HELOC: Home equity line of credit handbook

You may have heard of HELOCs, but what are they? And how can they help you? As a homeowner, you might be on the lookout for ways to improve your financial situation. A home equity line of credit (HELOC) is just one option.

With a HELOC, you may borrow money against the equity in your home and use it for whatever purpose you like — from paying off debt or making home improvements to investing in real estate or putting a down payment on a vacation home.

What is a HELOC?

• A home equity line of credit is a revolving line of credit that allows you to borrow against the equity in your property.
• Equity is the difference between the appraised value of your home and the amount owed on any existing mortgage(s).
• HELOCs can be used for various purposes such as home improvements, debt consolidation, emergency expenses, or other financial needs.
• Unlike traditional home equity loans that are received in a lump sum, HELOCs may offer a flexible borrowing option — you can draw funds from available credit as needed.

History of HELOCs

HELOCs have a history that traces back several decades. The origins of this financial tool can be attributed to the need for homeowners to access equity in their homes.

The concept of borrowing against home equity dates to the mid-20th century. Initially, homeowners primarily relied on closed-end second mortgages to tap into their property’s equity and receive a lump sum of funds. These home equity loans are still a common way to access equity for cash. In the 1980s, financial institutions responded to homeowners’ desire for more flexible options when leveraging the equity in their homes and started to offer HELOCs as a revolving line of credit rather than a lump sum loan.

By the 2000s, HELOCs had become even more prevalent as they were actively promoted as a versatile financial product. Homeowners took advantage of rising property values and accessed their home equity through HELOCs for both essential and discretionary purposes. However, the financial crisis of 2008 presented challenges associated with HELOCs, especially when property values declined, and homeowners faced difficulty repaying their debts. The crisis prompted a more cautious approach towards HELOC lending from financial institutions, and stricter regulations were put into place to mitigate potential risks.

Since then, the financial industry has implemented measures to try and ensure responsible use of HELOCs. Lenders now may assess a borrower’s creditworthiness, income, and debt-to-income (DTI) ratio more carefully. Additionally, new regulations required more transparent disclosures to borrowers.

Today, HELOCs continue to be a popular financing option for homeowners who want to convert a portion of their property’s equity into cash. The evolution of HELOCs has led to more consumer-friendly terms, improved regulations, and led to a better understanding of the risks and benefits associated with this type of credit.

What can a HELOC be used for?

Homeowners can use this versatile financial tool to achieve a variety of goals. Some of the most common uses for a HELOC include:

• Home improvements: One of the most popular uses of a HELOC is to finance home improvement projects. From kitchen remodels to bathroom renovations, this type of financing is a common strategy for when you want to draw money as you need it to complete a project. HELOC funds can also be used to make upgrades to the home’s electrical or plumbing systems or even to install solar panels or other energy-efficient features.
• Debt consolidation: Do you have high-interest credit card or other loan balances? A HELOC may allow you to benefit from lower interest rates and potentially lower your monthly payments so you can work to pay off your debt faster.
• Education expenses: HELOCs can be used to finance education expenses, including college tuition and fees, textbooks, and other education-related costs. With the flexibility to withdraw funds as expenses arise, this type of financing could potentially make education more affordable for you or your family.
• Vacations or large purchases: Funds from a HELOC can be used for discretionary purposes such as a vacation or other large purchases. Just remember, your home serves as collateral for this loan, so make sure you borrow money responsibly to avoid withdrawing more than you can afford to pay back.
• General financial planning: Lastly, having a HELOC in place can help with overall financial planning. It can be a cushion during difficult times, reduce the risk of accruing high-interest credit card debt, or provide flexibility in times of need or opportunity.

Regardless of the reasons to take out a HELOC, it’s always important to carefully consider the loan’s long-term effects and impact on your finances.

How does a HELOC work?

A HELOC is a line of credit with a limit based on your home equity. Homeowners can typically borrow up to 80% of their home’s equity with a HELOC, though that percentage can change based on what your lender offers.

Although a HELOC functions like a credit card account, it is considered a second mortgage. This means homeowners who open one may have to go through a similar application and closing process and pay any potential fees such as application fees, origination fees, or home appraisal fees. As you pay back your loan, you will need to manage both your original mortgage payments and monthly HELOC payments.

After closing a HELOC, you will enter the draw period. During this time, you can borrow money from the HELOC and may have the option to make interest-only monthly payments. Once the draw period ends, you enter the repayment period. Throughout the repayment period, you can no longer borrow money from the credit line.

