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A home is one of the most valuable assets most of us will ever own. It's not as liquid as cash, where you can simply use an ATM to withdraw money whenever you want, but you do have several options to borrow against the equity you have built up in your home.
One popular way to access the value of a home is a home equity line of credit, or HELOC. A HELOC is a type of second mortgage that allows you to borrow against the value of your home to make purchases as needed and repay them over time. Here's what you need to know about HELOCs, including their benefits and downsides and how to apply for one.
How a Home Equity Line of Credit Works
A HELOC is a type of revolving credit line that allows you to use your house as collateral in order to borrow against the equity in your home. Like with a credit card, you'll have a credit limit you can borrow up to repeatedly as you make purchases and pay down your outstanding balance. As such, you can borrow again as needed, and you can borrow as little or as much as you like up to your credit limit.
HELOC lenders will generally let you borrow between 60% and 85% of your home's current appraised 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, lender, your creditworthiness and other factors.
HELOCs usually come with variable rates, although fixed-rate HELOCs are becoming more common. A HELOC term can last up to 30 years and involve two periods:
- Draw period: Typically, you can draw on the line of credit for 10 years. 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.
- Repayment period: 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.
Pros and Cons of a HELOC
As with any line of credit, it's wise to carefully weigh the pros and cons of a HELOC to determine whether this line of credit is your best option.
Pros of a HELOC
- Lower interest rates than unsecured credit: Your lender's risk is lower than with an unsecured loan or credit card because it uses your home as collateral. For this reason, HELOCs typically come with lower interest rates.
- Larger loan amounts than other options: 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 the uber wealthy, but for most of us, a HELOC is an easier way to access that much credit.
- Better control over the borrowing amount: Most loans require you to borrow the entire amount in one lump sum. But as a line of credit, a HELOC allows you to 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.
- Repayment term is flexible: HELOC terms vary by lender, but your lender may provide flexible repayment terms. For example, some lenders offer a discounted interest rate for a short time, called an introductory rate, which can temporarily make your monthly payments more manageable. If your lender allows it, you may be able to pay an additional amount towards the principal during the draw period, which could minimize the payment increase when you enter the repayment period.
Cons of a HELOC
- Puts your home at risk: The biggest downside to a HELOC is the requirement to use your home as collateral to secure the credit line. If you fail to repay your HELOC, your lender could foreclose on your home.
- Lowers your equity: Any funds you access through your HELOC come directly from your home's equity. That may not be a problem now, but it could be in the future. If your property value drops significantly and you've pulled a lot of money out of your home's equity, you could end up underwater on your home loan, owing more than the home is worth.
- Significant payment increase during the repayment period: Your payments will increase substantially when the draw period ends because you'll have to pay off the loan principal. 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.
- May include a "balloon" payment: Be aware, some lenders include a balloon payment at the end of the draw period. That means you must make one lump-sum payment to pay off the entire balance plus interest at that time. Before you take out a HELOC, make sure you understand the terms of the HELOC and verify whether a balloon payment is required.
How to Qualify for a HELOC
Qualifying for a HELOC involves submitting your application, providing documentation to support the information in your application and fulfilling the lender's requests while you await approval. Eligibility conditions vary by lender, but standard requirements include the following:
- Sufficient equity: When you apply for a HELOC, your lender will likely conduct a property appraisal to determine the value of your home so they can establish how much equity you have. You'll likely need at least 15% to 20% equity to qualify for a HELOC.
- Good or excellent credit: Minimum credit score requirements vary, but HELOC lenders typically want a credit score of at least 680; 700 is better, and some may require a score of 720 or more.
- A satisfactory debt-to-income ratio (DTI): To assess your ability to repay the line of credit, lenders will also consider your DTI—the percentage of your total income that goes to pay outstanding debt. As a general rule, the lower your DTI, the better your odds of approval are, and it should not exceed 43%.
- Adequate income: Lenders will want to review your pay stubs, W-2s, tax returns or other proof of income to demonstrate you have sufficient income to repay the HELOC.
