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What Is a HELOC (Home Equity Line of Credit)?
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A HELOC, short for home equity line of credit, is a type of second mortgage that works like a credit card with a credit line that you can use as much (or as little) as you need. HELOCs are typically variable-rate loans.
A HELOC may be a useful tool if you need to tap your home’s equity for home improvements or other financial goals over a period of time.
What is a HELOC?
A HELOC is a line of credit borrowed against your home equity. You can use as much (or as little) of the credit line as you need and pay interest only on the amount you use. This timeframe is called a “draw period” and typically lasts 10 years.
During the draw period, most HELOC lenders allow you to make interest-only payments. That means you pay the monthly interest charge only, but the loan balance stays the same. Most HELOCs come with a variable rate that can change over time, however, some lenders offer a fixed-rate HELOC option.
Once the draw period ends, the home equity line of credit balance is repaid in fixed installments, known as the “repayment period.” The most common repayment period lasts 15 to 20 years.
HELOCs are secured by your home, which means you could lose your home if you can’t repay the HELOC balance. HELOCs are “second mortgages,” because they get paid after your first mortgage if your home is foreclosed on.
What is home equity?
Home equity is the difference between how much your home is worth and how much you currently owe. For example, if your home’s value is $250,000 with a loan balance of $200,000, you have $50,000 in home equity ($250,000 – $200,000 = $50,000).
How does a HELOC work?
A HELOC gives you the flexibility to use your equity as needed. Here are seven unique features of HELOCs compared to other home loan products:
1. A draw period. This is a set time (usually 10 years) when money can be drawn from your maximum available credit line and paid as needed.
2. A payment based only on what you draw. HELOC lenders calculate your payments based on the balance you actually use, rather than the amount available.
3. An interest-only payment option. Most lenders allow interest-only payments on the balance owed during a HELOC draw period.
4. A variable rate. Lenders usually set home equity line of credit rates based on an index and margin that changes with financial markets. Similar to adjustable-rate mortgages (ARMs), the rates typically start with a low introductory rate then adjust based on the HELOC terms for the life of the loan.
5. A fixed repayment period. After the draw period ends, you must pay the balance off on a fixed payment schedule.
6. Annual maintenance and membership fees. Many HELOC loan programs require annual maintenance and membership fees.
7. Early termination or prepayment fee. You may have to pay a prepayment penalty or close-out fee if you decide to close your HELOC ahead of schedule.
Pros and cons of a HELOC
You can use the line, pay it off and reuse as needed.
You can choose from an interest-only payment option to keep draw period payments lower initially.
You may be able to deduct HELOC interest if you use the funds for home improvements.
You’ll get lower interest rates with a HELOC versus a personal loan or credit card.
You might see higher monthly payments because HELOC rates are usually variable.
Your payments may become unaffordable once the fixed repayment schedule begins.
You might have to pay extra fees for maintenance, membership or prepayment with a HELOC versus other products.
You could lose your home to foreclosure if you fail to repay the HELOC.
Why should I get a HELOC?
A HELOC is a useful tool for covering unexpected debts or financial needs spread out over time. Consider a HELOC for:
- Smaller home improvement projects, like new appliances or HVAC upgrades
- Short-term debts such as unexpected medical bills
- Periods of unstable income if you see a drop in earnings from commissions or self-employment
- Buying inventory for a side hustle to process orders
What are the HELOC requirements?
To qualify for a HELOC, expect to meet these requirements:
- Credit score. You’ll need a minimum score of 620, but the most competitive rates typically go to borrowers with scores of 740 or higher.
- LTV ratio. Your loan-to-value (LTV) ratio measures the amount you’re borrowing compared to the home’s value. The LTV ratio for a HELOC is normally capped at 85%, according to the Federal Trade Commission (FTC). For example, if your home is worth $200,000, the balance of your current mortgage and the new HELOC amount cannot exceed $170,000.
- No mortgage insurance. You won’t pay mortgage insurance even if you borrow more than 80% of your home’s value with a HELOC.