Since a HELOC is a revolving line of credit, you typically only pay interest on what you take out. Be aware, however, of the variable interest rates — your monthly payments may fluctuate unpredictably based on national economic conditions.

Understanding HELOC rates

HELOC interest rates typically consist of two components: a variable rate and a margin. The variable rate is tied to a benchmark rate, such as the prime rate that’s reported by the U.S. Federal Reserve.¹ As the benchmark rate fluctuates, the interest rate on your HELOC will adjust accordingly.

The margin is a fixed percentage that a lender adds to the benchmark rate. The specific margin is determined based on factors like your creditworthiness, loan-to-value (LTV) ratio, and the amount of credit you’re looking for. The sum of the benchmark rate plus the margin is the total interest rate on a HELOC.

Differences from other home financing products

• Variable vs. Fixed rates: Unlike traditional fixed-rate mortgages or home equity loans, HELOCs primarily feature variable interest rates. These rates may change over time, making HELOCs more flexible but also potentially riskier in a rising rate environment.
• Flexibility in borrowing: With a HELOC, you have a line of credit you can access as needed, allowing you to borrow only the amount you require at any given time during the draw period. The principal loan amount you withdraw is important to keep in mind when trying to determine how much you can expect to pay in interest charges.
• Interest on amount borrowed: HELOCs typically charge interest only on the amount borrowed, not on the full credit line. For example, if you have a $50,000 HELOC but only borrow $10,000, you will only incur interest on the $10,000.
• Draw period and repayment period: HELOCs have a draw period during which you can borrow from the credit line, usually ranging from 5 to 10 years. After that, the loan enters the repayment period, typically around 10 to 20 years. During the repayment period, you can no longer borrow and must begin repaying principal and interest.
• Ability to reuse credit: Unlike other home financing products, HELOCs typically allow you to reuse the credit you have paid off during the draw period. As you repay your outstanding balance, the available credit becomes accessible again.
• Variable payment amounts: Due to the variable interest rates, your payment amount can change over time. During the draw period, if you only need to make interest-only payments, your payments are typically lower. However, during the repayment period, your payments will include both principal and interest, potentially leading to higher payment amounts.

Pros and cons of a HELOC

Like with any loan or financial product, there are both advantages and disadvantages to consider. If you’ve been thinking about tapping into your home equity to access cash, here are some reasons why — or why not — a HELOC is the way to go.

Pros

• Lower interest rates than alternatives: Even with their variable interest rates, HELOCs typically offer lower rates than traditional credit cards or personal loans, making them a more affordable option for borrowing. This is because your home secures the loan as collateral, where those other types of accounts don’t require any collateral to open.
• Flexibility: HELOCs may offer flexibility in borrowing, allowing you to withdraw from your credit line as needed.
• Tax deductible interest: The interest you pay on a HELOC may be tax-deductible if you use it for specific expenses such as home renovations. This could potentially lower the overall cost of borrowing, but you should consult with a tax advisor before borrowing for this reason to see what might apply to your situation.
• Ability to reuse credit: As mentioned earlier, a HELOC is unique from other loan products in that you can reuse the credit you’ve paid off while you’re still in the draw period.
• Improved credit scores: Consistently making payments on time may improve your credit score, which can lead to even better borrowing options in the future.

Cons

• Risk of losing home: Because HELOCs are secured by your home, you may risk foreclosure if you are unable to repay the loan.
• Potentially fluctuating interest rates: Variable rates may increase over time and potentially lead to higher payments. You will want to make sure you understand what future payments could potentially look like based on the terms of your loan, so you know what you need to budget for.
• Additional fees: HELOCs may come with additional fees such as application fees, annual fees, or even early termination fees.
• Potential for overborrowing: The flexibility of a HELOC may make it easy to overborrow and potentially create financial strain that makes it challenging to repay the loan. Remember to borrow only what you can afford to pay back.
• Lengthy repayment period: The longer your repayment period is, the more you may pay in interest charges over the life of the loan if you only make the minimum monthly payment.

