What Is A HELOC (Home Equity Line Of Credit)?

What is a HELOC?

A HELOC (Home Equity Line of Credit) is a variable-rate, revolving type of credit similar to a credit card. The loan line is tied to the equity in your home. You can borrow and repay funds as needed within a specified period. You will then repay the borrowed amount in installments.

Your home is the collateral for your line of credit, so if you miss a payment, your home is at risk of foreclosure.

HELOC variable rate vs. fixed rate

HELOC interest rates vary. This means that they fluctuate up and down according to general interest rate trends and change periodically. The interest rate on a HELOC is typically tied to a variable interest rate index. The interest rate on a variable HELOC reflects the performance of this index, plus an additional several percentage point markup placed by the lender.

A variable interest rate means the required minimum payment amount for a HELOC can change from month to month. However, some lenders allow borrowers to convert a portion of a HELOC’s variable rate balance to a fixed rate. As a result, you can lock in your interest rate so your payments don’t fluctuate, giving you stable and predictable repayments. This can typically be done at any time during the HELOC drawing period.

Additionally, it is possible to obtain a fixed rate HELOC. This means that the interest rate you pay on the money you borrow remains the same during the draw period and the repayment period.

How does a HELOC work?

If you’re approved for a HELOC, you’ll be given a credit limit based on the available equity in your home. Borrowers are typically able to take advantage of up to 80 percent of their home’s value minus their mortgage balance (which can be as high as 85 percent or 90 percent, depending on lender policies and eligibility).

During the initial withdrawal period, you can spend your funds using a special check, withdrawal debit card, or online transfer. You’ll have to pay interest every month on the amount you borrow, but the funds will be replenished as you pay back your HELOC. This lottery period typically lasts 10 years.

After that, the repayment period begins. During this period, you will not be able to access your funds and will instead have to repay the principal and unpaid interest. Most HELOC plans allow you to pay off your balance over a period of 10 to 20 years.

In many cases, you only need to pay interest during the draw period, but you can also pay both principal and interest at this stage if you wish. This will make it easier to manage your payments when you enter the repayment period.

“Maximize your HELOC by reviewing your balance during the draw period to make sure you’re not overspending,” says Linda Bell, senior writer on Bankrate’s home lending team. “To manage your payments effectively, you can consider options such as interest-only payments or fixed-rate conversions. By incorporating HELOC payments into your long-term financial plan, you can protect your financial well-being and maximize your potential. You can protect your home from risks.

Why HELOCs will be popular in 2024

About 1.3 million HELOCs were issued in 2023, followed by 500,000 by the second quarter of 2024, according to the New York Fed. These numbers are comparable to pre-pandemic levels. But what’s really interesting is that HELOC balances are starting to recover after nearly 13 years of decline, and are up 20% since bottoming out in 2021.

Much of its appeal lies in its flexibility. HELOC funds are available as needed and provide homeowners with a cushion against unexpected expenses. Borrowers appreciate the option of borrowing only what they need and paying interest only on what they use.

Also, it is attractive that the price has become cheaper recently. Interest rates began to retreat in early 2024 and, as of October, had fallen to their lowest level in more than a year, spurred by the Federal Reserve’s September cut in the benchmark interest rate.

HELOCs are still cheaper than other forms of consumer debt, such as credit cards or personal loans. And unlike cash-out refinancing, which is the old-school go-to way to access homeownership, a HELOC allows homeowners to continue borrowing on their mortgage at a lower interest rate.

With residential real estate values ​​on the rise, homeowners looking to take full advantage of low interest rates have plenty of assets to tap. As of August 2024, 32 million mortgage holders had at least $100,000 in available equity, and approximately 4.6 million had at least $500,000 in equity. Additionally, about 1.2 million people own more than $1 million, according to data analyst ICE Mortgage Technology.

