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

What Is a HELOC?

A HELOC is a line of credit that allows you to access a portion of the equity in your home, using your home as collateral. Equity is your home's appraised value minus what you owe on your mortgage. Put another way, it's the amount of your home you actually own. Lenders typically allow you to borrow up to 85% of your home's equity.

With a HELOC, you can draw funds when needed for a set period of time, as opposed to in one lump sum (as with a home equity loan). It could be a good option for covering a variety of expenses, such as:

• Financing home renovations
• Covering emergency home repairs
• Consolidating high-interest debt
• Preparing your home for sale

For example, if you're using HELOC funds to pay for a home renovation project, having the flexibility to draw funds as needed can be beneficial if the project has multiple stages or the contractor goes over budget. You can access additional funds up to your credit limit when needed without having to reapply for a loan.

How a HELOC Works

A HELOC works much like a credit card. You can borrow money when you need it up to your credit limit, and only pay interest on the amount you use. Be aware, however, the HELOC uses your house as collateral, so if you default, your lender could foreclose on your home.

Most HELOCs come with variable rates, but fixed-rate HELOCs are becoming increasingly available. HELOCs consist of two periods:

• Draw period: The draw period typically runs five to 10 years, during which time you can borrow as little or as much as you like up to your credit line. Depending on your lender, your payments may be for interest only, or they may include a portion of the principal. You can no longer withdraw funds when the draw period ends.
• Repayment period: Once the draw period expires, the repayment period begins, typically lasting 20 years. During this time, you'll make payments covering both the principal and interest at a variable rate. Alternatively, your lender might require a large balloon payment to pay off the remaining balance. Make sure you understand the payment schedule and repayment terms of any HELOC before signing for one.

Learn more >> What You Need to Know About HELOCs

How Much Does a HELOC Cost?

Like any loan or line of credit, it's essential to understand a HELOC's associated costs, such as:

Interest Rate

HELOCs usually have variable interest rates, meaning your rate can be adjusted each month. Your lender calculates your HELOC rate each month by adding a margin to an index, such as the prime rate. This can cause your payments to go up or down.

Learn more >> What Is a Good HELOC Interest Rate?

Closing Costs

Closing costs on a HELOC vary by lender, with most charging 2% to 5% of the loan amount. If you take out a HELOC for $200,000, for example, you could be looking at paying between $4,000 and $10,000 in closing costs.

It's possible to find HELOCs without closing costs, but you may have to keep the line open for a specific period, so you won't be able to repay your HELOC early without a penalty. Included in the closing costs are a variety of expenses, including:

• Origination fee: Lenders charge this fee to set up and process your loan, including verifying your financial information and determining your eligibility. The origination fee typically costs around 0.5% to 1% of your loan.
• Appraisal fee: Lenders require an appraisal to determine your home's value and confirm you have enough equity to qualify for a HELOC. The fee for this service varies widely by location and the size of your property but starts at roughly $300.
• Title search fee: The purpose of the title search fee, with costs from $75 to $200, is to check public records to ensure there are no liens or ownership disputes on the home.
• Credit report fee: Of course, your lender will want to review your credit to see how well you manage debt and check your credit score. The fee for this service costs about $35 per applicant.

Other Fees

In addition to your rate and closing fees, your HELOC may be subject to additional fees, such as:

• Annual fee: A yearly charge to maintain your account.
• Transaction fee: A fee charged each time you withdraw funds from your HELOC.
• Inactivity fee: A fee charged if you don't draw from your HELOC for a specific period.

Remember, every lender's rates and fees are different, so shop and compare to find the lowest rates, favorable terms and limited fees.

What You Need to Qualify for a HELOC

There are a few eligibility criteria you should be aware of before applying for a HELOC. Qualifications vary by lender, but standard requirements include the following:

• Adequate equity: When you get a HELOC, you must get a professional appraisal to determine your home's current value and how much equity you have. Most HELOC lenders require you to have a minimum of 15% to 20% equity in your home.
• Strong credit: Each HELOC lender sets its own minimum credit score requirement, but most want your credit score to be at least 680, with some requiring a 720 score or higher.
• Steady income: Be prepared to show proof of income, such as recent pay stubs, W-2s or income tax returns, to show you bring in enough to support a new HELOC payment.
• Low debt-to-income ratio (DTI): One of the most critical factors lenders review is your DTI ratio, which measures the percentage of your gross monthly income used to cover your monthly debts. As a general rule, the lower your DTI, the better your approval odds, and many lenders set their DTI limit at 43%. A low DTI ratio shows lenders you keep your debts low compared to your income and are more likely to make good on your monthly HELOC payments.

Keep in mind, borrowers with substantial home equity, high credit scores and low DTIs may qualify for better interest rates and a larger draw maximum. So, 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.

Learn more >> Requirements for a Home Equity Loan or HELOC

How to Get a HELOC

The timeline to get a HELOC can be two to six weeks or longer once you find a lender you want to use. You may avoid delays by promptly submitting any supporting documents your lender requests.

1. Research Lenders

Shopping lenders to find the best rate and terms on your HELOC is an important first step. You can start with your current mortgage lender, but also consider additional banks, credit unions and online mortgage lenders that offer HELOCs (not all do) to compare offers. Getting prequalified could help you find out how much lenders are willing to let you borrow. Gather at least three HELOC estimates, comparing rates, fees and draw and repayment periods to get the best deal.

