What Is a Home Equity Line of Credit (HELOC)?
A HELOC is functionally very much like a credit card – tap your home’s equity and get money when you need it. Your payment is only based on how much you use, and you can pay the balance off and reuse it as needed for a set time. Understanding how a HELOC works will help you decide if it’s the best option for your financial plans.
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→ You’ll have a variable rate and may be able to make low, interest-only payments for a period of time
→ You can use the cash to pay off other debt, reduce your monthly expenses or meet another financial goal
What is a HELOC?
A HELOC is a type of second mortgage, meaning you could get one even if you still have your first, or primary mortgage on the house.
Because a HELOC is a line of credit, it functions differently from a “regular” installment loan. While a home equity loan provides one lump sum of cash that you repay over time with equal payments and a fixed interest rate, a HELOC has two phases.
HELOC phases
Just like with a credit card, with a HELOC you’re given a set period of time in which to spend money from your line of credit and a date at which the balance comes due. A HELOC has a different timeline with different phases than a credit card, however.
Phase one: Draw period
Once you’re approved for a HELOC, the draw period starts. In this first phase you can borrow as much cash as you want each month (up to the cap). To make withdrawals, you’ll have checks or a card that’s like a credit card you can swipe. Many HELOC lenders require a minimum withdrawal — the amount will depend on the lender and how large your credit limit is. Many HELOC loan programs also have fees, including one-time fees for closing costs and ongoing fees like annual maintenance and membership charges.
The minimum payment required can change depending on how much you’ve borrowed and the current interest rate. You can potentially make interest-only payments for this phase, which is typically 10 years.
Phase two: Repayment period
After the draw period, you can no longer borrow from the credit line and you’re required to repay your remaining credit line balance. HELOCs can require repayment all at once or over time. Drawn-out repayment periods typically last 20 years.
Follow these steps to get an idea of how much you might be able to borrower with a home equity line of credit:
- Estimate your home’s value. Try an online value estimator or ask your real estate agent.
- Multiply your home’s value by 85%. You’ll need to convert the percentage to a decimal; in this case you’ll multiply your value by 0.85.*
- Subtract your mortgage balance from step 2. The result is how much HELOC money you might be able to borrow.
*85% is the standard maximum LTV for a HELOC. However, some lender may set higher or lower LTV ratio limits, so ask your lender when you start shopping for a HELOC.
Example: Math to estimate a HELOC
See how the numbers work if your home is worth $400,000, your current loan balance is $250,000, and your lender sets their HELOC LTV limit at 85%.
| Enter your home’s value: | $400,000 |
| Multiply the value by .85: | X 0.85 |
| $340,000 | |
| Subtract your loan balance: | ($250,000) |
| Estimated HELOC money you may qualify for | ⇒$90,000 |
Pros and cons of a HELOC
HELOCs can be convenient, however, the drawbacks to a HELOC can be pretty steep. It can be easy to spend too much, making the low, interest-only monthly payment and getting a nasty shock when you need to start making full payments. Because HELOCs use your home as collateral, in the worst-case scenario, the bank could foreclose on your home.
| Pros | Cons |
|---|---|
| You can withdraw cash as needed like a credit card | You might have to pay monthly maintenance and membership fees, and possibly a prepayment penalty |
| You'll typically pay a lower rate than personal loan or credit card APRs | Your HELOC interest rate is usually variable |
| You can typically make low, interest-only payments for a set time period | Your payments may become unaffordable once you have to pay the balance off in principal and interest payments |
| You may be able to write off your interest if your HELOC funds are used for home improvements | You could lose your home to foreclosure if you can't make the payments and default on your HELOC |
| You can avoid PMI even if you finance more than 80% of the value of your home with a HELOC |
A HELOC can be a good idea if you have ongoing expenses you need to cover and a set plan to pay off the loan. A HELOC can be a great funding source for home improvement projects, debt consolidation, education expenses and medical bills.
A HELOC likely isn’t a good idea if you don’t have a solid financial plan to repay it — the lender could foreclose on your home.
HELOC eligibility requirements
To qualify for a HELOC, you’ll need to provide financial documentation, such as W-2s and bank statements — these allow the lender to verify your income, assets, employment and credit scores. Expect to meet these requirements:
Minimum credit score of 620
You’ll need a minimum 620 score, but the most competitive rates typically go to borrowers with scores of 740 or higher. You can get your free credit score here.
Will a HELOC hurt my credit score?
When you apply for almost any loan, the hard credit inquiry will ding your credit score by a few points — but only temporarily. As you make payments on time and in full, your credit score will benefit. If you default on the loan, however, or the lender forecloses on your home, your score will significantly decrease.
Debt-to-Income (DTI) ratio under 43%
This is your total debt (including your housing payments) divided by your gross monthly income. Typically, your total DTI ratio shouldn’t exceed 43% for a HELOC, but some lenders may stretch the limit to 50%. Here’s how to calculate your DTI.