HELOC requirements

There is no one set of requirements that fits all to qualify for a HELOC. That said, criteria generally include:

• Amount of home equity: Lenders typically require homeowners to have at least 15 to 20 percent equity in their home.
• Credit score: Homeowners typically need a credit score of at least the mid-600s to qualify for a HELOC. If you are approved with a lower credit score, you may qualify for a higher interest rate.
• DTI ratio: Many lenders want your debt-to-income (DTI) ratio to be 43 percent or less. However, some financial institutions may approve with DTI ratios up to 50%.

How to apply for a HELOC

• Review and strengthen your credit. A high credit score, ideally in the 700s, will get you the most favorable interest rates and terms. To improve your credit, make all your payments on time, collect past due payments, and work to resolve or at least pay off outstanding balances. Check your credit report and correct any errors. Do all of this several months before you actually apply.
• Find a HELOC lender. Explore and compare offers. Even a small difference in interest rates can save you thousands of yen in the long run. Find out if your HELOC lender charges an annual maintenance fee or early closing fee.
• Apply for a HELOC. Depending on your lender, there are several ways to do this: in person, over the phone, or online. No matter how you apply, you must provide your residential history, income and employment information. You’ll also need to verify your identity and give the lender permission to retrieve your credit report.
• Hurry up and wait. Your lender will order an appraisal to determine your home’s current value. The appraiser’s assessment of your home’s overall value determines how much equity is available, which helps size your loan facility. Your lender may respond with a pre-approval or initial decision within a few days. You may need to wait until the entire underwriting process is complete.

How do I access my funds using a HELOC?

To access your HELOC funds using a HELOC, you can typically use a check, debit card, or make an online transfer from one account to another. The exact method depends on the financial institution you choose.

There are a few more things to keep in mind when considering how to use your HELOC.

1. Minimum drawing requirements and potential fees: Some HELOCs may require minimum withdrawals, charge transaction fees each time you access your funds, or charge an annual maintenance fee. It is wise to clarify these terms with your lender in advance.
2. drawer: To manage your finances effectively, withdraw only the amount you need and make timely payments. This can help you minimize interest charges and positively impact your credit score.
3. Principal repayment: Many HELOCs allow you to make minimal interest-only repayments during the drawing period. Although it may be tempting, if possible, making principal payments will reduce the balance owed over the repayment period.
4. Early payoff penalty: Conversely, if you pay off your HELOC in full and terminate the HELOC early (within 2-3 years of inception or before the scheduled payment period), you may incur early termination or cancellation fees.

How much can I borrow with a HELOC?

The amount you can borrow with a HELOC depends on several factors, including your creditworthiness, the value of your home and equity, and your loan-to-value ratio (LTV), which is the total amount of your mortgage. Compare it to the value of your home. Typically, lenders will allow you to borrow up to 80 to 90 percent of your home’s equity.

For example, if your home is appraised at $300,000 and your mortgage balance is $200,000, you have $100,000 in equity. If your lender requires you to keep 20% of your equity intact, you could have an $80,000 line of credit.

You don’t have to use the entire HELOC at once. You may choose to use a portion of your allowable credit and the remaining amount will continue to be available for future use. For example, if you have $100,000 in available credit and have only used $65,000, you still have $35,000 left on your credit line. You only need to pay back the portion of the credit that you have used.

How to calculate your HELOC borrowing limit

When considering your HELOC application, lenders will consider the equity in your home. Equity is the value of your home minus any outstanding mortgage payments.

Let’s say your home is valued at $375,000 and you still owe $150,000 on your mortgage. Therefore, total assets are $225,000 ($375,000 – $150,000).

You can also determine your level of equity by calculating your loan-to-value ratio (LTV). Simply divide $150,000 by $375,000 and multiply by 100 to get the percentage. In this case, the LTV ratio would be 40%. This means you own 60% (or $225,000) of your home.

With a HELOC, you can typically borrow up to 80 percent of your total LTV (CLTV). CLTV takes into account the value of your home and your first mortgage debt, plus the maximum amount you want to borrow via a HELOC, which is the sum of all home-based debt.

Let’s say your financial institution allows up to 80 percent CLTV. Using the example above, it would look like this:

So even if your total stock is worth $225,000, your HELOC borrowing limit is $150,000.