How to qualify for a HELOC

Qualifying for a HELOC involves meeting certain criteria and requirements. Lenders may assess several factors to determine if you’re eligible to take out the loan, and each lender will have their own specific requirements for HELOC eligibility. In general, however, you should meet the following criteria when seeking a HELOC:

• Home equity: You must have a certain amount of equity in your property to take out a HELOC. Equity is calculated by subtracting your outstanding mortgage balance(s) from your home’s current market value. Lenders typically require a minimum amount of equity, often around 15% to 20%. However, each lender may have specific guidelines, so be sure to compare lenders and their individual requirements.
• Credit score: Your credit score plays a significant role in qualifying for most loans, including HELOCs. Lenders will consider your score as a reflection of your credit history and ability to make on-time debt payments. Specific credit score requirements may vary among lenders, a higher credit score generally improves your chances of qualifying for a HELOC with more favorable terms. Lenders typically set a minimum credit score requirement, but you may be more likely to receive lower interest rates on your loan with a higher score.
• Income: Lenders will likely consider your income during the qualification process. Although requirements may vary, every borrower generally needs to demonstrate a stable income source to ensure they can make the required monthly payments. Lenders may request proof of income, such as pay stubs or tax forms to verify your ability to repay the loan.
• Debt-to-income (DTI) ratio: Your DTI ratio is an essential factor in determining HELOC eligibility. It compares your total monthly debt payments to your total monthly income. Lenders typically prefer to see a DTI ratio of 43% or below. This means that all monthly debt payments, including the new HELOC payment, should not exceed 43% of your income. A lower DTI typically indicates a better capacity to take on and manage new debt and may increase your chances of qualifying.
• Other factors and documentation: In addition to the requirements listed above, lenders may choose to review other factors such as your employment history, assets, or overall financial profile. They may also request documentation including bank statements, tax returns, and property appraisals to assess eligibility accurately.

What is the application process for a HELOC?

If you’re interested in applying for a HELOC, consider taking the following steps to begin your loan process:

• Check your credit score: Check your credit score before applying — a higher 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 or ITIN, employment information (including monthly or annual income), mortgage information, other debts and monthly payments, and the amount of equity you’d like to borrow.
• Verify your household income: After you apply, you may 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 funds: After closing, you should be able to start accessing your funds within a few days. During the draw period, you can pull money out as you need it, if you don’t exceed the credit limit.

Common HELOC alternatives

While HELOCs may offer equity borrowing with interest rates that are lower than personal loans or credit cards, you may want to explore other equity financing as you consider the options available to you.

Home equity loan

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 may feature a variable interest rate.
• Home equity loans provide a lump sum payment for your borrowing and typically feature a fixed interest rate.

Because of the predictability of certain borrowing amount and the potential fixed interest rate, home equity loans may include a stable monthly payment from the first payment until the loan is paid off.

Cash out refinance

HELOCs and cash out refinances both use your available home equity to borrow funds, but are different in a few ways:

• HELOCs may offer a flexible line of credit and likely features a variable interest rate, while acting as a second mortgage in addition to your existing mortgage.
• A cash out refinance provides lump sum borrowing, typically 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 may benefit you by helping you simplify bills into one payment to cover both your mortgage and the amount of equity you borrow. Depending on current available rates, it may lower the interest rate of your existing mortgage to reduce your interest charges and sometimes even lower your monthly payments.

Closing thoughts: Should you get a HELOC?

When considering a HELOC as a borrowing option, you should weigh the potential advantages and disadvantages to decide if it’s suitable for your financial goals and circumstances.

A HELOC may offer several advantages, including low initial interest rates, flexibility in borrowing and repaying, and the ability to reuse credit during the draw period. This makes it an attractive option for homeowners looking to finance home improvements, consolidate debts, manage emergencies, or make large purchases. However, there are also potential downsides to consider.

The risk of losing your home if the loan is not repaid, potentially fluctuating interest rates, additional fees, the temptation to overborrow, and lengthy repayment periods are all important factors to be aware of.

To determine if a HELOC is right for your situation, consider the following:

1. Evaluate your financial goals: Determine how you plan to use the funds and whether a HELOC aligns with your objectives. Assess the benefits and risks to ensure it complements your financial strategy.
2. Assess your home equity: Calculate the amount of equity you have in your home to meet the minimum requirement set by lenders. Ensure you have enough equity to access your desired amount of funds.
3. Check your credit score: A higher credit score may increase your chances of qualifying for a HELOC with better terms. If you want to improve your score before applying, try to pay down your existing debts, make regular on-time payments on all your open debt accounts, and lower your DTI ratio.
4. Understand your financial responsibilities: Be aware of the potential risks associated with HELOCs, such as the possibility of foreclosure or increasing interest rates. Only borrow what you can comfortably repay and make timely payments to protect your financial well-being.