A home equity line of credit, or HELOC, is a loan against your home. It allows you to borrow as needed, paying interest only on the amount of credit that you use. HELOCs normally have variable interest rates. They work like credit cards in that you can make a minimum payment each month or pay a higher amount, and you can borrow more whenever you want, up to your credit limit.
How Do HELOCs Work?
With a HELOC, your lender approves you for a specific amount of credit. You can borrow any time you want during the loan’s term up to your credit limit.
Every HELOC has a “draw” (“borrowing”) period during which you may tap the line of credit. The draw period depends on the total loan term. Commonly, the loan term is 20 years and the draw period is 10 years. Once the draw period expires, you can no longer borrow and must enter the repayment phase. Your payment in the repayment phase depends on your balance, the number of years remaining on your loan, and your interest rate.
With a HELOC, you don’t begin making payments until after you begin borrowing against your line of credit. During your draw period, you are only required to make a minimum payment that covers the accrued interest. You can pay more, however, up to the entire account balance if you wish.
Once your draw period expires, your repayment phase begins. If you have ten years left on your loan, your payment is reset to an amount that will clear your balance in ten years.
Note that a HELOC’s interest rate isn’t usually fixed. Instead, your rate depends on the current prime rates plus a margin set by the lender. The prime rate can go up or down over time, and your payment changes accordingly.
Some HELOCs are convertible, which means you get the chance at one or more points during the loan’s term to convert your balance to a fixed-rate loan with an unchanging payment.
What Are Good Uses for a HELOC?
It’s best to use a HELOC for the right reasons. HELOCs are ideal when you need more flexibility than you’d get with a fixed home equity loan. For instance, when you have an ongoing need for smaller amounts over time rather than one lump sum.
College tuition, which you pay several times a year, or home improvements that you complete in stages over time are expenses ideally suited for HELOCs. You can also use them as emergency funds or to help with cash flow for a small business.
“A HELOC is a great way to set up a renovation fund for your home or to create a supply of cash to help with your child’s college tuition,” suggests Martin Orefice, CEO of Rent To Own Labs. “Because it offers flexible amounts of cash over a long period at low interest rates, it’s well-suited to periods in a homeowner’s life when they might have several moderate expenses over several years. However, a HELOC may not be a good choice for a single fixed expense, since you can usually get better terms with a more traditional home equity loan.”
HELOCs typically charge lower interest rates and fees than home. You can pay your balance in full or make minimum payments on the interest during the draw period.
Consider that the flexibility of a HELOC comes in handy when you don’t know the exact cost of the thing you want to fund, such as a kitchen remodel, versus a home equity loan, which requires you to commit to a set amount of borrowed money upfront. Because it can be used when you need it, like a credit card, you can borrow various amounts over different periods, too.
Carter Seuthe with Credit Summit particularly recommends using a HELOC to finance home improvements, as these projects can increase your property’s value.
“A good candidate for a HELOC is a person who owes less on their home than the actual value of their home,” adds Seuthe.
How Much Can You Borrow With a HELOC?
You may be allowed to borrow up to 85 percent of your home’s appraised value minus the amount owed on your existing mortgage, based on your creditworthiness as a borrower and the amount of your total outstanding debt.
“A HELOC is secured by the equity you’ve built up in your home, meaning that the limit on a HELOC is defined by the difference between your home’s value and the remaining balance on the mortgage,” Orefice explains.
If your appraised home value is $200,000 and the lender assigns an 80 percent credit limit, you can borrow against $160,000 of home equity ($200,000 * 80%). If you currently owe $100,000 on your mortgage, your possible line of credit limit would be $60,000 ($160,000 minus $100,000).
Inquire with your lender if there is a minimum withdrawal requirement at the time you open your HELOC account and after you open it.
As with any loan or line of credit, it’s important to avoid borrowing more than you can afford to repay.
What Are HELOC Eligibility Requirements?
