Home Equity Line of Credit
There are many scenarios where you may need some additional cash. You might need funds to renovate an aging kitchen, help your child pay for college, buy a car or pay off high-interest debts. Ideally, you'd like to pay for these out of pocket with funds you already have on hand. But most of us don't have that kind of cash just sitting around in our bank account.
If you’re a homeowner with some equity in your property, you may be able to get the cash you need with a home equity line of credit, or HELOC. Borrowing money this way can offer several advantages, including low interest rates, financial flexibility and potential tax benefits that are not available with other types of loans.
HELOCs - The Basics
What is a home equity line of credit? It's a type of second mortgage against your property, a variation on a regular home equity loan. But instead of giving you a single lump sum of cash, a HELOC is akin to a giant credit card account that's secured by your property.
Once the HELOC is set up you can borrow cash as you wish, up to your approved credit limit, and only pay interest on the amount you withdraw. This makes HELOCs useful for situations where you have irregular expenses, such as an extended home improvement project, helping a child pay for college or starting a small business.
Most HELOC lenders will allow you to borrow up to 80 percent of the value of your home, sometimes 90 percent for well-qualified borrowers. That's for your mortgage and HELOC combined.
To estimate what you might be able to borrow, you'll need to know the current value of your home refinance and the balance remaining on your mortgage and any secondary liens you may have. Subtract the mortgage balance and any secondary liens from 80 percent of your home value. The remainder is what you could get with a home equity line of credit.
For example, suppose $250,000 is the appraised value of your home; 80 percent of that is $200,000. If you still owe $150,000 on your mortgage, you'd subtract that from $200,000, meaning you could potentially get a line of credit of up to $50,000 to use as you wish.
Having home equity is only part of what you need to be approved for a HELOC. Other factors will include your credit history, income, how much debt you have and your other financial obligations.
Finally, because a HELOC loan is a type of mortgage – a loan secured by your home – the interest you pay is usually tax-deductible for borrowers who itemize deductions, up to certain limits. For most borrowers, those limits are the interest on up to $50,000 in home equity debt for a single borrower or $100,000 for a couple.
More information: HELOC advantages
How a HELOC works
There are two phases to a home equity line of credit, the draw period, and the repayment period. During the draw, which is generally around 10 years, you can borrow funds as you wish, up to your credit limit. You may be provided with an actual credit card or checks to use for drawing funds.
During the draw, you're only responsible for paying interest charges. Once the draw period ends, you enter the repayment phase, generally 10-20 years, and you start repaying the loan principal. You cannot draw further funds once your HELOC enters the repayment phase.
Some people at this point will choose to refinance into a new HELOC, paying off the old balance with the new loan, in order to keep a line of credit available to them.
During the draw, HELOCs are adjustable-rate loans. That means the interest rate you are charged fluctuates according to market conditions. There will be limits to just how much your rate can change and the formula for determining your rate will be spelled out in your loan documents.
In any event, you only pay interest on the amount you have actually borrowed, not on the entire line of credit. You may still have to pay annual fees for maintaining the account, however.
Once the loan reaches the repayment phase, HELOCs often switch to a fixed-rate. That means your interest rate is unchanged until the balance is paid off. The fixed-rate you get will be based on current market rates at the time you enter the repayment period, as spelled out in your loan documents.
Most home equity lines of credit will allow you to make payments against the loan principal during the draw phase without penalty. Doing so not only reduces your debt obligation, but also frees up that portion of your credit line for repeated use later on.
More information: Finding the hidden fees in HELOCs
HELOCs vs home equity loans
HELOCs and standard home equity loans are really just two versions of the same thing. They're loans backed by the equity in your home. But there are significant differences.
With a standard home equity loan, you borrow a single sum of money and begin paying it back almost immediately. The interest rate is usually fixed, meaning your costs are predictable, although you can get an adjustable-rate home equity loan as well.
With a HELOC, you've got a line of credit to use as you wish. You borrow money as you need it and pay interest only on what you've borrowed. You don't have to repay any loan principal for 5-10 years, just interest payments, though you can repay principal if you wish. The initial interest rate is lower than on a regular home equity loan, because it's adjustable, though it can fluctuate over time.
The standard home equity loan usually has higher closing costs, while a HELOC often has an annual fee. A HELOC may also have an early cancellation charge if you close it before the draw period ends.
A regular home equity loan is a good choice if you need a certain amount of money for a single purpose, like debt consolidation, a major purchase or a limited home improvement project like a new roof or windows.
A HELOC loan is often the better choice for situations where you're going to have ongoing expenses, such as starting a business, paying for college or extended home improvement projects where you're going to be making multiple purchases of supplies and payments to contractors.
HELOC loans are also useful when your expected costs are variable, since you only borrow what you need when you need it. They're also good if you don't want to begin repaying the loan right away.
More information: HEOC pros and cons
Financial flexibility with a HELOC
One of the main advantages of a HELOC is financial flexibility. This makes them a very versatile type of loan, usable in ways that may not have occurred to you.
Managing cash flow
HELOC loans allow you to you borrow cash as you need it. You can also pay it back early, which frees up your line of credit for more borrowing in the future. This means you can use it as a tool to manage your cash flow.
Consider someone with an irregular income, a small business owner, a contractor or a consultant whose earnings come in big chunks at different times of the year. They could use the HELOC to cover expenses during the lean times, then pay it back when they get paid.
Compared to a credit card, a HELOC typically offers a much lower interest rate and the interest is often tax-deductible as well – which credit card interest is not.
