Home Equity Line Of Credit: What It Is And How It Works

When you need cash, whether it’s to consolidate your debt or pay for home improvements, it’s important to find the right financing option for you. A home equity line of credit is a popular choice among homeowners because it provides easy access to cash whenever you need it without the higher interest rates you might pay with other loans.

Home equity lines of credit have some major advantages and can be used for many different purposes. But before you apply for one, it’s important to understand how they work, how to get one and the risks associated with them.

What Is A Home Equity Line Of Credit (HELOC)?

A home equity line of credit (HELOC) is a revolving credit line that allows you to borrow against your existing home equity. A HELOC combines some features of a secured loan and a credit card.

Like any other secured loan, a HELOC requires collateral – in this case, your home. You can borrow up to a particular percentage of your home’s value, minus any existing mortgage balance you have. This collateral protects the lender because if you fail to make your payments, the loan agreement allows the lender to foreclose on your home.

As we mentioned, a HELOC also has some features that are similar to a credit card. Unlike many loans, HELOCs are revolving credit lines, meaning you can borrow against them again and again.

Imagine you need to borrow $50,000. With an installment loan, you would get a lump sum of $50,000 and then repay it over a set period of years, usually with fixed monthly payments.

But with a HELOC, you would get a $50,000 credit line. You could choose to borrow the full amount at once, but you could also choose to borrow just a portion of it. And you can continue to borrow against your credit line again and again as long as you have available credit left.

With a HELOC, rather than having fixed monthly payments to repay your full balance by a certain date, you simply have a minimum payment each month, similar to a credit card. You can choose to pay only the minimum payment. Alternatively, you could choose to repay a larger portion of the balance – or even the entire thing.

Common Uses For HELOCs

HELOCs can be used for just about any purpose, but there are specific situations where they may be most appropriate.

• Home improvements: One of the most common uses for a HELOC is to pay for home improvements. A HELOC is particularly suitable for this type of expense because it can directly increase your property value, making the borrowing costs worth it. As an added bonus, your interest may be tax-deductible if the money is used to substantially improve your residence.
• Debt consolidation: A HELOC can be a great way to consolidate high-interest debt like credit cards and personal loans. First, you can consolidate all of that debt into one place with just one monthly payment. Additionally, HELOCs often have lower interest rates than unsecured debt, meaning you can save money.
• Major purchases: A HELOC could help you fund a large purchase, such as a vacation, a wedding and more. The low interest rates might make HELOCs more appealing than alternative options, such as credit cards or personal loans.
• College tuition: Many parents choose to use a HELOC to help fund their children’s college education. This has several benefits. If you’ve owned your home for a long time, you probably have a large amount of equity to borrow from at a low interest rate. And because of the nature of HELOCs, you can slowly pay it off and continue to borrow from it for each year’s tuition.
• Real estate: You might consider using a HELOC to fund the down payment on an investment property or second home. One of the benefits here is you’re still getting home equity out of the funds – you’re just getting that equity in a different property. It can help reduce the barrier to buying another property.
• Financial emergencies: Ideally, you would have an emergency fund to help pay for any financial emergencies that arise. However, a HELOC can be a suitable addition or replacement for an emergency fund. The money is easily accessible when you need it, but in a perfect world, you’ll never have to use it.

How Does A Home Equity Line Of Credit Work?

As we’ve mentioned, a HELOC is a revolving line of credit, similar to a credit card. You’ll be approved for a specific credit line and can borrow up to that amount as many times as you want, as long as you continue to pay on your balance and have available credit. However, unlike credit cards, HELOCs don’t exist in perpetuity.

HELOCs are split into two distinct periods: the draw period and the repayment period. Here’s how those work:

• Draw period: The draw period, which typically lasts about 10 years, is the period during which you can borrow from your line of credit. During this period, you may only be required to pay interest or may have a minimum payment that includes your interest, as well as a portion of your principal balance.
• Repayment period: The repayment period is the period during which you’ll repay both the principal and interest on your HELOC. This period typically lasts 10 – 20 years. During this period, you won’t be able to borrow any more from the HELOC.

