Home equity line of credit (HELOC): Requirements, terms, and repayment
Please note: Discover® Home Loans offers a home equity loan product, but does not offer HELOCs.
A famous rock band once sang, "Time Waits for No One." And, it's true. The clock is ticking, and you need to landscape the yard, replace that leaky roof, or pay for your child's college education. To get the ball rolling, one option is using a home equity line of credit, or HELOC, which is an ongoing line of credit that lets you borrow money against the value of your home to achieve other financial goals, such as:
- Making home improvements
- Consolidating debt with a lower rate and one monthly payment
- Paying for education expenses, major medical bills, or other significant life events
- Refinancing your mortgage or an existing home equity loan or credit line
If you're wondering about how to get a HELOC, there are certain factors that can influence whether you will be successful at securing one. While Discover does not offer HELOCs, the requirements for a home equity loan are similar.
Home equity loan vs. HELOC
Home equity financing typically comes in two forms:
- HELOC. A HELOC (pronounced "hee-lock") is a revolving line of credit that lets you withdraw funds, up to your approved credit line limit, during an initial term, called a HELOC draw period. While some HELOCs allow you to pay interest only during the draw period, when the draw period ends, the repayment period begins, where you cannot take out any additional funds and you will pay back the principal of the loan, along with interest charges. HELOCs typically feature variable interest rates (although some HELOCs use fixed rates). These are determined by adding a margin determined at origination to an index like the national prime rate (which can fluctuate up or down over the life of your loan). The margin is determined at origination and could depend on a variety of factors including the amount borrowed, the length of the repayment period, and the borrower’s credit score, income, and combined loan-to-value (CLTV) ratio. A HELOC may be a good choice when you intend to borrow various sums from time to time rather than all at once.
- Home equity loan. A home equity loan gives you a lump sum, typically with a fixed repayment term of 10, 15, 20 or 30 years and fixed rate and payment. A home equity loan may be a good fit when you know how much you want to borrow and for how long, and when you prefer the stability of a fixed-rate loan over the potential changes of a variable-rate HELOC.
How a HELOC works
A HELOC can be a more complex financial product. When you apply for one, there are some terms you should understand.
Some HELOCs may have a variable rate, which can fluctuate as market interest rates change. When your HELOC's rate changes, your payment will also change.
Variable-rate HELOCs usually have two rate caps. The periodic cap limits how much your rate can increase each time it's adjusted.
The lifetime cap sets the maximum rate you'll be charged, even if market rates are higher.
You'll only be charged interest for the loan amount of your HELOC that you draw.
HELOC draw period
Your draw period is a set time frame, usually 5, 7 or 10 years, during which you can borrow funds from your HELOC. You'll typically have to make a HELOC minimum payment during your draw period if you draw any funds. You may be allowed to make interest-only payments during this period. If you repay funds during your draw period, you typically will be able to draw those funds again.
Home equity line of credit repayment period
Your home equity line of credit repayment period is a set time frame during which you'll have to repay the funds that you borrowed. Your repayment term's length depends on how your HELOC is structured. During this period, your monthly payment will include principal and interest.
Your repayment period starts when your draw period ends, unless your lender approves an extension or you refinance your existing HELOC into a replacement HELOC with a new draw period.
Paying back a HELOC may involve a balloon payment at the end of the draw or repayment period. The amount will be depend in part on how much you borrowed and repaid during your draw period.
You should plan ahead for your balloon payment, which may be significantly larger than your HELOC minimum payment during your draw and repayment periods.
During your repayment period you may have an option to convert your HELOC into a home equity loan with a fixed rate and fixed monthly payment that includes principal and interest. This option may make sense for you if you want a fixed payment while you're paying back a HELOC.
HELOC requirements vary by lender, so compare your options with other home equity products you may qualify for.
How to get approved for a HELOC
To qualify for a HELOC, you'll have to meet your lender's guidelines for this type of financing.
While the details vary from lender to lender, examples of typical requirements include:
Typically more than 20% equity in your home
Before you can borrow against your home's equity, you need to have some equity. If you're focused on how get a HELOC, that number must typically be at least 20 percent of the home's market value. Some lenders may let you borrow with less equity available, but it is common to see that at least 20%-30% available equity is required. Your home equity is equal to your home's current value minus any amounts you owe on your existing home loans.
