What is a HELOC? Everything to Know About Home Equity Lines of Credit

For many, the Great American Dream still is home ownership. Owning your home can provide profound emotional benefits and a sense of security. It also has financial dividends, such as equity accumulation, which is the home’s resale value minus the mortgage balance.

You can tap your home’s equity for cash through a home equity loan or a home equity line of credit (HELOC). A HELOC is a revolving credit source based on the equity you’ve accumulated in your home. 

A HELOC lets you borrow up to a set amount of money using your home’s equity as collateral. Unlike other lines of credit, you only pay interest on the amount you draw, not the entire credit line.

Draw Period

During your draw period, which usually lasts 5 to 10 years, you can borrow money from your HELOC as needed, up to your credit limit. 

You can use the money you draw on anything you like. You also control how quickly you repay the loan, though a minimum payment is due each month. In other words, you can regulate your cash flows out of and into a HELOC.

If you stay within your credit limit, you can borrow, repay, and borrow again. This is useful when you need money in an emergency or plan a big-ticket purchase.

The price of this flexibility is the interest the HELOC charges.

Repayment Period

The repayment period begins after the draw period ends. It typically lasts 10 to 20 years, during which you can no longer borrow money through the HELOC. You must repay the principal and the interest once you enter the repayment period.

During the draw period, you can choose to make payments solely on the interest. 

Suppose you’ve only been making interest payments. Your monthly expenses will increase because you are now paying back the principal and interest. You’ll know well in advance when the repayment period begins, giving you ample opportunity to budget your payments.

It’s essential to stay up to date on repayments. If you don’t, you risk losing your home through foreclosure.

Some HELOCs allow you to refinance the loan or extend the repayment period. If you exercise this privilege, you’ll pay extra fees, and your interest rate may change. Your HELOC agreement will explain all the details. 

You must repay the total outstanding balance by the end of the repayment period, which may require paying a lump sum. 

Fixed and Variable Interest Rates

HELOCs can have fixed or variable interest rates. A fixed-rate stays the same for the entire term, whereas a variable rate can change over time.

Variable rates can start lower than fixed rates but usually increase over time. You won’t necessarily know how much your interest rate will change. However, a HELOC may set caps for the maximum amount. Unpredictable rates are risky because they may go high enough to threaten your budget.

Some HELOCs offer a combination of fixed and variable rates. You may start with a variable rate and switch to a fixed rate later. Often, variable-rate HELOCs begin with a fixed rate that lasts for a specified period.

Access to Funds

It’s easy to access funds from your HELOC. You can write a check, use a linked debit card, or request an online transfer to another account. You don’t need special permissions to access your credit line if you don’t overdraw the account.

You can borrow as much or as little as you need, up to your credit limit. As your home equity grows, you can request an increase in your credit limit. Your equity can expand through your regular mortgage payments, an increase in the home’s selling price, or a combination of the two.

The lender will send you a monthly statement similar to that from credit cards. It outlines your current balance, minimum payment due, your activity during the billing period, and the interest you’ve accrued. 

Typical Uses

You can use a HELOC for many reasons. Home improvements are a common choice because they can increase your home’s value. This may allow you to get a higher credit limit. Other popular uses include paying for education or consolidating higher-interest debt.

A HELOC can also help cover unexpected expenses, such as medical bills or emergency repairs. It can be cost-effective because the interest rate is usually lower than that of credit cards and personal loans.

Using a HELOC responsibly can improve your financial situation if you repay it on time. Failure to do so can wreck your finances, leading to foreclosure, ruined credit, and possible bankruptcy.

Lenders look at several factors to gauge your eligibility for a HELOC. They assess your credit score, the amount of equity in your home, and your income and debt levels. 

Each lender has different standards, so shop for the best rates and terms. 

Typical Eligibility Requirements

Lenders usually only approve a HELOC if you have a good credit score. An average FICO score of 620 or higher from the three major credit bureaus is enough to qualify in most cases. Some lenders are stricter, especially if you want a low interest rate.

Other lenders specialize in consumers with bad credit. Your credit score predicts the chances you’ll default on your loan within the next two years.

You can get a HELOC even if you have poor credit, but the lender will charge a higher interest rate and reduce the percentage of the equity you can borrow. It’s a good idea to check your credit report and improve your score before applying.

Lenders typically require at least 15% to 20% equity in your home to qualify for a HELOC. They want to be sure they can get their money back if they foreclose on the house. Equity motivates borrowers to make payments since they may lose their equity and home if the lender forecloses. 

Lenders also check your debt-to-income (DTI) ratio to see if you rely too much on credit. Your DTI ratio is your monthly debt payments divided by your monthly income.

