What is a HELOC? | Guide to Home Equity Lines
What is a HELOC?
A home equity line of credit, or “HELOC,” is a line of credit secured by your property that converts the home’s value into cash. HELOC loans are a great way to access the equity you’ve built in your home without having to sell or refinance it. If you’re considering a HELOC, here’s what you need to know.
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How does a HELOC work?
Home equity lines of credit work a bit like credit cards; these are revolving credit lines with a maximum spending limit. You can pull the line up to your credit limit whenever you need cash. When you pay back the balance (with interest), your Available Balance is replenished.
But HELOCs have some key differences compared to credit cards. Initially, you can only use the credit limit for a certain period of time (so-called drawing period), after which you can no longer borrow money and must repay the outstanding amount. Second, HELOCs are “secured loans” backed by the value of your home.
The fact that HELOCs are secured loans means borrowers get lower interest rates than credit cards or personal loans. But the downside is that, like a traditional mortgage, you face foreclosure if you don’t make loan payments. So, consider both the risks and the benefits before deciding on a HELOC.
HELOC interest rates
HELOC interest rates are generally higher than standard mortgage rates but lower than home equity interest rates. However, like credit cards, HELOCs typically have variable rates. These interest rates rise and fall based on a public index, such as the federal funds rate or the US Treasury rate. If the interest rate fluctuates, the cost of your loan will also change. That can make a HELOC more difficult to budget for than a fixed-rate home equity loan or payout refinance.
Use and Refund of Your HELOC
HELOC drawing periods typically last 10 years. During the drawing period, only interest payments are required on any amount you have borrowed under the line of credit. If you wish, you can pay more than the minimum interest rate on your HELOC and start paying off the principal. This will replenish available funds and reduce your interest debt.
After the drawing period on your HELOC has expired, you will enter the repayment phase. During this time, you will not be able to draw additional funds from your line of credit. You start paying back any outstanding withdrawals plus interest monthly.
Most HELOC terms allow you to pay back the balance over a period of 10 to 20 years. That’s a good thing, because in contrast to a classic 30-year mortgage, the shorter term means less interest. But your monthly payments will also be proportionally higher.
How much can you borrow with a HELOC?
With a HELOC, you have a credit limit based on your available home equity. Banks and lenders typically allow you to borrow up to 85 percent of the value of your home, minus any outstanding mortgage debt.
For example, let’s say your home was appraised at $300,000 and you have $200,000 in your current mortgage balance. If you’re approved to borrow up to 85 percent of the value of your home, your total mortgage (first mortgage plus HELOC) can be as much as $255,000. Since you have $200,000 left on your first mortgage, the amount you can get for a HELOC is $55,000.
Example of HELOC Loan Amount Calculation:
- Estimated value: $300,000
- $300,000 x 85%: $255,000
- Current mortgage balance: $200,000
- Available HELOC Amount ($255,000 – $200,000): $55,000
Other factors lenders consider are your debt-to-income ratio and your credit score.
How to qualify for a HELOC
Qualifying for a HELOC is similar to qualifying for a traditional mortgage. Your lender will need financial records and good credit scores that demonstrate your ability to repay. Income documents such as payslips, W-2s, and tax returns are some of the documents you will need to have ready for your lender.
Lenders have different creditworthiness requirements for a HELOC. In general, a minimum score of 620 is required. Credit values over 700 are preferred and usually result in better terms and interest rates.
Your DTI, or debt-to-income ratio, is the amount you owe on monthly debt payments like your mortgage, car loans, and credit cards in relation to your monthly income. Your lender considers your debt ratios to ensure that a new HELOC payment will not exceed your ability to repay your debt.
How to get a HELOC
When you’re ready to apply for your HELOC, follow these steps:
- Determine the amount of cash required based on your reasons for borrowing. Common reasons for completing a HELOC include debt consolidation, medical expenses, home improvement, wedding expenses, college tuition, and more
- Create a budget to ensure you are happy with the monthly payments
- Compare lenders by shopping and getting estimates. Be sure to compare not only interest rates, but also repayment terms, fees charged, and eligibility requirements
- Put the documents in order and submit an application. Most lenders have online HELOC applications to make this process quick and convenient. Be prepared to submit your income wealth documentation at the time of application
- Get a home appraisal. After the underwriter has checked your creditworthiness and income, your lender will contact an appraiser to check the current value of your home. This helps determine how much you can borrow on your HELOC. The appraiser will contact you to arrange an appointment for the valuation
- Complete the loan. Depending on where you live and your lender, a HELOC degree can be scheduled at either their office, a law firm, or possibly in your home
- Get your money. Once your cancellation period has expired, you can dispose of your credit. You can access your money when you need it, either by writing a check, making an online transfer to another account, or using a credit or debit card associated with the HELOC
The entire HELOC process from applying to receiving your funds can take anywhere from two to four weeks. The need for a home appraisal and full underwriting means HELOC loans cannot be closed immediately. However, some lenders are quicker than others, so it’s worth shopping around and asking lenders for their estimated closing times.
A HELOC is a type of mortgage loan. A HELOC is a second mortgage, meaning it is taken out on top of your primary home loan. The two loans have different terms and payments. The main difference between a HELOC and a traditional mortgage is that a HELOC is typically completed after you’ve bought your home and accumulated equity.
A HELOC is repaid to your lender in a number of ways. Most lenders only charge monthly interest payments during the first drawing period. At the end of the drawing period (usually 10 years), you start making monthly payments, which include principal and interest. If you sell your home and have a balance on your HELOC, the balance on your first and second mortgages will both be paid in full from the proceeds of the sale.
Like any other type of loan, a HELOC is not without its risks. However, they can be a great option when you need to pay off equity but don’t want to give up the low fixed rate on your existing mortgage. Another HELOC benefit is that you may be able to deduct HELOC interest charges when using the funds to buy a home or improve your existing home.
When you apply for a HELOC, your lender deducts your credit. Loan requests can temporarily lower your credit score, although the impact is small – typically 5 points or less. On your credit report, a HELOC shows up as a revolving line of credit, like a credit card. If you have too much debt and too many open lines of credit, it can negatively affect your credit rating. On the other hand, making HELOC payments in a timely and complete manner can help improve your credit score in the long run.
HELOC loans have a drawing period and a repayment period. The funds are borrowed during the drawing period, which is usually 10 years. At the end of the 10-year drawing period, the outstanding balance is converted into a loan with principal and interest for a 20-year repayment period.
Is a HELOC right for you?
Understanding how a HELOC works, how much equity of your home you have access to, and the qualifications required can help you decide if a HELOC is right for you. When you’re ready to take the next steps, speak to a mortgage lender to discuss your options.
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for the products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policies or position of Full Beaker, its officers, parent companies or affiliates.