To qualify for a HELOC, you have to meet a lender’s guidelines. They vary, but some requirements are common.
“You need a (FICO) credit score of over 620, a low debt-to-income ratio, and a stable monthly income,” notes Seuthe.
Note that a 620 credit score may not be enough; aim for a FICO score of 700 or more, if possible. The higher your credit score, the lower your interest rate is likely to be.
Your debt-to-income ratio (DTI) equals your total monthly debt payments plus your housing expense (mortgage plus property taxes and homeowners insurance) divided by your gross monthly income. Suppose that your before-tax income is $6,000 per month, and your payments look like this:
Mortgage principal, interest, taxes, and insurance: $1,500
Auto loan and credit card minimum payments: $300
HELOC payment if you use the full credit line: $200
Total payments is $2,000
Your DIT calculation is $2,000/$6,000, or 33.33%. Every HELOC lender sets its own DTI maximum, but 36% is typical.
What Are HELOC Interest Rates?
Don’t forget: the interest rates for HELOCs are variable, not fixed, and are based on an index like the prime rate plus a margin. At the time of this writing, the prime rate was 3.25 percent.
“HELOC interest rates are generally 3.5 percent to 8.63 percent, on average,” Seuthe says.
Keep in mind that the interest rate you will pay will depend on many factors, including your credit score, income, and loan-to-value (LTV) ratio (which is determined by dividing your mortgage loan amount borrowed by the appraised value of your home).
What Are HELOC Fees?
Be aware that lenders may charge fees for a HELOC. These can include:
Application fee, which may not be refundable if you are denied credit
Loan origination fee
Upfront fee, such as one or more points (each point is equivalent to 1 percent of your credit limit)
Property appraisal fee to determine your home’s value
Annual fee to maintain your account
Cash advance fee or other fee to use your account
Penalty fees, including over-the-credit limit or late payment fees
Fees to maintain your account, such as an annual fee
Closing costs, such as charges for the title search, attorney, mortgage title and property insurance, mortgage preparation and filing, and taxes
HELOC fees are usually lower than those for home equity loans and can be much lower than those for traditional mortgages. And some lenders don’t charge fees at all but may impose a higher interest rate or prepayment penalty. Ask your lender about these options.
HELOC Alternatives
Of course, a HELOC is not your only choice when it comes to financing your life’s goals. It may be smarter to consider an alternative.
A home equity loan, for example, offers the stability and peace of mind of a fixed interest rate and fixed monthly payments you can count on. This can be a better option if you know exactly how much you need to borrow and are prepared to begin repayment soon after taking out the loan.
Another alternative is a personal loan, especially when you have not accrued enough equity in your home to take out a HELOC.
“With personal loans, you can use the money for any purpose, with the amount borrowed dependent on your income and credit history,” says Ann Martin, director of operations for CreditDonkey. “Interest rates are typically two to three times higher than those for HELOCs, but you won’t be charged any closing costs or fees and the repayment options vary from three to seven years.”
Or, ponder a cash-out refinance. “Here, you refinance your primary mortgage for more than you currently owe and receive the difference in a lump sum. This is a perfect option if you are eligible for rates that are lower than you are currently paying on your mortgage,” adds Martin.
However, cash-out refinancing usually makes sense only when you need a very large amount of cash because the cash-out fees apply to the entire mortgage balance and can come to thousands of dollars.
Charging via one or more credit cards can be a good strategy if you plan to spend smaller amounts and can pay off most or all of your balance in full each month. However, credit cards carry much higher interest rates than HELOCs. They are great for paying for things but less great when you can’t pay them in full.
Borrowing With a HELOC
A HELOC can help you accomplish a financial goal with a lot more flexibility and simplicity than other lending options. But before committing to a HELOC, take the time to carefully review the requirements, terms, and fees imposed by the lender. Determine if there are better alternatives that can cost you less money in the long run. And remember that this financial transaction has consequences if you cannot repay what you borrow.
