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What is a HELOC?

A home equity line of credit or HELOC is a line of credit you can borrow from based on the amount of equity you have in your home. You might use a HELOC to help pay for home renovation projects, consolidate debts, or set up an emergency fund.

Similar to a credit card, a HELOC gives homeowners access to revolving a credit line that they can tap into as needed. This is different from a home equity loan, which provides you with a lump sum of money up front.

For those interested in a HELOC, it’s important to understand how they work, how to apply for this unique line of credit, and alternative solutions that can help you reach your financial goals.

How does a HELOC work?

A HELOC is a line of credit with a limit based on the borrower’s home equity. Homeowners can commonly borrow up to 80% of their home’s equity with a HELOC. They can then use this money for whatever they choose, such as home improvement projects or debt consolidation.

Since a HELOC is a revolving line of credit, borrowers only have to pay interest on what they take out. So if your credit limit is $80,000 but you only use $30,000, you only have to pay interest on $30,000. Be aware, however, that HELOCs have variable interest rates, so your monthly payments may fluctuate unpredictably based on national economic conditions.

Though a HELOC functions like a credit card account, it is actually considered a second mortgage. This means that homeowners who open a HELOC will have to go through a similar application and closing process, including potential fees. As they pay back their HELOC, they will need to manage both their original mortgage payments and monthly HELOC payments (unlike a cash-out refinance).

After closing a HELOC, the homeowner enters a draw period, which typically lasts 5-10 years. During this time, they can borrow money from the HELOC and may have the option to make interest-only monthly payments.

Once the draw period ends, they enter the repayment period, which usually ranges from 10-20 years. Throughout the repayment period, the homeowner can no longer pull money from the HELOC. Rather, they now pay off the principal and variable interest in monthly installments.

How to qualify for a HELOC

Each lender will set its own requirements for HELOC eligibility. In general, however, you should meet the following criteria when seeking a HELOC.

Home equity

Your home equity is the difference between the current value of your home and the amount you still owe on any outstanding mortgage loans. So if your home is worth $300,000 and you still owe $200,000 on your mortgage, you have $100,000 of equity. To qualify for a HELOC, you should have at least 15-20% equity in your home.

Use loan amount calculator from Discover® to see how much money you can borrow through your home’s available equity.

Credit score

To qualify for a HELOC, you should have a fair, good, or excellent credit score of roughly 620 or above. Your credit score shows lenders that you can be trusted to make on-time payments and responsibly manage your loan’s payments. A high credit score can also help you secure more favorable loan terms, such as a lower interest rate.

Household income

You’ll need proof of a steady income by providing forms such as tax returns, W2s, 1099s and bank statements to validate your ability to repay the HELOC.

Debt-to-income ratio

Your debt-to-income (DTI) ratio is a calculation of your monthly debts — like your home, car, and credit card payments — divided by your monthly income. As a rule of thumb, HELOC lenders typically prefer to see a DTI of 43% or less.

Payment history

Lenders will want to see that you have a history of making consistent, on-time payments. This will help prove your creditworthiness and your ability to responsibly pay off debts.

Comparing HELOCs with home equity loans

A HELOC is a revolving line of credit that you can tap into, similar to a credit card. A home equity loan, on the other hand, allows you to take out a lump sum of cash at the outset, which you then pay back over a 10- to 30-year period, like your original mortgage. For example, if you borrowed $60,000 for a 20 year term at 8.99% APR, your fixed monthly payments would be $539.45.

Unlike HELOCs, home equity loans also have fixed interest rates. This means your monthly payments won’t balloon over the lifetime of your loan. With a fixed interest rate, you can better plan for steady and predictable payments.

Use monthly payment calculator from Discover to find a fixed rate and monthly payment that fits your budget.

What is the application process for a HELOC?

If you’re interested in applying for a HELOC, take the following steps to begin your loan process.

Check your credit score

Check your credit score to make sure it’s in the mid-600 range or above. A high credit score helps demonstrate your creditworthiness and healthy credit history to lenders. HELOC lenders may require a fair, good, or excellent credit score to approve your loan.

Complete your HELOC application

Fill out a HELOC application online or over the phone with a lender. For this application, you’ll likely need your:

  • Social security number
  • Employment information, including monthly or annual income
  • Mortgage information
  • Other debts and monthly payments
  • The amount of equity you’d like to borrow

Verify your household income

After you apply, you’ll need to verify your household income by providing documents such as W2s, paystubs, tax returns, and bank statements.

Have the value of your home assessed

After your HELOC is approved for processing, your lender will assess the value of your home to determine the amount of equity you have in your property.

They may be able to do this by simply researching current market values and home listings. However, they may also require an in-person appraisal to assess the home with a professional appraiser.

Review and sign your documents after approval

Once your HELOC application has been approved, you can close on your loan by reviewing and signing all documentation. Make sure all personal information and loan terms are correct before signing.

Withdraw your HELOC funds

After closing, you should be able to start accessing your HELOC funds within a few days. During the 5-10-year draw period, you can pull money from your HELOC as you need it, as long as you don’t exceed the credit limit.

During this draw period, some HELOC lenders will allow you to pay only the interest against the amount you withdraw. Other lenders will require you to make monthly payments towards both the principal and the interest of the amount you borrow. Be sure to check with your HELOC lender to understand how monthly payments will be derived during these two HELOC periods.

Begin HELOC repayment period

When the draw period comes to a close, you’ll enter the HELOC repayment period. Throughout this 10-20-year term, you’ll pay any outstanding principal and interest each month. Be aware that your monthly payments may substantially increase going into the repayment period if you were only making interest payments during the draw period.

While the repayment period should have relatively consistent monthly payments, a HELOC’s variable interest rate can lead to fluctuations as interest rates move.

Common alternatives to HELOCs

While HELOCs can offer equity borrowing with interest rates that are better than comparable personal loans or credit card options, you may want to explore other equity financing as you consider your HELOC.

Home equity loans

HELOCs and home equity loans both act as second mortgages and both use your home’s available equity and measures of your credit health to derive a borrowing limit and interest rate for your financing.

There are two primary differences between HELOCs and home equity loans:

  • HELOCs allow you to borrow money when you want up to a certain limit and feature a variable interest rate.
  • Home equity loans provide a lump sum payment for your borrowing and feature a fixed interest rate.

Because of the predictability of certain borrowing amount and the fixed interest rate, home equity loans will include a stable monthly payment from the first payment until the loan is paid off. To learn more about home equity loans, visit our Monthly Payment Calculator.

Cash-out refinancing

HELOCs and cash-out refinancing both use your available home equity to borrow funds.

HELOCs and cash-out refinancing are different in a few ways:

  • HELOCs offer a flexible line of credit and a variable interest rate, while acting as a second mortgage to your existing mortgage.
  • A cash-out refinance provides lump sum borrowing, features a fixed interest rate, and pays off your existing mortgage to act as your first lien mortgage – giving you one bill to pay.

A cash-out refinance benefits you by simplifying bills to one payment to cover both your mortgage and the amount you borrow, while it often can improve the interest rate of your existing mortgage to reduce your interest charges (and sometimes even lower your monthly payments!). Our quick Cash-out Refinance Calculator can help you understand how you can benefit from a Discover cash-out refinance.

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