A home equity line of credit (HELOC) is a secured loan that allows you to borrow money against the equity you’ve built in your home.
As you pay your mortgage, you accumulate equity in your home. This is a form of wealth that you can tap into and use to pay a variety of expenses. A HELOC is just one way of accessing the equity. While HELOCs provide a great deal of flexibility in how you use the money, they also come with a degree of risk.
Using the equity in your home can be the right choice under the right circumstances. If you’re considering a home equity line of credit, read on for a complete rundown of the pros and cons of HELOCs.
What Is a Home Equity Line of Credit?
A home equity line of credit uses your home as collateral to secure a loan and your lender will place a second lien on your home. Unlike a mortgage that you borrow in one lump sum, a HELOC is a revolving credit account kind of like a credit card.
How does a HELOC work?
HELOCs work like a credit card in the sense that you can draw money out of the account and then reuse the funds as you repay that amount back plus interest.
The lender will approve a maximum amount based on the amount of equity you have in the home and your ability to repay the loan. The funds will be held by the bank, and you’ll be able to access them when needed by either writing a check, making an online transfer to a different account or with a credit or debit card associated with the HELOC.
You’ll be able to access funds from the line of credit during what’s known as the ‘draw’ period. During this time, you typically won’t have a limit on how much money you can draw — up to the maximum credit line limit — or how many times you can withdraw funds. The interest rate charged on the loan is usually a variable rate, although some banks will charge a fixed rate.
During the draw period, you’ll be required to make interest-only payments on any amount you’ve drawn from the line of credit, but not on untapped funds. Some lenders, however, may require you make a minimum withdrawal, so make sure you ask about this before committing to a specific provider. You can also repay any amounts drawn — aka the principal — which will replenish the available funds and reduce how much you owe in interest.
After the draw period ends, you enter into the repayment phase of the HELOC. During this time, you won’t be able to draw any money from the line of credit and you’ll start repaying any outstanding withdrawals plus interest on a monthly basis.
HELOC term lengths
HELOCs term lengths are divided into draw and repayment periods. Draw periods usually have a term of 5 or 10 years, while repayment periods may last for 10, 15 or 20 years.
How much can be borrowed with a HELOC?
HELOCs are capped at 85% of your home’s appraisal value minus any outstanding mortgage balance. For example, your home is appraised at $350,000 and you still owe $200,000 on your mortgage. Eighty-five percent of your home’s value is $297,500. Subtract the unpaid mortgage balance and your potential line of credit is $97,500. However, lenders will also take your ability to repay into account when determining the maximum amount they are willing to lend.
What is a HELOC used for?
There are no restrictions on how you can use the money from a line of credit. Some of the most common reasons for taking this type of loan out include:
- Home improvements
- Medical expenses
- Large purchases
- Tuition or education costs
- Debt consolidation
Benefits of a HELOC
The biggest benefit of a home equity line of credit is its flexibility, providing you with access to cash whenever you need it. Other benefits of a HELOC include:
- No down payment required
- No interest payments until funds are drawn
- Interest is only paid on funds you use, not the total amount of the HELOC
- Lower closing costs than cash-out refinance loans
- Lower interest rate than personal loans or credit cards
- Interest payments may be tax deductible if the money is used for home renovations
Downsides of a HELOC
The biggest risk associated with a HELOC is the possibility of losing your home. Because the loan is secured using your house as collateral, the lender can initiate a foreclosure if you fail to repay the HELOC within the agreed upon term.
Other HELOC risks include:
- The lender might freeze or reduce your line of credit if you miss payments, the equity in your home changes or some other financial setback inhibits your ability to repay.
- The lender might freeze or reduce your line of credit if market conditions cause your home to lose value.
- Most HELOCs have a variable interest rate, so there could be rate increases during the term of the loan.
- You may be tempted to use the funds for non-essential purchases.
What Is the Difference Between a Home Equity Line of Credit and a Home Equity Loan?
Both home equity loans and HELOCs allow you to borrow against the equity in your home. Both types of loans require paying closing costs, but these can be a little bit lower than the costs of a primary mortgage. There are no limitations on how you spend the money from either a home equity loan or a HELOC. That’s where the similarities end.
A HELOC is a revolving line of credit and could be a good option if you have to pay for recurring costs but aren’t sure how much those costs will be. As long as you pay back the funds you draw, you can keep using the money until the end of the draw period. You can withdraw funds to pay for any type of expenses that may pop up.
The interest rate is usually adjustable. The initial rate is typically lower than the rate on a home equity loan, but your rate and your monthly payments may change depending on market conditions. However, you don’t have to pay interest unless you draw funds and then only on the amount you take out, not the entire credit line.
Home equity loans, on the other hand, will disburse a lump sum for the amount approved by your lender. A home equity loan may be a good option if you need a specific amount of money for a one-time expense.