What fees are there for a HELOC?

The cost of a HELOC depends on a variety of factors, including the lender, loan terms, interest rate, and amount borrowed. Additionally, there are additional costs such as establishment fees, application fees, and appraisal fees, also known as closing costs. Some HELOCs also have annual fees, fees to lock in the interest rate, and early termination penalties if you close the line of credit within one to two years of opening it or before the end of the repayment period. You can

Once you start looking, you can get an idea of ​​the cumulative cost of these fees by comparing your HELOC’s current interest rate to the current annual percentage rate (APR). The APR takes into account both interest and other fees. In some cases, the difference can be as much as 1 percentage point or more.

“Compare at least three lenders and consider all financing costs, not just one aspect like closing costs or interest rates, before choosing one,” says Bell. “Knowing all your costs up front will help you plan your budget and avoid any hassles down the road.”

What are the pros and cons of a HELOC?

Here are the pros and cons of HELOCs:

What should I use my HELOC for?

Best uses for a HELOC include financing home renovations and improvements, paying off or consolidating high-interest debt, and starting a business or establishing an emergency fund. But just because you can use a HELOC for most things doesn’t mean you should.

“While HELOCs offer flexibility, they may not be the best choice if your home is your primary asset or if you want to purchase unnecessary big-ticket items like luxury vacations or luxury cars.” says Bell. “Why should I risk my home for something that provides little or no long-term value?”

What should I do if I can’t open my HELOC?

If your HELOC application is denied, an important first step is to understand why. Common reasons include a low credit score, insufficient income, high debt-to-income ratio, or lack of sufficient home equity.

After you decline, consider the following steps:

1. Request a rejection letter. You have the right to receive a written explanation or rejection letter from your lender explaining the reasons for the rejection. This letter can clarify financial areas to focus on for future applications.

2. Address the reason for the rejection. Once you understand why you were rejected, you can take steps to rectify the situation. For example, if your credit score is a factor, you can focus on improving your credit score by paying your bills on time, reducing your outstanding balance, or fixing errors on your credit report. . If lack of income is an issue, you may want to consider a side job, gifts from family members, or forgivable loans.

3. Reevaluate your home. Dear Borrower, Sometimes the fault is not you but your home. If the appraisal determines it’s not enough to secure a loan line (or a larger loan line than you’d like), look carefully for errors (did you get the square footage wrong? Are you counting the numbers wrong? Are you using an old comp? You can also undergo a second appraisal at your own expense.

4. Talk to other lenders. Because different financial institutions have different risk tolerances and HELOC eligibility criteria, and some institutions specialize in serving applicants with bad credit, you may have better luck if you take your business elsewhere.

5. Consider other options. If a HELOC is not possible, other financing solutions are available, including:

• Personal loan: These are unsecured loans, so no collateral is required and it is much easier and faster to get a loan. However, the interest rate can be higher than a HELOC and the term can be shorter. One particular type of home improvement loan has more favorable interest rates and can reach amounts up to $100,000.
• Credit card: One of the most expensive forms of borrowing, five-figure credit lines can be difficult to obtain, but they are convenient and relatively easy to qualify for.
• home equity loan: This is a fixed-amount, fixed-rate loan that uses your home as collateral. The criteria are similar to a HELOC, but a HELOC may be easier to qualify for.
• cash out refinance: These reviews include exchanging your current mortgage for a new, larger mortgage. You subtract the difference in your cash reserves, but that amount is based on your home equity stake. As a mortgage loan, a cash-out REFI typically has a lower minimum credit score than a HELOC (620-640 instead of 680 or higher) and a lower interest rate. However, depending on when you got your mortgage, the interest rate could be much higher than your original mortgage, and the application process could be more onerous.

Please note that each option has its own terms and conditions and your choice depends on your individual circumstances and financial needs.

A good rule of thumb after a HELOC denial is to wait at least about six months before submitting a new credit application with the same lender.

Home Equity Line of Credit Frequently Asked Questions

Additional reporting by Mia Taylor