Fixed-rate lines of credit keep the same APR despite variations in the prime rate, and can make it easier for borrows to predict the repayment schedule.
When selecting between lenders for which HELOC you should choose, it is important to remember that the final amount you pay will depend not only on factors such as how much you wish to borrow and your pre-existing debt but also on other terms such as closing costs and fees associated with your loan opening process. Although there can be slight variations in rates depending on the lender, it can often make more sense to go with a lender whose overall package offers better terms than just chasing after the lowest possible monthly interest payment.
HELOC Pros and Cons
A home equity line of credit can be a valuable tool for building wealth or reaching personal goals.
Advantages of a HELOC
Borrowing Flexibility: HELOCs allow for flexible withdrawal and repayment, making them a good option if you don't know the specific amount you will need to borrow.
Repayment Flexibility: Unlike traditional home equity loans, HELOC payments change over time. If you are able, you can pay down the interest and principal during the initial withdraw period, or you can choose to pay only interest and to pay down the balance when in repayment.
Low interest rates: The primary advantage of a HELOC over other forms of financing is the low interest rate. Because it is a secured loan, backed by your home equity, you can access lower rates than with a personal loan or other forms of unsecured debt.
Tax deductions: If you plan to use your HELOC to fund home improvements, you may be eligible for a tax deduction on interest payments. The laws changed in 2017, so it's important to understand what is and isn't tax deductible when it comes to HELOCs .
Disadvantages of a HELOC
Risk of foreclosure: The most significant risk associated with a HELOC is that it increases your risk of foreclosure if you can't make the payments on the loan. If your income is unstable or you don’t have enough money coming in to cover the monthly payments, then taking out a HELOC could put you at real financial risk.
Loan fees: Upfront fees for a HELOC usually include closing costs, application fees, and appraisal fees. Make sure that you can afford all aspects of the credit line in addition to monthly payments before signing the paperwork.
Monthly repayment: Because with a HELOC you are not required to make payments on the principal that you have borrowed until the repayment period begins, it can be easy to get in over your head. It's important to consider if you will be able to make the minimum monthly payments once repayment begins and to look for variable interest rate HELOCs so that you can predict what your payments will look like.
Alternatives to a HELOC
A HELOC is one of several types of financing you can receive from your home equity.
In contrast to a HELOC, a home equity loan gives you a lump sum upfront with repayment terms that provide more stability over time. The trade-off is that if interest rates drop while you are paying back a home equity loan, you will not benefit from those lower rates until you have paid off the loan or refinanced it with lower rates.
Another option is cash-out refinancing, which is a process of refinancing your existing mortgage and borrowing more than you currently owe on your home. The difference between the new loan amount and the original mortgage balance is given to the borrower in cash, which can be used for various purposes. This type of refinancing is beneficial when the interest rates are lower than the current mortgage rate or when the home's value has increased significantly.
If you don't qualify for a HELOC, alternatives include credit cards and personal loans, or funding that is specific to what you plan to use the money for. For example, student loans, construction loans, and small business loans. In general, these options come with higher interest rates and/or more stringent repayment terms than secured home equity financing.