The interest rate on this type of loan is usually fixed, so you’ll have predictable monthly payments. Unlike a HELOC, you’ll have to start making those payments on the full amount of the loan the month after receiving the funds, whether you use the money immediately or not.
What to know before applying for a HELOC
Just as you would do when applying for any type of loan, you want to be familiar with the terms and conditions of a HELOC to make sure it’s the best option for you. Different lenders may have different products and requirements, but in general, you should be familiar with the following aspects of a home equity line of credit.
Different interest rates
You’ll find two types of interest rates on HELOCs.
Variable interest rate
The interest rate on a HELOC is usually variable. This means that the interest rate on the funds you draw won’t always be the same. Instead, they will react to market conditions and change periodically.
While variable rates tend to be lower than fixed interest rates, there is always a risk they could increase multiple times over the full term of the line of credit. To prevent rates from increasing too much, many lenders will put a limit or cap on either how much a rate can increase each time or on the maximum rate the interest can rise.
Fixed interest rate
Some lenders will offer fixed interest rate HELOCs, which won’t change over the full term of the line of credit. This type of rate provides a little more predictability since your monthly payments will only change based on the amount you draw. However, fixed interest rates on HELOCs tend to be higher than variable rates and are hard to find.
Common HELOC fees
When evaluating whether a HELOC makes sense for you make sure to consider the closing costs, which range from 2% and 5% of the total line of credit amount. Some lenders may charge these fees while others may waive them, roll them into the line of credit or not charge them, so shop around before deciding on a provider.
Common HELOC fees include:
Appraisal fees: An appraisal may be required to establish your home’s current fair market value and determine how much equity you have in the home.
Application fees: Lenders may charge an application fee to cover the cost of underwriting your application and originating the line of credit.
Attorney fees: Depending on the rules in your state, an attorney or document preparation specialist may need to go over the terms and conditions of the line of credit before it can be finalized.
Title search fees: A title search company will research your property to make sure you hold the title and that there are no issues such as unpaid taxes, easements or assessments.
Recording fee: This fee is paid to your local tax office to record the new lien on your property.
Notary fees: Some lenders may charge a separate fee for having the line of credit documents notarized.
Once you’ve been approved for a HELOC, there may be additional costs associated with maintaining the line of credit. These include:
Annual/maintenance fees: Some lenders charge an annual fee to manage your account, similar to the annual fee on a credit card.
Transactions fees: You may be charged a fee every time you withdraw funds from your line of credit, which can add up if you’re making multiple draws per month.
Inactivity fee: Depending on the terms of your HELOC, you may be required to make regular draws from your line of credit within a specified period of time to avoid paying a fee.
Minimum withdrawal requirement: Some lenders may require a minimum withdrawal amount every time you draw funds, which could mean you’ll have to withdraw more than you need and pay more interest.
Cancellation/early termination fee: Your lender may require you to keep a HELOC open for a specific period of time. Paying off or canceling early may result in a pre-payment penalty.
Fixed-rate conversion fee: Your lender may allow you to convert your variable interest rate into a fixed interest rate but will charge a fee to do so.
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The three day cancellation rule
Once you’ve signed the agreement to open a HELOC, this federal rule gives you three business days, including Saturdays (but not Sundays), to cancel the agreement for any reason without penalty. The right to cancel does not apply to second homes or vacation properties, only to primary residences.
The three day cancellation period begins only after all of these things happen: you’ve signed the loan at closing, received a Truth in Lending disclosure form containing all the details of the credit contract, and received two copies of the Truth in Lending notice that explain your right to cancel.
The cancellation period ends at midnight on the third day after the last of the above requirements takes place. For example, if you signed the loan agreement and received the Truth in lending disclosure form on Wednesday but didn’t receive the two copies of the right to cancel notice until Friday, you’ll have until midnight Tuesday to cancel.
Note that you won’t receive access to the HELOC until after the three days have passed. You won’t owe any fees if you cancel within the three day period, and you will be refunded any fees already paid.
You can find more information on the three day cancellation rule and your rights as a homeowner when applying for a HELOC on the Federal Trade Commission website.
Qualification requirements can vary by lender, but generally include the following:
Minimum credit score: A minimum score in the mid 600’s is typically required for approval, although many lenders prefer scores above 700.
Reliable income: You’ll need to provide proof of a reliable source of income and that you can afford the monthly payments, particularly once the repayment period begins.
Enough home equity: You can’t borrow against your home unless you have equity built up. Most lenders require between 15% and 20% equity to approve a HELOC.
Low debt-to-income ratio: Most lenders will accept a maximum DTI, or how much of your monthly income goes towards paying expenses, of 43% but a lower ratio will increase your chances of approval. Use a DTI calculator to find your percentage.
A history of on-time payments: A history of late or missed payments signals to the lender you may not be able to meet your financial responsibilities.
Beware of these harmful practices
Because your home serves as collateral for a HELOC, it’s important to find a reputable lender and avoid deceitful practices that can lead to a costly misstep.
