Guide to Home Equity Line of Credit (HELOC) Loans

A HELOC, or home equity line of credit, is a type of second mortgage secured by the equity in your home. It works similarly to a credit card, providing homeowners with a revolving line of credit they can tap into as necessary. HELOCs offer flexibility, low interest rates and can be used for a wide range of projects, including home improvements, debt consolidation, and emergency expenses.

However, it’s crucial to understand the risk of taking out a HELOC, which includes the possibility of losing your home if you default.

Today, we’ll provide a complete overview of HELOCs, including how they work, how they differ from home equity loans, benefits and risks, and how to get one.

How Does a Home Equity Line of Credit Work?

Unlike a primary mortgage, a HELOC doesn’t provide a lump sum that you repay with standard monthly payments. Instead, it has two distinct periods known as the draw period and the repayment period.

The draw period of a HELOC typically lasts 5 to 10 years. During this period, a HELOC has revolving credit, meaning you can access a predetermined credit limit to borrow from and repay as needed. In the draw period, you’re only required to pay interest on the amount you’ve withdrawn, but you can make payments to the loan principal if you’d like.

Use our HELOC mortgage calculator to see how much you can borrow.

Once the draw period ends, the repayment period begins, typically lasting for 10 to 20 years. During the repayment period, you cannot withdraw any more funds, and you must make payments on the interest and principal, meaning your minimum payment will increase.

How do HELOC Interest Rates Work?

While it’s possible to find fixed-rate HELOCs, most have variable interest rates that are tied to a benchmark, such as a prime rate. Variable-rate HELOCs adjust based on changes in the benchmark rate, usually at specified monthly, quarterly, or annual intervals.

Many variable rate HELOCs also include rate caps and floors to limit how much the interest rate can change. A cap sets the maximum interest rate increase allowed during each adjustment period, while a floor sets the minimum interest rate that can be charged.

How To Get a Home Equity Line of Credit

When applying for a HELOC, borrowers can expect similar qualification requirements from most lenders. These include:

• Sufficient equity: Lenders require a minimum level of equity, usually ranging from 10% to 20% of the home’s value. Lenders may express this as a loan-to-value ratio, equivalently 80% to 90%.
• Reliable credit history: While specific credit guidelines may vary, most lenders require a credit score of 620 or higher. The higher your credit score, the lower the interest rate you may qualify for.
• Low debt-to-income ratio (DTI): DTI is the percentage of your monthly income that goes toward debt payments. Lenders typically prefer a DTI ratio below 43%.
• Employment and income stability: Demonstrating a steady and dependable source of income is an important factor in qualifying for a HELOC. There are no set employment guidelines that lenders follow, but you must meet their DTI requirements.

Remember, requirements vary by lender, so shop around and get pre-approved for the most accurate loan estimate.

Difference Between a Home Equity Loan and a Line of Credit

HELOCs and home equity loans both allow you to borrow against the equity in your home, but there are some key differences between them.

Unlike a HELOC, a home equity loan is a lump-sum amount. You receive the entire loan amount upfront and start making payments immediately on both the principal and interest. Home equity loans usually come with fixed interest rates that remain constant over the duration of the loan, typically 5 to 20 years.

With a HELOC, you can access a credit line and borrow as much or as little as you need, up to your approved credit limit. This is a key difference from a home equity loan, where you can only access the amount you borrowed initially. With a home equity loan, you must apply for a new loan or refinance if you need more money.

Overall, home equity loans are less complicated than HELOCs, with a straightforward repayment structure. However, they can be restrictive for projects that require flexibility and uncertain funding needs.

HELOC Benefits vs. Risks

You’ll want to weigh the risks and benefits of a HELOC loan before deciding to apply. HELOCs have more options than limitations regarding what you can use them for. So, their pros and cons mainly concern how they are structured.

Here are some benefits of HELOCs:

• Flexibility: HELOCs are flexible in what you can use them for and how you pay them back. You don’t have to pay anything back if you don’t withdraw money from your line of credit. So, if you take out a HELOC loan for $80,000 but only use $20,000, you only have to make payments toward the $20,000.
  
• Lower Interest Rates: HELOCs offer lower interest rates than credit cards and personal loans, making them a cost-effective financing option for purchases you can’t pay back before interest accrues.
  
• Tax-deductible interest: The interest on a HELOC is typically deductible under federal and many state income tax laws. This can significantly reduce the cost of borrowing funds compared to other methods of borrowing.

Use our Line of Credit Tax Calculator to see your potential tax savings with a HELOC.

Now, let’s look at some of the risks of HELOCs:

• Your home is collateral: The primary risk associated with a HELOC is losing your home. Because HELOCs use your home as collateral, failing to make timely payments can result in the lender initiating foreclosure proceedings to recover the outstanding balance.
  
• Variable interest rates: HELOC interest rates are usually variable and tied to benchmark rates, which fluctuate over time. This uncertainty can make it challenging to predict future borrowing costs and may increase financial risk, especially if interest rates rise significantly.
  
• Potential for overborrowing: Flexible access to funds may tempt borrowers to overborrow, leading to higher debt levels and potential financial strain.
  
• Potential for a credit line freeze: A credit line freeze or reduction occurs when the lender decides to limit or decrease the available credit line on a HELOC. A lender typically takes this action due to changes in the borrower’s financial circumstances, changes in the housing market, or concerns about the borrower’s ability to repay the loan.

Overall, HELOCs are an excellent resource for anyone needing access to a considerable amount of cash. But the cash isn’t free, and anyone considering a HELOC should work with their financial advisor to ensure they are helping themselves in the short and long term.

Best Uses for a HELOC

There are almost unlimited options for what you can use a HELOC for, but that doesn’t mean they’re suitable for every scenario. To make the best use of a home equity line of credit, you should leverage its flexibility and unique payment structure.

Here are some areas where HELOCs can be best utilized:

• Home renovations: Homeowners can tap into their home equity to fund renovations, effectively reinvesting in their property and potentially increasing its resale value. The flexibility of HELOCs allows homeowners to access funds incrementally as remodeling expenses arise, rather than taking out a lump sum loan all at once.
  
• Further education: HELOCs can be used to cover the costs of higher education, including tuition, fees, and other educational expenses. You can take advantage of having a single source of funds, and you only have to pay interest on what you take out.
  
• Starting a business: Homeowners can fund a new business with a HELOC. Their flexibility can be beneficial for financing the initial expenses associated with starting a business, like inventory, equipment, and operational costs.
  
• Medical bills: Many people turn to their HELOCs to pay for medical expenses that insurance may not cover. A HELOC offers lower rates than credit cards, and its flexibility can be beneficial to help fund long-term treatment needs.

Is a HELOC the Right Choice for You?

Deciding whether a HELOC is the right choice depends on your financial situation.

HELOCs are a practical option for ongoing expenses, as they provide a revolving line of credit. If your borrowing needs are primarily for a one-time cost, a home equity loan or refinance might be more appropriate.

As with any major financial decision, it’s always wise to speak with an expert. A loan officer or financial advisor can provide guidance based on your unique circumstances and help you evaluate whether a HELOC is a good choice for you.