At the end of your HELOC, a couple of things may happen. First, your HELOC may simply end once you’ve repaid the full balance during the repayment period. However, you may also be given the option to renew your HELOC. The benefit here is that you regain access to those funds without having to go through the approval process again.

How Much Money Can You Borrow With A Home Equity Line Of Credit?

The amount you can borrow with a HELOC depends on a few key factors. First, you can only borrow up to a percentage of your home equity. Your maximum loan-to-value (LTV) ratio will usually be between 80% – 85% and includes any outstanding mortgage balance you have.

Suppose your lender allows an LTV of up to 80%. Your home has a value of $400,000, meaning an 80% LTV would be $320,000. However, let’s say you still owe $250,000 on your mortgage. In that case, the most you would be able to borrow through your HELOC is $70,000.

The amount you can borrow will also be determined by other factors. For example, your lender will take into account your creditworthiness and your ability to repay the loan when approving you for a credit limit.

Average HELOC Interest Rates

Like other loan interest rates, HELOC rates fluctuate based on a variety of factors. They are typically higher than mortgage rates because they are a higher risk for the lender. However, they are usually lower than unsecured lending options such as credit cards and personal loans.

The annual percentage rate (APR) on a HELOC depends not only on the market but also on your personal finances. A good credit score and low debt-to-income ratio can help you land a lower rate and save money on your credit line.

HELOC Loan Qualification Requirements

Though the specific requirements to get a HELOC may vary by lender, there are some basic requirements you can expect to be subject to:

• At least 15% – 20% equity in the home
• Debt-to-income ratio (DTI) of 43% or less
• Credit score of 620 or higher

Keep in mind that individual lenders may be more stringent in their requirements. For example, though 620 is often the bare minimum credit score for a HELOC, some lenders may require higher scores. Lenders will also do a deep dive into your credit history. Even if you have a credit score that meets the minimum requirements, if you have a spotty payment history, you may not qualify.

Benefits Of A Home Equity Line Of Credit

A HELOC has several key benefits that make it a great option for a variety of expenses.

• Low APR: HELOCs usually have lower interest rates than unsecured competing loan products, such as credit cards and personal loans.
• Flexible terms: HELOCs offer flexibility in terms of how much you can borrow, how high your monthly payments will be and how long you can take to repay your balance.
• Accessible funds: Once your HELOC is open, you can access the funds again and again without having to apply and be approved each time.
• Tax-deductible interest: Depending on how you use the funds, you may be able to claim a tax deduction for your HELOC interest.

Drawbacks Of A Home Equity Line Of Credit

Despite their benefits, HELOCs also have some downsides and risks that you should consider before you open one.

• Your home is collateral: Because your home secures the HELOC, failing to repay the money you borrow could result in foreclosure.
• Potential increase in interest rate payments: HELOCs have variable interest rates, meaning your rate, and, therefore, your monthly payment, could increase.
• Upfront and ongoing costs: HELOCs require some upfront costs, such as a home appraisal fee, as well as possible ongoing costs, such as an annual maintenance fee.
• Reduced home equity: Because you’re borrowing against your home equity with a HELOC, your ownership in your home is reduced.

How To Get A Home Equity Line Of Credit

If you’re considering getting a home equity line of credit, here’s how to get started:

1. Calculate Existing Equity In Your Home

Before you apply for a HELOC, it’s important to get an idea of how much you’ll be able to borrow. While you may not be able to get an exact estimate without an appraisal, use your latest home value and subtract your current mortgage balance(s) to find out how much is left to borrow.

2. Prepare The Necessary Documentation

The documentation you’ll need to provide when you apply for your HELOC is similar to what you provided when you applied for your mortgage. Be prepared to provide:

• Government-issued ID
• Proof of employment
• Pay stubs, W2s or other proof of income
• Bank statements
• Information on assets and liabilities
• Tax returns

3. Apply With Multiple HELOC Lenders

Don’t just apply for a HELOC with one lender. Instead, shop around and get interest rate quotes from multiple lenders to find the best deal. In addition to comparing interest rates across lenders, you should also compare loan amounts, fees and other loan terms.

