Categories

Mortgage Basics

What Is a Home Equity Line of Credit (HELOC)?

Do you need access to a large chunk of cash, but don't have any liquid assets you can use? If you're like many Americans, your home is your most valuable asset. As you pay down your mortgage and as property values increase, you build up equity—the difference between the amount you owe on your mortgage and the current value of your home. A home equity line of credit, or a HELOC, is revolving credit that allows you to tap into that equity to borrow money.

How a Home Equity Line of Credit Works

HELOC lenders let you borrow between 60% and 85% of your home's current assessed value, minus your remaining mortgage balance. For example, suppose your house is worth $350,000 and you still owe $110,000 on the mortgage. You have $240,000 in home equity, so you might be able to borrow as much as $204,000, depending on your income, your creditworthiness and other factors.

Don't confuse a HELOC with a home equity loan. Home equity loans are installment loans, meaning you repay them over a set number of years at a fixed monthly payment and interest rate. A HELOC is revolving credit, like a credit card, so you can choose how much of the credit line to tap into. HELOCs generally have variable interest rates.

Typically, you can draw on the line of credit for 10 years (called the "draw period"). During that time, you make interest-only payments on the amount you've borrowed, although some lenders will let you make payments on the loan principal too. When the draw period ends, the HELOC closes; at that point, you have to either repay the balance (generally over a 20-year period) or refinance the loan.

What Can You Use a HELOC For?

The proceeds of a HELOC can be used for any purpose you choose. However, the most common reasons homeowners take out HELOCs include:

  • Financing home improvements: Many people use HELOCs to pay for home upgrades that will add to the value of the home. HELOCs can be a good way to finance home remodeling because they let you borrow only as much as you need for each stage of the project. Depending on how much the improvements add to your home's value, you might even be able to deduct some or all of the interest on the HELOC at tax time if you itemize deductions. Learn more about home improvement loan options.
  • Accessing lower interest rates on credit: If you are facing hefty medical bills, credit card bills or other sizable debt, you could use a lower interest HELOC to get the money you need to pay off higher interest debt. If you choose this option, however, it's important to make sure you don't get back in debt again. Otherwise, you could be putting your home at risk if you can't pay off the HELOC.
  • Paying education costs: Since education is generally considered a good investment, some people use HELOCs to pay college tuition for their children or continuing education costs for themselves.
  • Starting a business: Getting a loan to start a business can be difficult, so many startup entrepreneurs use a HELOC to finance their launch. However, it's important to weigh the potential consequences: If your business fails, you could lose both your business and your home.

What to Consider Before Getting a HELOC

Before getting a HELOC, you should carefully consider the advantages and disadvantages.

Advantages of a HELOC

  • Low interest rates: Because they're secured by your home as collateral, HELOCs have lower interest rates than unsecured loans or credit cards.
  • Large amounts: Depending on your amount of home equity, a HELOC can allow you to borrow large sums of money. Getting a credit card with a $150,000-plus credit limit might be a snap for Kim Kardashian, but for most of us, a HELOC is an easier way to access that much credit.
  • Flexibility: Unlike a loan, which requires borrowing the entire amount in a lump sum, a HELOC lets you use only as much credit as you need. If you get a $100,000 HELOC for a home remodeling project and it only ends up costing $75,000, you never have to use that extra $25,000 (which means you never have to repay it). If you had taken out a loan for that amount, you'd still have to pay back $25,000 plus interest.

Drawbacks of a HELOC

  • Reduces your equity: Building up equity in your home takes a long time. A HELOC can wipe out a substantial portion of your equity or in some cases, put you right back where you started. This can be a problem if home values in your area tend to fluctuate or if they drop unexpectedly, as happened during the 2008 recession. (In fact, if your home value declines substantially, your lender may freeze your HELOC.)
  • Sudden increase in payments: When the draw period ends, your payments will increase substantially because you have to pay off the loan principal. This can be a big blow to your budget. If you're not prepared for this expense or if your financial situation has worsened in the 10 years since you took out the loan, you could have difficulty making the payments, and you could lose your home.
  • Risking your home: The biggest disadvantage of a HELOC? You're putting your home on the line as collateral and could lose it if you can't repay the money you've borrowed.