2. Gather Your Documents

Before filling out the HELOC application, ask your lender what documents they require so you can begin collecting them. Having your supporting documents handy will help you complete the application faster and respond to your lender's requests for additional information. Standard documents you may wish to gather include proof of income, bank account statements, mortgage documents and homeowners insurance details.

3. Schedule an Appraisal

Your lender will likely require a home appraisal to get an accurate estimate of your home's value. This process has the potential to delay your approval. Since it could take several days for an appraiser to inspect your home and another week to prepare a thorough report, you should schedule an appraisal as soon as possible.

4. Complete the HELOC Application

Fill out your application completely, referring to the information you have already gathered as necessary. After you submit it, you should hear from a lender representative within a few business days who will review it and potentially request additional documentation.

5. Wait for an Approval Decision

The underwriting process for a HELOC can take up to six weeks. During this time, your lender will review your income, credit, debt and other eligibility criteria to decide whether to approve you for a new HELOC.

6. Sign Your Loan Documents

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.

Learn more >> How Long Does It Take to Get a HELOC?

Should You Get a HELOC?

A HELOC can offer lower rates than credit cards and other financing options, but it uses your home as collateral, a serious risk you must consider. Consider these pros and cons of HELOCs before you take one out.

Pros

• Lower interest rates: Because your HELOC is backed by your home, your lender assumes less risk than creditors offering credit cards and other unsecured loans, which typically translates to substantially lower interest rates.
• Large borrowing amounts: If you have substantial home equity, you may qualify for a much larger amount than you would with other payment forms. If eligible, you may qualify to borrow up to 85% of your home equity, or $85,000 for every $100,000 of home equity (minus fees).
• More control over funds: Unlike most loans, which distribute funds in one lump sum, a HELOC allows you to draw as much or as little as you need, as often as you like, up to your limit during the draw period.
• Potential tax benefit: You may be eligible to deduct your HELOC interest on your income taxes if your HELOC funds are used to improve your home and you meet borrowing limits.

Cons

• Risks your home: You could lose your home to foreclosure if you default on your HELOC.
• Reduces your equity: When you draw funds from your HELOC, you lower your home equity. This isn't as much of a problem when home prices are rising as when they are falling. If your property value falls and you've borrowed heavily from your HELOC, you could end up with negative equity and owe more than the home is worth.
• Payments spike during the repayment period: Be prepared for the payment amount to jump when the draw period ends and you begin making payments on the principal and interest. Or, your lender may require a balloon payment to pay off the entire balance in one lump-sum payment.
• Payments are unpredictable: HELOCs usually have variable interest rates, so they could change over time. Your payments could be much higher than you planned for during your repayment period.

Alternatives to HELOCs

While HELOCs are a popular choice among borrowers looking to remodel their home or cover other expenses, they're not your only option. Here are other financing alternatives to consider:

• Personal loan: Since most personal loans are unsecured, this option may help you get the funds you need without risking your home. Personal loans also tend to have higher interest rates and shorter repayment terms ranging from a few months to seven years, but they typically come with fixed interest rates.
• 0% introductory APR credit card: Credit cards usually have much higher rates than HELOCs, except for this option. With good credit, you might qualify for an intro 0% APR credit card, where you can avoid paying interest for up to 21 months. However, any balance remaining after this period ends will accrue interest at the card issuer's standard rate, which could be significantly higher.
• Home equity loan: Similar to a HELOC, a home equity loan allows you to convert your home's equity into cash and use your home as collateral. Where a home equity loan differs, however, is that you'll receive your funds in one lump-sum payment and repay the amount in fixed monthly payments over the loan's term, usually five to 30 years.
• Cash-out refinancing: With a cash-out refinance, you replace your existing mortgage with a new, larger one and receive the excess amount in one lump sum. However, this option may not make sense if current mortgage rates are higher than your original ones.

Frequently Asked Questions

• How to Get the Best HELOC Rate

  Shopping multiple lenders and comparing offers can help you find the best HELOC rate available. Other tactics to get a lower rate include improving your credit score and lowering your debt-to-income ratio. Remember, borrowers with high credit scores, low debt, high income and substantial home equity tend to receive the most favorable HELOC rates.

• How Does a HELOC Affect Your Credit?

  Taking out a HELOC by itself doesn't affect your credit much, other than the hard inquiry (credit pull) your lender performs to review your credit. However, the way you treat your HELOC could influence your score. For example, making consistent, on-time payments could improve your payment history and, in turn, your credit score. Additionally, using HELOC funds to pay off credit card balances can lower your credit utilization ratio—the percentage of available revolving credit you're using—which might help your credit.

• Can You Deduct HELOC Interest on Your Taxes?

  The IRS allows you to write off interest on home equity loans and lines of credit on your income taxes if you use the funds to "buy, build or substantially improve" your main residence. That means you may be eligible to deduct your HELOC interest if you use the funds for a home renovation project like a kitchen or bathroom remodel. On the other hand, using the funds to pay off credit cards or medical bills wouldn't be a tax deduction.

The Bottom Line

A HELOC can provide many valuable benefits, including large borrowing amounts, potential tax benefits and lower interest rates than other financing options. It's also a flexible way to access cash in smaller amounts as needed rather than receiving a single lump-sum payment.

It helps to have good credit to qualify for a HELOC with favorable rates and terms. Before applying, take a moment to check your credit report and score for free with Experian. You'll discover where your credit stands, which can help you understand your loan options to decide if a HELOC is your best option.