HELOC: Defined
A HELOC is a loan taken out against the equity in your home. It provides you with a revolving line of credit (usually at a lower mortgage interest rate) that can be used to pay for big-ticket items. You can also use it to consolidate and pay off higher-interest debts like credit cards.
A happy family, husband, wife, and child, standing in front of their home window, showcasing the benefits of a Home Equity Line of Credit (HELOC).
Since it’s a revolving line of credit, a HELOC doesn’t come with a fixed payment schedule. You can borrow, repay, and reborrow funds up to your established credit limit. A HELOC’s flexibility is one of the biggest reasons homeowners may opt to take it on.
This post will take a closer look at the concept of a home equity line of credit, how it works, how fixed interest rates and variable interest rates apply, and some of the pros and cons of taking out a loan against your home equity.
How a home equity line of credit works
Here are the basic steps and considerations involved in obtaining home equity loans to generate cash flow:
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HELOCs are typically available through traditional lenders like banks. When applying for a home equity loan, the lender will determine your home’s value, review your outstanding mortgage payments, assess your monthly income and debts, and review your credit score and history.
In most cases, a borrower can take out a loan amount of up to 85% of their home’s value minus their outstanding mortgage balance.
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If the lender approves your application, they’ll set a limit on how much you can borrow. They’ll then set a draw period (usually ten years) during which your home equity line of credit works somewhat like a credit card. You’ll be able to access funds with a dedicated debit card or special check.
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One key aspect of a home equity line of credit is that you only make monthly payments on the amount you’ve borrowed rather than the entire credit amount. Every time you repay your HELOC, your credit renews, allowing you to borrow additional funds throughout your draw period.
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When the draw period ends, the HELOC changes over to a repayment period. In most cases, the repayment period lasts 20 years. Your payments will be set up in fixed installments against principal and interest. At this point, you can no longer borrow money against your home equity.
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Your home equity line of credit may come with minimum withdrawal requirements across the draw period, much like when retirees withdraw funds from their retirement accounts. You may also request to make larger payments against your principal during the draw period rather than interest-only payments, which is the norm.
Remember that, like a mortgage, a HELOC may come with annual fees and closing costs.
Qualifications for a HELOC
For a subject to qualify for a HELOC, they must meet specific requirements, including the following:
- Sufficient home equity: First and foremost, you must have sufficient equity built up in your home. The outstanding amount of your mortgage balance must be lower than the overall value of your home. A good benchmark is to have at least 15%–20% of equity in your home to qualify for the loan.
- Solid credit score and history: Lenders will look at your credit score and history to evaluate whether you’re a good candidate for a home equity line of credit. Most lenders look for scores of at least 620. A high score indicates that you’re a responsible, active borrower who can keep up with monthly payments.
- Debt-to-income ratio: Your debt-to-income (DTI) ratio calculates how much of your gross monthly income applies to your outstanding debt payments. Lenders prefer to see low DTI ratios in most cases. Many like to see DTI ratios of 43% or less for a home equity line of credit. This assures them that you’ll be able to manage repayments easily.
- Reliable income: Home equity lenders will also want to see a consistent stream of income. Meeting a minimum income threshold will prove you have dependable revenue to repay timely.
- Mortgage history: Lastly, your lender will look to see how you’ve paid off your mortgage. After all, these payments are the most effective way to build equity in your home.
Interest rate options
A home equity line of credit may come with different options for interest rates.
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Variable interest rate
A variable interest rate is the most common type of rate for a home equity line of credit. It correlates to a certain financial index (most often the Prime Rate) and the specific margins the lender defines. Your HELOC interest rate will do the same when the Prime Rate increases or decreases.
Most of the time, variable interest rates begin at lower points than fixed rates. This structure might work well for you if you feel confident that the Prime Rate won’t fluctuate too much over the draw period.
However, stability is never a given. In times of economic flux, the variable interest rate may increase, affecting your repayment plan. On the other hand, if the Prime Rate drops, you may have more access to credit with a variable interest rate.
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Fixed interest rate
You might also choose a HELOC with a fixed interest rate, which is locked in for the entirety of the draw period, regardless of how the Prime Rate moves. This structure makes monthly repayments on the interest more predictable and management.
Fixed rates are typically higher than variable rates, at least to begin with. They’re also relatively inflexible, which runs counter to one of the main benefits of a home equity line of credit. Additionally, your lender may impose limits on how much you borrow during the draw period to account for potential increases in rates.
Pros and cons of a home equity line of credit
A home equity line of credit can be a very useful tool for expanding your access to finances. However, it can also come with certain drawbacks that may be difficult to manage.
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Pros
Some distinct advantages of a HELOC include:
- Flexibility: Since it’s essentially a revolving line of credit, a HELOC is easy to work with. You only pay for interest on the amount you actually borrow rather than the entire mortgage amount.
- Lower interest rates: You might enjoy a lower interest rate than you would for credit cards or other loans, especially if you get a HELOC with a variable interest rate. This is particularly helpful during the draw period, when you only pay interest on the amount you borrow.
- Tax benefits: If you use a HELOC to pay for approved expenses like home improvements, there’s a good chance that the cost of those expenses is tax-deductible. A financial advisor specializing in taxes can identify what kinds of costs you can write off.
- Better liquidity: You can use your HELOC to access cash for emergencies or sudden large expenses quickly.
- Debt consolidation: You may be able to use your HELOC to manage other higher-interest loans you owe, consolidating them into a single payment with lower interest. This strategy could save you considerable money.
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Cons
All that being said, taking out a home equity line of credit can also have certain downsides, such as:
- Risk of overspending: A HELOC gives you quick access to large amounts of credit — which could lead to spending too much. This, of course, is also a common drawback of credit cards.
- Uncertainty with variable rates: Most HELOCs have variable interest rates, which are unpredictable by nature. When they go higher, the rates will increase your monthly payment schedule and strain your budget.
- Potential home foreclosure: Since your home is used as collateral in a HELOC, the lender can seize or put liens on your house if you don’t honor the terms of your loan agreement.
- Fees: Like most real estate deals, a HELOC can present a lot of unexpected expenses, including closing costs, transaction costs, and annual fees.
- Possible depreciation: If your home loses value, you may find yourself underwater if the value is less than you owe. Such a situation creates a negative equity, which could make selling or refinancing your home more difficult.
Talk to a HELOC expert
Influential publications like The Wall Street Journal frequently advise on taking out home equity loans. Although these sources are generally reliable, they’re no substitute for having a personal financial adviser to walk you through the process. Find one with experience with HELOCs to determine whether it’s the right vehicle for you.