How to Qualify for a HELOC

When you apply for a HELOC, lenders will conduct a property appraisal to determine the value of your home so they can establish how much equity you have. They will also perform a title search and conduct a credit check. Having substantial equity in your home isn't all it takes to qualify, however. HELOC lenders typically want you to have a credit score of at least 680; 700 is is better, and some may require a score of 720 or more. Your credit score and the amount of equity you have in your home are key factors in determining your loan terms. If your credit score is on the low end, having a lot of equity can balance it out. Learn more about what credit score you need to get a HELOC.

To assess your ability to repay the line of credit, lenders will also consider your debt-to-income ratio, or DTI (that is, the percentage of your total income that goes to pay outstanding debt) and how long you've been employed. They'll also be on the lookout for any past financial problems, such as bankruptcies or foreclosures, in your credit history.

Before applying for a HELOC, it's a good idea to get a free credit report and check your credit score to see where you stand. If necessary, take steps to improve your credit score before you apply; this can boost your chances of qualifying for a HELOC.

How a HELOC Can Affect Your Credit Score

As with any type of credit, the way you use your HELOC can affect your credit score either positively or negatively. For example, using the proceeds of a HELOC to pay off high interest credit card debt can help to improve your credit score (as long as you don't start running up your credit card balance again). You can also help to boost your credit score by making on-time payments on the HELOC.

Keep in mind that a HELOC also affects your credit utilization ratio—the total percentage of your available credit that you're actually using. You should aim to keep your credit utilization below 30%. If you are using the full amount of credit available in your HELOC, reduce the use of your other credit (such as credit cards) to keep your credit utilization reasonable and maintain a good credit score.

What Are the Alternatives to a HELOC?

A HELOC is not your only option when you need to remodel your home or pay for other large expenses. Other alternatives to consider include:

  • Personal loans: A personal loan doesn't require collateral, so unlike with a HELOC or home equity loan, you don't have to put your home on the line. While that's good news for your home, it also means personal loans have higher interest rates than home equity loans or HELOCs. As with any type of loan, you will receive the entire loan amount in a lump sum and make fixed monthly payments. Personal loans have shorter repayment periods than home equity loans, so they work best if you need to borrow a smaller amount of money. Find out more about the difference between a personal loan and line of credit.
  • Home equity loans: Like a HELOC, a home equity loan (sometimes called a second mortgage) allows you to borrow against the equity in your home. While a HELOC is revolving credit, a home equity loan is an installment loan. You'll receive the entire amount of the loan in a lump sum and make fixed monthly payments over the life of the loan, which can be up to 30 years (just like a first mortgage). If you know exactly how much money you need, a home equity loan can be a better option than a HELOC because it offers a predictable repayment schedule and a fixed interest rate.
  • Cash-out refinancing: If you have sufficient equity in your home, a cash-out refinance is another loan alternative that offers fixed interest rates, set monthly payments and a long loan term. A cash-out refi replaces your existing mortgage with a new, larger mortgage. You use the loan proceeds to pay off your original mortgage; then you receive whatever is left over as a lump sum in cash, which can be used for any purpose you choose.

Homeowners with lower credit scores may find it easier to qualify for cash-out refinancing than for HELOCs or home equity loans. However, keep in mind that you're now on the hook for a whole new mortgage—not just a small loan. The new mortgage may have higher interest rates than your original mortgage or require you to have private mortgage insurance (PMI), which adds to your monthly costs of homeownership. In addition, you'll have to pay closing costs on the entire amount of the mortgage, making closing costs more expensive than for a HELOC or home equity loan. Carefully consider whether a cash-out refinancing will cost you more than it will benefit you in the long run. Read more about the pros and cons of cash-out refinancing.

Understand Your Options

Having equity in your home gives you a lot of options for borrowing money or obtaining a line of credit. However, using your home as collateral can put your biggest asset at risk. Before you apply for a HELOC or any other financing secured by your home, carefully consider all your options and check your credit score to see which options are most realistic for you. By assessing the costs, risks and benefits, you'll find the option that works best for you.

Resources