Loan-to-Value (LTV) Ratio under 85%
Your potential lender will order a home appraisal and compare your home’s value to how much you want to borrow. The LTV ratio is normally capped at 85%, according to the Federal Trade Commission (FTC). For example, if your home is worth $300,000, then the combined total of your current mortgage and the new HELOC amount can’t exceed $255,000.
How to get a HELOC
Getting a HELOC is similar to getting a home equity loan. You’ll need to provide clear information about yourself (and potentially your co-borrower) and your home.
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- Make sure a HELOC is the right move for you. HELOCs are best when you need large amounts of cash on an ongoing basis, such as covering home improvement projects or medical bills. If you’re unsure what option is best for you, compare different types of loans, such as cash-out refinancing vs. HELOC vs. home equity loans. Whatever you choose, be sure you have a sure-fire way to repay the HELOC.
- Shop around. Look at what different lenders are offering regarding rates, fees, maximum loan amounts and repayment periods. It doesn’t hurt your credit to apply with multiple lenders for a HELOC anymore than it does to apply to just one, as long as you do the applications within a 45-day window granted by the credit bureaus.
- Gather documents. You’ll need to provide the following information to lenders.
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- Property: The address, purchase price, purchase date, proof of insurance and current estimated value.
- Applicants: The names, dates of birth, Social Security numbers, employment status, marital status, tax returns, pension or retirement benefits and income of each applicant.
- Loan: How long you’d like to draw on your home equity and how much you’d like to be able to borrow.
- Other debts: Outstanding mortgages, car loans, credit cards, home equity loans, student loans.
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- Apply to HELOC lenders. Apply to a few lenders and see how they respond. At LendingTree, you could get up to five HELOC offers from lenders at once, depending on your creditworthiness.
How long does it take to apply for a HELOC and get a response?It can take two to six weeks from your first application submission to when you receive your HELOC card or checks in the mail
- Compare offers. Take a critical look at the offers on your plate. Consider total costs, the length of the phases and any minimums and maximums
- Close on your HELOC. If everything looks good and it’s the right move, sign on the dotted line! You may have to bring a check to cover closing costs, which can range from 2% to 5% of the HELOC’s credit line amount
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You can cancel a HELOC for any reason within three business days after your closing. You’ll have to do it in writing and the lender must refund any fees you’ve already paid. This three-day time period includes Saturdays, but not Sundays. If you can prove that the lender didn’t provide all of the required material about the HELOC, you could get up to three years to cancel the line of credit.
If neither of these solutions apply, your best bet may be to refinance your HELOC by getting another loan. Look at your contract to see if there are any penalties for early payoff and closing. You may be able to pay it off with your savings, another loan or even another, better HELOC.
Alternatives to HELOCs
Not sure if a HELOC is the best option for you? Here are other loans worth considering:
Home equity loan
As mentioned earlier, a home equity loan is another second mortgage option that allows you to tap your home equity. Instead of a line of credit, though, you’ll receive an upfront lump sum and make fixed payments in equal installments for the life of the loan.
Cash-out refinance
A cash-out refinance replaces your current mortgage with a larger loan, allowing you to “cash out” the difference between the two amounts. The maximum LTV ratio for most cash-out refinance programs is 80%. The exception is the VA cash-out refinance program, which allows military borrowers to tap up to 90% of their home’s value with a loan backed by the U.S. Department of Veterans Affairs (VA). However, it’s important to keep in mind that a higher loan balance will push your DTI up, which can lead to a higher interest rate or additional fees at closing.
Personal loan
A personal loan isn’t secured by any collateral and is available through private lenders. Personal loan repayment terms are usually shorter, though the interest rates are higher than HELOCs.
Is a home equity loan better than a HELOC?
Whether a home equity loan or a HELOC is better for you will depend on your needs. A home equity loan is good when you need a large sum of cash upfront and you like fixed monthly payments. Meanwhile, a HELOC can be better if you have ongoing expenses — here’s a home equity loan calculator if you’d like to run some numbers.
Frequently asked questions
You can only deduct HELOC interest when you’re using the funds to buy, build or substantially improve the home that secures the loan. But the amount you can deduct is capped, based on how you file taxes.
Yes, you can get a HELOC on an investment property, but you’ll pay a higher interest rate and need to meet more stringent requirements. Standard investment property HELOC guidelines include a 720 to 740 minimum credit score and proof of at least 18 months’ worth of cash reserves.
If you’re having trouble making mortgage or HELOC payments, contact your lender. Many companies have programs to help borrowers avoid foreclosure. Be prepared to explain why you’re having financial trouble, how extensive your hardship is and how long you expect the trouble to last. The lender may have you do a mortgage assistance application before providing options to you.
You can also contact a housing counselor who’s approved by the U.S. Department of Housing and Urban Development (HUD). They can point you toward other assistance programs, help you choose the best option for your situation and guide you through paperwork.