A 43% DTI ratio is the highest you can have and still qualify for a government-backed mortgage. However, many banks and lending institutions state that a DTI ratio higher than 36% would cause for denial.

You will seldom get a HELOC for 100% of your equity. Instead, expect to receive a credit line equal to about 80% of your equity. You don’t get 100% because lenders may need to tap the unused equity to pay for expensive foreclosure proceedings and the home’s forced sale, typically at auction. The extra equity also cushions the lender should housing prices fall.

The Application Process

To apply for a HELOC, research different lenders and compare their offers. Key factors include interest rates, fees, and repayment terms. One of the most significant costs is the origination fee, which covers processing your application and underwriting the credit line. The fee typically ranges from 0.5% to 1% of the total credit line.

For example, you can expect to pay an origination fee of $250 to $500 if you take out a $50,000 HELOC. Some lenders may waive HELOC fees if you have a relationship with them or agree to certain conditions, such as automatic payments deducted from your checking account​.

Documentation Required

You’ll need to gather your financial documents before applying for a HELOC. These documents help the lender verify your financial situation and determine your eligibility for the loan. You must submit proof of income, such as pay stubs, tax returns, and W-2 forms. These documents show you have a steady income and can repay the loan.

In addition to proof of income, you must provide information about your home. This includes a recent mortgage statement and proof of homeowners insurance.

The lender needs these documents to assess your home’s value and calculate the amount of equity you have. Personal identification, such as a driver’s license or passport, is also required to verify your identity.

The lender will have you complete and submit an application form containing information about yourself, your income, debts, home, and other pertinent data. 

Being organized accelerates the application process and shows the lender you are serious about obtaining a HELOC. You want the lender to view you as a responsible borrower, not someone who is scatterbrained.

The Appraisal Process

During the appraisal process, the lender needs to determine your home’s current market value to determine how much equity you have and how much they can lend you. A professional appraiser will visit your home to assess its value. They will examine various factors, including the condition of your home, its size, and its location.

The appraiser will also compare your home to similar homes recently sold in your area to help determine a fair market value. They will send a report to the lender, who will use this information when deciding your borrowing limit.

The appraisal process can take a few days to a week. Some lenders require thorough on-site inspections, while others may be satisfied by a drive-by appraisal. A good appraisal can unlock a larger HELOC and a reduced interest rate. The opposite is true if the lender receives an unfavorable report. 

If you can afford to do so, try to do some repairs and renovations before applying for a HELOC. Spending money upfront can result in easier approval and a larger line of credit.

Approval and Closing

The lender will decide on your line of credit once it has reviewed all your documentation and the appraisal report. If you’re approved, you’ll receive a letter describing the terms of your HELOC. The letter will include the credit limit, interest rate, and repayment terms.

The next step is the closing process, where you will sign the HELOC agreement and other required documents. The lender will explain all the terms and conditions of the loan. Don’t hesitate to ask questions if you need help understanding something.

Closing typically occurs at the lender’s office, a title company, or a lawyer’s office. You will pay any outstanding fees at this time. Once you sign the documents, the lender will set up your HELOC account, and you can access the funds as needed. 

The entire process can take a few weeks from application to closing. Some lenders advertise faster turnaround times, as short as 48 hours, but you should be skeptical about these deals. When lenders move too fast, that can be a red flag that the company doesn’t want you to do more research or comparison shopping. 

As with everything financial, HELOCs have strengths and weaknesses. Consider the big picture before deciding to add one to your financial arsenal.

Benefits

• On-Demand Access to Funds: Unlike other loans, you can determine precisely how much you can borrow, up to your credit limit, and can do so at any time during the draw period. Compared to a traditional unsecured credit card, a HELOC typically offers lower interest rates and spending flexibility but lacks rewards and perks.
• Use for Multiple Purposes: There are no restrictions on using the funds. Typical uses include home improvements, large purchases, education costs, or debt consolidation. HELOCs are also an excellent source of emergency funds when you need them. You may want to open a HELOC precisely for this reason.
• Repayment Flexibility: During the draw period, you can make interest-only payments. That can be useful if your goal is holding on to as much money as possible. However, you can repay the principal during the draw period, reducing your debt and total interest costs. The choice is yours, but if you repay only the interest, you will have more to pay back during the repayment period. If you plan to sell the house before the repayment period begins, this might not concern you. 
• Lower Interest Rates: HELOCs are collateralized debt, which makes them cheaper than credit cards and personal loans. The average interest rate for a HELOC is around 7% to 8.5%. Rates can vary depending on your lender, credit score, and other factors. The average interest rate for personal loans is between 10% and 15%, and credit card APRs average around 22%. A HELOC may save you thousands in interest over the draw period.