- Debt-to-income ratio. Lenders evaluate your ability to repay a loan using your debt-to-income (DTI) ratio. It’s calculated by dividing your total debt (including your housing payments) 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%.
- Documentation. Most lenders verify your income, assets, employment and credit scores. Have your recent paystubs, W-2s, bank statements and other financial paperwork on hand to share with your HELOC lender.
- Ongoing home value checks by your lender. To get a HELOC approval, your lender will order an appraisal to get a professional home value estimate. Additionally, lenders may review your home’s value during the HELOC term, too. The Consumer Financial Protection Bureau (CFPB) cautions borrowers to watch out for freezes or reductions in available HELOC funds if home values drop significantly.
What’s the difference between a HELOC and a home equity loan?
Homeowners often weigh the differences between a home equity loan and a HELOC. A home equity loan is more like a traditional mortgage. Why? Because you receive your funds upfront in a lump sum and make payments on a fixed schedule from the start.
The table below shows the differences between a HELOC and a home equity loan.
|Loan feature||HELOC||Home equity loan|
|Access to funds||Use and pay off as needed||Receive in one lump sum|
|Monthly payment||Interest-only option to start; based only on the amount drawn||Principal and interest based on the total amount borrowed|
|Interest rate||Typically variable, but fixed options may be available||Fixed|
|Ongoing costs||Maintenance and membership||None|
|Tax deduction||Only if funds are used for home improvement/construction||Only if funds are used for home improvement/construction|
|Prepayment penalty||May apply||None|
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).
- Personal loan. A personal loan is not secured by your home and is available through private lenders. Personal loan repayment terms are usually shorter, and the interest rates are higher than HELOCs.
FAQs about HELOCs
What can I use a HELOC for?
HELOCs can be used for a variety of expenses, but they often work best for big-ticket items. This can include debt consolidation, home improvements, education expenses and medical bills.
Do you pay fees on a HELOC?
How much are HELOC closing costs?
HELOC closing costs range between 2% and 5% of your loan amount. Some lenders offer HELOCs with lower costs than what you’d pay for a home equity loan, and others offer HELOCs with no closing costs.
If I take out a HELOC, do I have to use it?
While you have a lot of flexibility with how you spend a HELOC, many lenders do require a minimum draw — and some may even require you to take out money when you first establish the HELOC. Your minimum withdrawal will vary by lender, and can be different depending on the size of your HELOC.
Can you refinance a HELOC?
Yes. The process to refinance your HELOC is similar to other types of mortgage refinance loans. You must meet the minimum requirements to be approved, and a new appraisal will be ordered to get your home’s current value.
What is a HELOC statement?
Banks must disclose the initial and ongoing charges on your monthly HELOC statement. The statement should detail startup fees, such as mortgage points and include them in the finance charges for your first statement. They must include charges during the life of the loan like transaction or maintenance fees in the HELOC APR calculations.
Why choose a HELOC over a personal loan?
Both HELOCs and personal loans have their advantages and disadvantages. The loan you choose will largely come down to how much you need to borrow and what you need the money for.
HELOCs tend to have lower interest rates than personal loans. That’s because personal loans are typically unsecured, meaning you don’t have to put up your home as collateral — and with a home equity line of credit, you do. If you have any concern that you won’t be able to make your payments, you may choose a personal loan to avoid the risk of foreclosure. But if you’re borrowing for a big project, the money you save through a HELOCs lower interest rate could make it worth your while.
In addition, interest you pay on a HELOC can be tax-deductible if you use the loan for a home improvement project — that’s not the case with personal loans.
How do I find the best HELOC lenders?
Not all lenders offer HELOC products, so you’ll need to shop around to find the right HELOC lender for you. Gather at least three to five quotes; your local bank and credit union may offer special rates if you tie a HELOC to a current checking or savings account.
Can I get a HELOC on an investment property?
Yes, but you’ll pay a higher interest rate and need to meet more stringent mortgage 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.