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 to Apply for a HELOC
The time frame to get a HELOC can take two to six weeks or longer. You can help ensure the process runs efficiently by submitting any documents the lender requests promptly. Follow these steps to apply for a home equity line of credit:
- Be ready with your documents. You'll be able to submit your application faster and respond to your lender's subsequent requests right away if you have all the documents you'll need to get a HELOC. Before you apply, ask your lender for a list of documents they'll request, which will likely include your pay stubs, tax returns, bank statements, mortgage statements and home insurance information.
- Schedule an appraiser if necessary. Your lender may require a home appraisal to determine your home's estimated value. In that case, you'll want to schedule one as soon as possible. Keep in mind that it could take several days before an appraisal can inspect your home and another week or longer to prepare a thorough report.
- Fill out the application. Fill out your application completely, referring to the information you have already gathered as necessary. After you submit your application, you should hear from a lender representative within a few business days to review your application and potentially request additional documentation.
- Wait for an approval decision. Perhaps the hardest part of applying for a HELOC is waiting for a decision while the bank or lender underwrites your loan. This underwriting period can last up to 30 days. Underwriting is the process of reviewing your income, credit, debt and other eligibility criteria to determine if you qualify for a loan, or in this case, a HELOC.
- Close your loan and wait for funding. If approved, all that's left to do is sign your loan documents and close the loan, typically within one week. Bear in mind, this week includes a three-day rescission period when you can change your mind and cancel the 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. Consistently making your HELOC payments can positively influence your credit score since your payment history accounts for 35% of your FICO® Score☉ , which is used by 90% of top lenders. Conversely, making even one 30-day late payment can harm your credit.
Additionally, 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). That's because your credit utilization ratio—which measures the amount of your available credit you're using—makes up 30% of your credit score. However, this can be risky since you're converting unsecured debt to secured debt that's collateralized by your home.
If you don't already have a line of credit, adding a HELOC to your credit profile may improve your credit mix, which accounts for 10% of your credit score. Credit scoring models use credit mix to assess how well you manage different types of credit, such as credit cards, mortgages and other installment loans.
Remember, your lender will perform a hard credit inquiry to review your credit. As a result, your score may experience a temporary drop of a few points, but the inquiry's impact will diminish over time.
What Are the Alternatives to a HELOC?
A HELOC is one of many options when you need to remodel your home or pay for other large expenses. Other alternatives to consider include:
- Personal loan: A personal loan doesn't require collateral, so unlike 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. There are many differences between a personal loan and a line of credit; chief among them is that a personal loan will fund the entire loan amount in one lump sum. Personal loans typically come with shorter repayments than HELOCs, ranging from one to seven years.
- Home equity loan: As with a HELOC, a home equity loan involves borrowing against the equity in your home. However, instead of a revolving line of credit, you'll receive one lump sum. Generally, the interest rates on a home equity loan are fixed, so you'll repay the loan in monthly installments that remain the same over the life of the loan. A home equity loan is similar to a HELOC in that it uses your home as collateral to secure the loan, so you could potentially lose your home if you fall behind on your payments.
- Cash-out refinancing: A cash-out refinance involves replacing your existing mortgage with a new, larger one. You may not want to replace your mortgage if the interest rates are higher than when you took out your current mortgage. You can use the loan proceeds to pay off your original mortgage and receive the excess amount in one lump sum, which you can use for virtually any purpose.
- 0% Introductory APR credit card: If you have excellent credit, you may qualify for a 0% introductory annual percentage rate (APR) credit card. Introductory periods vary by lender, but you may qualify for a card with an interest-free period of up to 21 months if you make your payments on time. However, if you fail to repay the balance in full before the introductory period ends, the remaining balance will be charged at the card issuer's standard rate, which can be very high. According to the Federal Reserve, the average interest rate for credit cards in the fourth quarter of 2022 was 20.40%.
The Bottom Line
A HELOC can help you achieve an important goal, like consolidating high interest credit cards or financing a home renovation project. However, the risk with a HELOC is considerable since it involves using your home as collateral. In a worst-case scenario, you could lose your home if you default on the loan.
That's why it's essential to consider all your options carefully. You may want to check your credit score for free to know which options are most realistic for you. It's also a good idea to check your credit report for any erroneous information that may hurt your credit score. Improving your credit before applying for a HELOC, or any credit product may boost your approval odds and interest rates.