As a business loan
Though it can be risky, a HELOC can be an attractive option for a small business loan. If you have the home equity and another source of income, a HELOC can be easier to obtain than a regular startup business loan. The fact you can borrow as needed can also help you get over the rough spots when first starting out.
You can also use it as a loan for an existing small business to help manage cash flow, as noted above.
The downside is that you're putting your home on the line for a venture that may not pan out. So you want to proceed with caution here.
As a bridge loan
Yet another possibility is using a HELOC as a bridge loan when buying a new home and selling your old one. You can use a HELOC to cover your down payment, closing costs and even several months of dual mortgage payments until you sell your old home and pay it all off.
You could use a standard home equity loan to do the same thing, but a HELOC has little or no closing costs, allows you to postpone making any loan payments and allows you to continue drawing funds to make dual mortgage payments until you sell your old home.
If you do this, you have to be sure to set up the HELOC well before you list your home. Few lenders will do equity lines of credit for homes that are already on the market. Be aware you may have to pay an early cancellation fee as well once you sell the home.
Home equity line of credit requirements
"Do I qualify for a HELOC?" is the first question that many borrowers have about these loans. While the guidelines vary from lender to lender, there are a few general rules of thumb that can give you an idea of where you stand.
As noted above, lenders will generally let you tap up to 80 percent of your available home equity, sometimes 90 percent if you have excellent credit and low debt. That's for a combination of your HELOC and all other mortgage debt combined.
While some lenders will permit HELOCs with credit limits as low as $5,000, it's more common to have minimums of $10,000-$25,000. So you need to take that into account when determining if you have enough home equity to qualify for a HELOC.
You generally need better credit to get a HELOC than you do for a purchase mortgage or refinance – most HELOC lenders demand a FICO credit score of 660-680 or better.
Your actual income doesn't matter as much as your debt-to-income ratio, the percentage of your monthly gross income that goes toward debt payments of all types. Most lenders will want that figure to be 41 percent or less, including your mortgages, auto loan, minimum credit card payments and your potential maximum HELOC payment.
Shopping for a HELOC
The process of shopping for a HELOC is much like shopping for any other mortgage. You want to find the lender who offers the best HELOC rates and terms for borrowers like you.
Since HELOC rates are adjustable, you want to pay particular attention to how those rates are set. Don't just go for the one similar to shopping for a mortgage. Home equity line of credit terms and rates vary from lender to lender, so you want to check with several lenders to see what they're willing to offer you.
That's particularly important if you have a less-than-perfect borrower profile – flawed credit, minimal home offering the lowest rate up front – some lenders will start you off with a low introductory rate for a few months, then once the introductory period ends will raise it to a higher rate than you could have obtained elsewhere.
Watch too, for how much the rate can adjust over the life of the loan and how quickly. Some may allow considerably larger rate adjustments than others.
Many lenders will advertise that they do not charge any HELOC closing costs. That can be a good deal, though it's sometimes a matter of semantics – you may still be charged an "origination fee" or for an appraisal to determine the value of your home in some cases. Before you get too committed to one lender, make sure you know exactly what you'll have to pay to set up the HELOC.
Most HELOCs charge an annual fee for maintaining the account, regardless of whether you've drawn against it or not. Others may charge an inactivity fee if you don't draw against your credit line or maintain a loan balance for a certain length of time.So you need to look at the whole package.
Some lenders will charge a HELOC application fee, to cover the costs of processing the application, though that may be refundable when the HELOC is approved. Annual fees are often waived for the first year of the account as well.
In some cases you may have to pay a cancellation fee if you close out the HELOC before the end of the draw period, such as if you sell your home. However, you should not have to pay a prepayment penalty if you pay the principal off early; if a loan offer contains that provision, it's a good sign you should look elsewhere.
Finally, be sure to ask if the loan converts to a fixed-rate during the repayment phase or remains an adjustable-rate loan. Your long-term costs will be more predictable with the former.
More information: 5 tips for finding your HELOC
Getting the best HELOC rates
The best HELOC rates go to borrowers with high credit scores (FICO score of 740 or above), low debt and plenty of home equity. So the best way to get a low HELOC rate is to pay your bills on time, avoid taking on too much debt and steadily pay down your mortgage.
It's hard to change any of those quickly, but there are things you can do to get a lower rate. First, check your credit reports and make sure there aren't any errors that are bringing down your score, such as a billing dispute reported as a bad debt.
Second, pay down your bills as much as you can. In particular, avoid carrying too much debt on a single credit card. Using most of your credit limit on a single card is a red flag that will reduce your credit score; it's better to have that debt spread around several cards.
Third, avoid opening new lines of credit if you're planning to seek a HELOC. While a single new credit card won't hurt you much, opening several over the course of a year could have a definite impact. Something like a new auto loan will not only count as a new credit account, but will increase your debt load as well.
As noted above, you want to shop around for the best HELOC rate and terms. But it helps to know how HELOC rates are set. Most HELOC rates are based on the prime rate, which is the current rate commercial banks charge on loans to each other, plus an adjustment called the margin.
The margin plus the prime rate determine the interest rate on your HELOC. Remember, the rate is adjustable during the draw period, so it will fluctuate along with the draw.
What you want to look out for is a HELOC where the margin changes as well. Some lenders will offer an introductory or "teaser" rate for the first year or so, where you start out with a small margin that increases after the introductory phase is over. You want to be sure that your margin after the introductory phase isn't higher than what the competitors are charging.
You also want to be aware of the rate caps, or the limits on how much the rate can increase at any one time and over the life of the loan. Smaller is better.