Loan flipping occurs when the lender encourages you to repeatedly refinance the loan, which can cause you to borrow more money than necessary. You’ll also pay new closing costs and fees every time you refinance.
Insurance packing occurs when your lender adds different insurance products you don’t need to your financing.
Bait and switch is when the lender offers one set of terms and rates when you apply then changes them or pressures you into accepting different terms when you sign to close the deal.
Equity stripping can occur when the lender offers to finance an amount based solely on the equity in your home and not on your ability to pay. This can lead to missed payments and eventual foreclosure.
Non-traditional products, such as loans that have continually increasing monthly payments or low monthly payments with a big balloon payment due at the end of the loan’s term, can be dangerous if you aren’t on top of the details.
Mortgage servicer abuses can include improperly charged fees, inaccurate or incomplete account statements or payoff amounts, or failure to disclose your rights as a homeowner.
The “home improvement” loan scams occur when a contractor approaches you to make home improvements or repairs, quoting a reasonable price, but then pressures you into signing up for a home equity line of credit or loan with a high interest rate and fees.
How HELOCs are repaid
During the draw period of the HELOC, you’ll be required to make monthly interest-only payments. Once the draw period ends, you’ll also have to start repaying any outstanding balance on the HELOC.
The most common form of repayment is by making monthly payments that will cover both principal and interest, like on your primary mortgage. While your interest only payments may be relatively low, once you start repaying the principal your monthly payments will increase substantially.
Remember, the interest rate on a HELOC is usually variable, so your monthly payments may change over time. Before signing on the loan documents, make sure you understand what the upper cap is on the rate (in many instances it can be as high as 18%) and estimate how high your monthly payments can go during the repayment period to make sure you can afford them.
If the monthly payments get to be too high, you may be able to refinance the HELOC into a personal loan or second mortgage at a lower interest rate and payment.
Alternatives to a HELOC
Before deciding on a HELOC, consider other financing options that may better serve your needs.
Home equity loans
These are basically second mortgages, secured by the equity in your home. You’ll get a lump sum disbursement of the amount approved, so a home equity loan can be a good option if you know you need a specific amount to pay for a one-time expense, such as tuition or debt consolidation.
The interest rate is usually fixed and may be higher than the initial rate you’ll get on a HELOC, but the monthly payments will always be the same and are therefore easier to budget for. Repayment of the home equity loan begins the month following the approval and disbursement of the loan.
Cash out refinances
A cash-out refinance will also allow you to take advantage of your home equity by refinancing your existing loan into a larger mortgage. Your old loan is paid off and you receive the difference as a lump sum payment. A cash-out refi could be a good option to pay off a one-time expense or make home improvements that will pay off in the form of a higher home value.
The closing costs and interest rates can be higher than the rates on a HELOC, so you need to evaluate whether those higher costs are offset by the benefits of refinancing your current loan.
Reverse mortgages are available to homeowners 62 years of age or older. They allow you to use the equity in your home to receive a lump sum payment or monthly payments. One advantage of a reverse mortgage is that you don’t have to repay the loan within a specified time but have the option of making monthly payments similar to a regular mortgage if you so choose. You can also take a reverse mortgage as a line of credit.
Applying for a reverse mortgage is similar to applying for a mortgage. You’ll need to pay closing costs and appraisal fees, plus have homeowners insurance. If you choose not to make payments, your heirs will need to pay the loan in full if they want to keep the home.
You can consider a personal loan if you don’t want to use your equity. Personal loans can be a good option to pay off higher interest debt or cover one-time expenses. While the maximum amount you can borrow will vary by lender and depend on your credit and income, the borrowing limit is generally to about $100,000. There are two types of personal loans — secured and unsecured loans.
A secured loan means you use an asset, such as a CD or bank account, as collateral to guarantee repayment of the loan. If you have good credit, you can qualify for a relatively low interest rate and comfortable monthly payments with a secured loan.
An unsecured loan means you’re not using any collateral and are viewed by lenders as a higher risk. As a result, the interest rate on unsecured personal loans tend to be higher than those on a secured loan.
Home equity line of credit bottom line
A HELOC is a way to tap into your home equity and obtain a line of credit you can use to pay for recurring expenses. It can be a good option when you know you’ll have upcoming costs but aren’t sure of the amounts needed or when you’ll need them.
There are quite a few advantages to a HELOC. You can withdraw funds when you need them, paying interest only when you draw funds and only on the amount withdrawn. You can also repay the withdrawn cash and replenish the HELOC, giving you access to the full amount of the line of credit for a predetermined number of years.
Along with the benefits you’ll also have risks with a HELOC. Once the repayment period begins, your monthly payments can increase significantly. Late or missed payments can also lead to late fees and eventual foreclosure if you can’t repay the line of credit. Understand the pros and cons fully before committing to a home equity line of credit.