Your equity percentage is your equity divided by your home's value.
Here's an example:
|Current home value||$500,000|
|Home equity ($500,000 - $350,000)||$150,000
|Equity percentage ($150,000 / $500,000)||30%|
When you apply for a HELOC, your home's current value will be determined by an appraisal. The value may not be the same as your purchase price or property tax assessed value.
Debt-to-income ratio below 43%
Your debt-to-income ratio (DTI) is your monthly income divided by your monthly minimum payments for your mortgage, car loans, student loans, credit cards and other debt. Your mortgage payment includes your property tax, insurance, homeowner or condo association dues, and any other mortgage-related fees that you pay every month.
The 28/36 Rule is a bit of personal finance wisdom that means you should never let your DTI get higher than 36%, with no more than 28% of that debt going towards housing costs or mortgage costs. In many cases, 43% is the highest debt to income ratio that you can have and obtain a mortgage. Calculating your DTI is an important part of how to get a home equity line of credit.
Here's how to calculate your debt-to-income ratio:
Total of Monthly Debt Payments ÷ Gross Monthly Income = DTI
Multiply the number you get from that equation by 100 to make it a percentage. The lower it is, the better, because it means you haven't piled up too many debts. The higher the number, the more precarious your financial situation, because you have less wiggle room for unexpected expenses.
|Gross monthly income||$6,500|
|Monthly mortgage payment||$2,000|
|Monthly car payment||$250|
|Monthly minimum credit card payment||$100|
|Total monthly minimum payments
|DTI ($2,350 / $6,500)||36%|
Your monthly income may include your salary, hourly wages, side hustle or gig income, interest, dividends, rent, alimony or other income that you receive regularly.
If your DTI is too high for you to qualify for a HELOC, you can lower it by paying off some of your debt to lower your monthly minimum debt payments.
A credit score of 620 or higher
Your credit score is a three-digit number that that is partially based on the information in your credit report. Your credit report tracks how much credit you have, how much you usually use and whether you normally make your payments on time.
When researching how to get a HELOC, the higher your credit score, the more financially trustworthy lenders typically consider you to be. And in some cases, the higher the score, the lower the interest rate you'll pay on your HELOC. Credit scores are based on many variables including your payment history, total amount owed, length of credit history, types of credit accounts and new credit accounts.
Here's what credit score ranges typically mean:
- Exceptional: 800 to 850
- Very good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: Under 580
Two ways to potentially improve your credit score are:
- Establish a strong history of making your payments on time
- Lower the percentage of your available credit that you utilize
You shouldn't rush into getting a HELOC, but once you understand how a HELOC works and what the typical guidelines are to get one are, the decision to go ahead and apply may be easy.
Documents for HELOC application
Of course, there will be paperwork. You'll fill out an application that asks for estimated property value, the amount of credit line you're requesting, employment and income information, and information about other debts you have like car loans, student loans, credit cards and any other financial obligations.
Potential examples of the type of documents that may be required for a HELOC application include:
- Pay stubs: Most recent, showing 30-day and year-to-date (YTD) earnings.
- W-2s: Two most recent documents from your employer.
- Tax returns: If you are employed, lenders will want to see the most recent year's tax returns. If you are self-employed or on a pension, they'll want two years' worth of returns including all schedules. Some lenders will accept copies from you, but others may want you to fill out IRS form 4506-T, a request for a transcript of a tax return, so they can get them straight from the IRS.
- Bank and investment statements: If you are relying on Social Security, retirement or pension benefits to pay your HELOC, you'll need bank and investment statements showing the amounts being deposited in your account on a regular basis.
- Mortgage statement: Your lender will need to see how much you owe on your house so they can determine the equity that's in it.
- Proof of homeowners, hazard and flood insurance: This can be a policy or certificate of coverage, declarations page, insurance binder or payment receipt. If you own a property that's serving as collateral in an area designated as a flood zone by the Federal Emergency Management Agency (FEMA), you'll need proof of flood insurance.
In addition to these examples of documentation, a lender may order a home appraisal and examine the appraisal report along with your mortgage statement to decide the maximum amount you may be eligible to borrow with a HELOC.
Closing thoughts: HELOC requirements
When you have equity available in your home and need to access cash for other expenses, you may have several options for borrowing using your home as collateral for a loan.