What is a Home Equity Line of Credit?
Owning a home comes with a long list of benefits. From having private space you can freely decorate, to the feeling of possessing your very own piece of property, homeownership provides satisfaction to millions of Americans. One additional benefit people may not think about is potential access to funds via a home equity line of credit.
A home equity line of credit uses the equity you have in your home — the market value of your property, minus the amount you owe — to extend you cash for an emergency, home improvement project, or another need you may have.
You build equity in your home by making your monthly mortgage payments or making improvements that increase the value of your property.
There are pros and cons to tapping your home’s equity, but if you think you want to take advantage of this benefit, it’s helpful to have a good understanding of what a HELOC is, how it works, and whether it’s the right choice for your needs.
What is a HELOC?
When you take out a HELOC, you borrow against your home’s equity. For example: If you have a home loan on a property valued at $350,000 and you owe $150,000 on that loan, your equity would be $200,000. This doesn’t mean you can borrow all $200,000 — in fact, most lenders will only let you borrow up to 85% of the current value of your home.
Using the same example as before, that means:
$350,000 x 85% = $297,500 (loan-to-value ratio)
$297,500 – $150,000 = $147,500 (maximum loan-to-value ratio, minus what you still owe)
Like a credit card, you withdraw money from a HELOC as you need it. A home equity loan, on the other hand, also taps your home’s equity, but you would receive funds as a lump sum. Read more about the differences between a home equity loan and HELOC here. In either case, your home acts as collateral for the loan, which means if you cannot pay the loan back, you could lose your property.
How does a HELOC work?
A HELOC has two different periods:
- Draw period. You can borrow funds as needed until you reach the maximum loan amount determined by your lender. You are typically required to make interest-only monthly payments. Because you may decide not to borrow the full amount offered, your payments are based on the amount of money you borrow and the interest rate. The draw period is typically 10 years, though it could be shorter.
- Repayment period. Once the draw period expires, your loan enters the repayment period. Once you hit this phase, you won’t be able to borrow any more money against your equity. You will now be required to repay interest and principal. Keep in mind that many HELOCs have a variable interest rate, which we’ll describe in more detail below.
Once your lender approves you for a HELOC, there are several ways to access the money including online transfers, checks, or a credit card tied to the balance of the loan.
Qualifying for a home equity line of credit
Not all homeowners qualify for a line of credit on their home. There are certain requirements lenders want to see borrowers meet before they agree to loan the equity on a property.
The biggest factor is how much equity you have in your home, and how much you want to use. Your lender will also look at a few other factors including your income, credit report, debt to income ratio, and assets. Most lenders have a minimum amount they are willing to lend on a home equity line of credit, usually around $10,000.
“It’s usually recommended that borrowers look for at least that much to make up for the time and hassle of applying,” said Dennis Nolte, vice president and financial adviser at Seacoast Investment Services in the Orlando, Fla., metro area.
The application process is similar to that of any other loan or credit card. Your lender wants to know that you’ll be able to make your mortgage payment and your loan payment. If you think a HELOC would work for your situation, take the time to check your credit report and your credit score before applying.
Nolte noted that the application process is similar to a credit card application and that it’s less intensive than applying for a new mortgage; however, like a mortgage, borrowers may have to pay closing costs or other fees for a HELOC.
During the application process, your lender will gather any needed personal information. They’ll also confirm the value of your home. Some lenders will ask for an inspection; others may simply perform a “drive-by” appraisal of the property. Once the value has been confirmed, the loan can be completed. The entire process can take around 30 days.
How much you can borrow?
As we mentioned earlier, your borrowing power when it comes to a HELOC depends on your loan-to-value ratio (LTV). Your lender will look at the appraised value of your home, plus how much equity you have in the property. Typically, lenders will only offer between 80 and 90 percent of your total equity. So, even if you have $100,000 in equity, you won’t likely be offered the full equity value.
“Some lenders are willing to lend 100 percent LTV, but others will only do 80 percent, and some may loan up to 90 percent LTV, with a higher interest rate,” Nolte said.
To calculate your home’s equity, use LendingTree’s handy calculator.
Again, the advantage to a HELOC is that even if you are approved for a large amount of your home’s equity, you do not have to spend all of it. You can borrow as much or as little of your qualifying total as you want at a time. Your monthly payments will reflect the amount you choose to borrow. However, watch out for minimum draw requirements and other fees which we’ll describe below.
