HELOC: Understanding Home Equity Lines of Credit by Holden Lewis

August 23, 2019

A home equity line of credit, or HELOC, is a second mortgage that gives you access to cash based on the value of your home. You can draw from a home equity line of credit and repay all or some of it monthly, somewhat like a credit card.

With a HELOC, you borrow against your equity, which is the home’s value minus the amount you owe on the primary mortgage. This means:

You could lose the home to foreclosure if you don’t make the payments because you use the home as collateral.
You have to have plenty of equity to get a HELOC. Typically, a HELOC lets you borrow up to 85% of the home’s value minus the amount you owe on the loans.

The best reason to get a home equity line of credit is for something like a major repair or remodeling project that increases the value of your home. A reason not to get a HELOC is the risk of losing your home if you can’t pay back what you borrow.

Do I qualify for a home equity line of credit?

To get a home equity line of credit, you’ll typically need a debt-to-income ratioin the lower 40s or less, a credit score of 620 or higher and home value that’s at least 15% more than you owe.

How a HELOC works

Much like a credit card that allows you to borrow against your spending limit as often as needed, a HELOC gives you the flexibility to borrow against your home equity, repay and repeat.

Say you have a $500,000 home with a balance of $300,000 on your first mortgage and your lender is allowing you to access up to 85% of your home’s equity. You can establish a HELOC with up to a $125,000 limit:

$500,000 x 85% = $425,000.
$425,000 – $300,000 = $125,000, your maximum line of credit limit.

Most HELOCs have variable interest rates. This means that as baseline interest rates go up or down, the interest rate on your HELOC will adjust, too.

To set your rate, the lender will start with an index rate, like the prime rate or Libor (a benchmark rate used by many banks), then add a markup depending on your credit profile. Variable rates leave you vulnerable to rising interest rates, so be sure to take this into account.

How do you pay back a home equity line of credit?

A HELOC has two phases. First is the draw period, followed by the repayment period.

A HELOC has two phases. First is the draw period, followed by the repayment period.

During the draw period, you can borrow from the credit line by checkbook or card. The minimum payments often are interest-only, but you can pay principal if you wish. The length of the draw period varies; it’s often 10 years.

During the repayment period,you no longer borrow against the credit line. Instead, you pay it back in monthly installments that include principal and interest. With the addition of principal, the monthly payments can rise sharply compared with the draw period. The length of the repayment period varies; it’s often 20 years.

Home equity loan or line of credit?

While a HELOC behaves like a revolving line of credit, letting you tap your home’s value in just the amount you need as you need it, a home equity loanprovides a lump-sum withdrawal that’s paid back in installments.

Home equity loans are usually issued with a fixed interest rate. This can save you future payment shocks if interest rates are rising. Work with your lender to decide which option is best for your financing needs.

» MORE: Home equity loan vs. line of credit: pros and cons

Reasons to get a home equity line of credit

A HELOC is often used for home repairs and renovations. A bonus: The interest on your HELOC may be tax-deductible if you use the money to buy, build or substantially improve your home, according to the IRS.

Some use home equity lines of credit to pay for education. Financial advisors generally don’t recommend using a HELOC to pay for vacations and cars because those expenditures don’t build wealth, and may put you at risk of losing the home if you default on the loan.

Reasons to avoid a home equity line of credit

A HELOC introduces the risk of foreclosure if you can’t pay the loan. Consider tapping an emergency fund or taking out a personal loan instead.

Regardless of your goal, avoid a HELOC if:

Your income is unstable. If it’s possible that your income will change for the worse, a HELOC may be a bad idea. If you can’t keep up with your monthly payments, a lender might force you out of your home.

Those upfront costs may not be worth it if you need only a small line of credit.

You can’t afford the upfront costs. A HELOC may require an application fee, title search, appraisal, attorney’s fees and points. These charges can set you back hundreds of dollars.

You aren’t looking to borrow much money. Those upfront costs may not be worth it if you need only a small line of credit. In that case, you may be better off with a low-interest credit card, perhaps with an introductory interest-free period.

You can’t afford an interest rate increase. HELOCs have adjustable rates. The loan paperwork will disclose the lifetime cap, which is the highest-possible rate. Could you afford that? If not, think twice about getting the loan.

You’re using it for basic needs. If you need extra money for day-to-day purchases, and you’re having trouble just making ends meet, a HELOC isn’t worth the risk. Get your finances in shape before taking on additional debts.

Getting the best HELOC rate

This one’s on you: The more you research, the bigger your reward. As you look for the best deal on a home equity line of credit interest rate, get quotes from various lenders.

Get a quote and compare its rates with at least two other lenders.

First, make sure your credit score is in good shape. Then, check your primary bank or mortgage provider; it might offer discounts to existing customers. Get a quote and compare its rates with at least two other lenders. As you shop around, take note of introductory offers, initial rates that will expire at the end of a given term.

Look into the caps on your interest rate, both the lifetime cap, and a periodic cap if it applies. Caps are the maximum limits on interest rate increases. The annual percentage rate on your HELOC is most likely variable; it fluctuates with the market. Make sure you know the maximum rate you could pay — and that you can afford the payments based on it.

» MORE: 9 tips for getting the best HELOC rate

Steps for getting a home equity line of credit

Since a HELOC is a second mortgage, the process of getting one is similar to that of getting a mortgage to buy or refinance a home. You’ll provide some of the same documentation and demonstrate that you’re creditworthy. Here are the steps you’ll follow:

Determine whether you have sufficient equity, using a HELOC calculator.
Once you determine that you have enough equity, shop HELOC lenders.
Gather your documentation before you apply so the process will go smoothly. See this checklist of documents needed for a mortgage preapproval.
Once you have pulled together your documentation and selected a lender, apply for the HELOC.
You’ll receive disclosures. Read them carefully and ask the lender questions. Make sure the HELOC will fit your needs. For example, does it require you to borrow thousands of dollars upfront (often called an initial draw)? Do you have to open a separate bank account to get the best rate on the HELOC?
The underwriting process can take hours to weeks, and may involve getting an appraisal.
The final step is the loan closing when you sign paperwork and the line of credit becomes available.

How a HELOC affects your credit score

Although a HELOC acts a lot like a credit card, giving you ongoing access to your home’s equity, there’s one big difference when it comes to your credit score: Some bureaus treat HELOCs of a certain size like installment loans rather than revolving lines of credit.

This means borrowing 100% of your HELOC limit may not have the same negative effect as maxing out your credit card. Like any line of credit, a new HELOC on your report will likely reduce your credit score temporarily.

» MORE: Get your free credit score report