4. Close On Your HELOC

When your HELOC is finalized, you’ll have to sign some paperwork and pay upfront fees just like you would for a mortgage or home equity loan. These fees can amount to 2% – 5% of the line of credit amount.

Fees you may be subject to include an origination fee, appraisal fee, credit report fee and more. Some HELOCs also have annual maintenance fees, which are ongoing for the entire life of the HELOC.

Alternatives To A Home Equity Line Of Credit

A HELOC can be an excellent tool to help you consolidate debt, renovate your home or make a large purchase, but it may not be right for everyone. Depending on your financial situation and your amount of home equity, another option may be a better fit.

Here’s how HELOCs compare to home equity loans and cash-out refinances:

Home Equity Loan Vs. Home Equity Line Of Credit

A home equity loan is similar to a HELOC. It’s a type of second mortgage that uses your home as collateral. The key difference between these two is that a home equity loan is an installment loan. You borrow the money once and then repay it over a set repayment term. Home equity loans also typically have fixed interest rates, while HELOCs have variable rates.

Here are some key differences between the two loan types:

Cash-Out Refinance Vs. Home Equity Line Of Credit

A cash-out refinance is another possible alternative to a HELOC. Like a HELOC, a cash-out refinance allows you to borrow against your home equity. But instead of taking out a line of credit in addition to your mortgage, you’re replacing your mortgage entirely.

When you get a cash-out refinance, you borrow more than you currently owe on your mortgage. A portion of the loan goes to repay your current mortgage, and you get the rest in cash. You can use that cash for any reason, including any of the reasons one might use a HELOC.

An advantage of a cash-out refinance is that you still only have one monthly payment and may get a lower interest rate than a HELOC. However, you may not be able to get as low of an interest rate as you currently have on your mortgage, which could increase your total costs significantly.

Personal Loan Vs. Home Equity Line Of Credit

A personal loan is an unsecured loan, meaning it doesn’t have collateral. It’s the only loan on this list that isn’t secured by your home. The downside of that is you’ll probably have a higher interest rate. However, you also won’t have to put your home at risk.

A personal loan can be used for just about any purpose, including debt consolidation, home improvements, large purchases, financial emergencies and more. A personal loan could be a good option for someone who doesn’t feel comfortable borrowing against their home or someone who doesn’t have enough equity in their home to get a HELOC.

FAQs On Home Equity Lines Of Credit

Are you considering getting a HELOC? Here are a few more things you’ll want to know before you get started:

How much does a HELOC cost?

Closing costs on a HELOC typically range from 2% – 5% of the credit line amount. Additionally, there may be an annual fee, which can range from as little as $5 to hundreds of dollars, depending on the lender.

How long does it take to get a HELOC?

It generally takes between 2 – 6 weeks to get a HELOC. The amount of time it will take depends on your lender, how quickly you’re able to provide documentation to your lender, and how complex your financial situation is.

Is interest on a HELOC tax-deductible?

The interest on a HELOC may be tax-deductible if you use it to buy, build or substantially improve your home. You can’t deduct your interest if the funds are used for other purposes.

How can I increase my HELOC limit?

If you want to adjust your HELOC limit, contact your lender. However, not all lenders allow you to adjust an existing HELOC. If your home equity has increased and you want a higher limit, you may need to refinance your HELOC to one with a higher limit.

The Bottom Line: Leverage Home Equity With A HELOC If You’re Financially Prepared 

A HELOC is a flexible financial tool that allows you to borrow against the equity you’ve built up in your home and use the money to consolidate debt, improve your home, make a large purchase and more. Though HELOCs have some major advantages, they also have some complexities and risks, so it’s important to understand how they work before you apply.

If you need money and want to use your home, you can also consider a cash-out refinance. Apply to refinance your mortgage today to see if a cash-out refinance is right for you.