The cost of your home equity line of credit isn’t just the interest you’ll pay on the funds you use. Depending on your lender, you may face additional expenses like an annual fee, maintenance fee, transaction fees, and closing costs.
Closing costs may include property valuations, title insurance (if needed) and application fees; these can total anywhere between $100 and $2,000. However, many lenders cover these costs if you keep your line of credit open for a certain amount of time — talk to your lender to find out what their terms are for closing costs.
HELOCs typically have a variable interest rate. This means that after your introductory rate (usually 12 months), your interest rate could increase, sometimes substantially. If your rate does increase, your payments would also increase, and your loan could be more expensive over the long-term (based on how much you choose to borrow).
Questions to ask your lender. When choosing a HELOC, there are a few questions you should ask your lender. The answers will help you get a clearer picture of how much this type of financing will cost.
- What introductory rate do you offer? How long does it last?
- What is the maximum interest rate? (The absolute most you could pay.)
- Is there a minimum amount I have to borrow?
- Is there a minimum withdrawal I have to make each time?
- Do you charge inactivity fees?
- Do you charge withdrawal/transaction fees?
- Is there a prepayment penalty?
- Do you offer interest-only payments?
Your lender should be able to answer these questions clearly so you can decide if a HELOC (or that lender) is a right fit for your needs.
One thing to remember: Though many HELOCs come with a variable interest rate, meaning your interest rate could change over time, it may be possible to refinance into a fixed-rate loan.
HELOC vs. a home equity loan
A home equity line of credit is similar, but not the same, as a home equity loan. A HELOC allows you to access a line of credit for a fixed period of time. You use the funds like you would a credit card, only paying on the amount you use. A home equity line of credit typically has an adjustable interest rate and provides some flexibility on repayment terms (like interest-only repayment during the borrowing cycle).
A home equity loan is a lump sum payment. You borrow a certain amount of money and you have to pay off the total with monthly installments. A home equity loan is more like a traditional loan in the borrowing and repayment structure. Further, home equity loans are usually fixed-rate, which means your interest rate and your payments aren’t going to change during the life of the loan. You won’t have the flexibility of borrowing from a line of credit multiple times. And your repayment period starts immediately.
For both HELOCs and home equity loans, your home is used as collateral to obtain funding. Both HELOCs and home equity loans look at the amount of equity you have in the property to determine what you can borrow. Additionally, the interest rate for both is tax deductible, if you use the money to make substantial improvements on your home.
|HELOC pros and cons|
When a HELOC makes sense
Deciding whether a HELOC is the best option for your situation is a personal choice. But, borrowers should consider various factors including the interest rate, the amount they can or want to borrow, and fees. Because you put your home up as collateral when you choose a home equity line of credit, you should feel comfortable maintaining your regular mortgage payments as well as the new payments you’ll have with your line of credit.
A HELOC may make sense if you want access to a regular line of credit and want the flexibility of borrowing only what you need and if you’re comfortable with an adjustable interest rate. If you have a fair amount of equity, and need the cash to make home improvements or cover an emergency, this option can be a good option for taking advantage of lower interest rates.
Nolte recommended that borrowers consider opening a line before they actually need the money.
“I tell most people to have a line of credit on their house. It’s a good source of cheap, quick, funds. It should be a line people have access to,” Nolte said.
He also noted that some people opt to open this line of credit to free up cash that would otherwise be sitting in an emergency fund earning little or no interest.
When to avoid a HELOC
A HELOC may not be the best option for all customers. If you are struggling to make your mortgage payment, or you are concerned that an adjustable interest rate could make the payments on your HELCO unaffordable, you may want to reconsider.
According to Nolte, a HELOC is not for everyone.
“If [the borrower] has a ton of debt everywhere else and they are continuing to increase the debt, and this is their last resort, I don’t recommend it. I’d sure hate to have them leverage their home if they haven’t learned or if they have no strategy to get out of debt,” he said.
Further, if the idea of putting your home up as collateral makes you uncomfortable, or you think you may move within a few years, you may want to hold off. Some lenders will only agree to cover closing costs and offer lower introductory interest rate limits if you keep the account open for at least three years — you could spend more paying the difference. According to Nolte, you can sell a home with a HELOC (with no money owed), but it may require an extra step or two in the sales process. If you owe money on your HELOC, you’ll have to pay repay the balance before you can sell the property.
Opening a home equity line of credit has many benefits, but it’s not without risk. Talk with your lender and/or financial adviser to decide if this is the right next step for your finances.