Drawbacks

• Potential for Rate Increases: Most HELOCs have variable interest rates, which means your payments can increase over time. Before agreeing to a variable-rate HELOC, you should factor in the maximum rate increases. Variable-rate HELOCs usually come with rate caps and floors, limiting how high or low your interest rate can go. Plug these numbers into your calculations when you figure out how much a HELOC will cost.
• Impact on Monthly Payments: As you borrow more from your HELOC, your monthly payments will increase, especially once you enter the repayment period. Higher costs can strain your budget, perhaps to the breaking point. As mentioned earlier, you may be less concerned about the monthly payments if you plan to sell your home before the draw period expires.
• Defaulting on Payments Risks Your Home: Because HELOCs use equity as collateral, defaulting on payments will almost certainly lead to foreclosure. That’s a hefty price to pay for a low-interest loan. During the foreclosure process, the court may evict you from your home, the lender could seize and sell it (typically via an auction), and you’ll receive only the money left after repaying the debt, legal costs, and fees. Your credit score will suffer, and the foreclosure will remain on your credit reports for seven years. Employers and landlords may shy away from dealing with you, and you will have to live with the emotional scars of losing your home and your credit standing.

Despite its drawbacks, a HELOC can be an excellent option to maintain access to cash. As with any collateralized loan, ensure you can repay it so you don’t forfeit your property.

You can use your home as collateral in other ways, including a home equity loan or a cash-out refinance. These two methods are best when you want a lump-sum loan rather than a revolving line of credit.

Home Equity Loan

A home equity loan uses your home as collateral. It allows you to borrow a lump sum based on the equity in your home. 

To qualify, you need a good credit score and sufficient home equity. Once approved, you receive the loan amount as a lump sum and repay it with fixed monthly payments over 5 to 15 years. 

The interest rate for a home equity loan is fixed, so your payments remain unchanged throughout the loan term. The lender can foreclose on your home if you fail to repay the loan. You can use the loan to pay for anything, including home improvements, medical bills, or debt consolidation.

Cash-Out Refinance

A cash-out refinance is a loan option in which you replace your existing mortgage with a new, larger one and take the difference in cash. This option allows you to access the equity you have built up in your home. 

You pay off your original mortgage and receive the remaining cash when approved. The new mortgage typically has a different interest rate and term, which can change your monthly payments. 

When you opt for a cash-out refinance, several fees are involved. These fees are similar to those you would encounter with a traditional mortgage. Here are some standard fees:

• Origination Fee: This fee pays the lender’s costs for processing your new loan. It is typically around 0.5% to 1% of the loan amount.
• Appraisal Fee: The lender requires an appraisal to determine your home’s market value. This fee usually ranges from $300 to $500.
• Title Search and Title Insurance: These fees ensure the property title is clear of any liens or issues. Title search fees can be around $75 to $200, and title insurance can cost between 0.5% to 1% of the loan amount.
• Credit Report Fee: Lenders check your credit report as part of the approval process. This fee is typically between $25 and $50.
• Recording Fee: You pay this fee to the local government to record the new mortgage and release the old one. It usually ranges from $50 to $150.
• Attorney or Document Preparation Fees: In some states, an attorney must review the loan documents. Depending on the transaction’s complexity, this fee can range from $200 to $1,000.
• Points: You can pay points to reduce your interest rate. One point equals 1% of the loan amount. Points are optional but can lower your monthly payments.
• Escrow and Settlement Fees: These fees cover the costs of managing the loan transaction, such as handling the funds and documents. They typically range from $300 to $800.
• Prepayment Penalties: If your original mortgage has a prepayment penalty, you may need to pay it when refinancing. This fee varies depending on your existing loan terms.
• Other Miscellaneous Fees: These can include fees for flood certification, courier services, and other administrative costs. They usually add up to a few hundred dollars.

These fees could add up to 5% of the loan amount. Cash-out refinancing is helpful for homeowners who need a large sum of money and prefer to integrate it into their mortgage.

The following chart compares HELOCs, home equity loans, and cash-out refinancing:

Choose the option that makes sense for your financial needs and budget. Consider how long you plan to own your home and your fee tolerance.

A HELOC is a good alternative to a credit card or personal loan, allowing you to borrow money whenever you need it. Because a HELOC uses your home equity as collateral, you’ll pay lower interest rates, and will only need to pay off interest during the draw period. You can also use the funds for any purpose, such as home improvements or education. 

However, you risk losing your home if you default on your payments, and won’t have access to the perks a credit card can provide. It’s important to do your research before opening any line of credit. When used properly, a HELOC can be a powerful tool for managing your finances and regulating your cash flow.