What is a Home Equity Line of Credit?
HELOC for short, a home equity line of credit is a way to use your home’s equity to get cash as needed. Let’s delve into how this unique financial tool works and how it may work for you.
How a HELOC Works
With a HELOC, you create a revolving line of credit by using your home’s equity as collateral to borrow a specified sum. Often up to 90% of your equity is available for the line of credit.
It’s (kind of) Like a Credit Card
As you would with a credit card, you can draw on a HELOC’s line of credit as you like and repay all or some of it each month.
HELOCs have draw periods, which are usually from five to 10 years, and repayment periods, which are usually from 10 to 20 years. Like a credit card, as you repay the outstanding balance, that amount of credit is replenished.
However, HELOCs aren’t exactly like credit cards, which most people use for minor expenses; HELOCs are intended for larger cash outlays such as home improvements or paying off high-interest debt.
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HELOC or HELOAN: What’s the difference?
They’re both great options to use your home to get cash. They’re both sometimes referred to as second mortgages. HELOCs and HELOANs, however, have significant differences.
With a HELOAN, a home equity loan, the borrower gets money in a single lump-sum payment. The borrower repays this loan over a set period, usually five to 15 years, but repayment terms can go as long as 30 years. Like a conventional mortgage, HELOANs have monthly payments and can have either fixed or adjustable interest rates.
A HELOAN is a set lump sum; you can’t take out more money if an emergency arises.
Requirements for a HELOC
While different mortgage professionals may have different requirements, a HELOC borrower should probably have:
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- Debt-to-income ratio (DTI). A DTI of 40% or less is best. If your DTI is higher, there are ways to reduce your DTI before applying for a HELOC. These include paying down credit cards and increasing your income with a side gig.
- Credit score. Ideal candidates for HELOC approval will have a credit score of 640 or higher. If your credit score is lower, there are ways to boost your credit score fast. These include paying down revolving account balances and diversifying your credit mix.
- Income history. Just as they would with conventional loan approval, a mortgage professional may want to see between 12 and 24 months’ worth of verified income. This could be pay stubs from a salaried position or bank statements. With the latter, people who work for themselves often get loan approval by showing how much money their accounts accumulate each month.
- Property appraisal. Mortgage professionals generally require a home appraisal to determine the home’s current market value and calculate an appropriate loan amount.
- Home equity. Having at least a 15% equity stake in your home is usually the entry point for approval. The more equity you have, the more money you can access through a line of credit.
How much can you borrow with a HELOC?
That depends on three factors: the home’s value, the equity you have in the home, and the amount the mortgage professional determines you can afford.
As a hypothetical, a HELOC candidate has a home appraised at $300,000 with a balance of $200,000 on the mortgage. The mortgage professional allows accessing up to 85% of the home’s value: $255,000. Subtract the $200,000 owed on the mortgage, and you get $55,000 available to borrow with a HELOC.
The Pros and Cons of a HELOC
The pros of HELOCs include:
- Interest rates. The interest rates for HELOCs are typically lower than rates for other types of loans. Rates for HELOCs can be about a third of the average interest rates for credit cards.
- Tax benefits. The interest on HELOCs could be tax-deductible; the IRS says to write off the interest, the HELOC needs to be used to “buy, build, or substantially improve the residence.”
- Easy approval. With the secured debt of the mortgage in place, a mortgage professional may only have to do a credit check, income verification, and a home appraisal. This usually makes for a speedy approval process.
- Flexibility. You probably don’t know exactly how much those home renovations will cost. So you likely don’t know how much money you need to borrow. With a HELOC, you can access the amount you need when you need it.
The cons of HELOCs include:
- It’s debt. For some, debt such as a mortgage is an easily managed aspect of their financial lives. For others, that debt can be less manageable.
- It’s debt backed by your home. Using your home as collateral for a loan is a serious financial decision. That makes it important you speak with your mortgage professional at length about how much HELOC you can afford.
How to apply for a HELOC
You apply for a HELOC as you would for a purchase or refinance mortgage. You’ll want to have:
- Financial documentation. This can include tax filings, bank statements, property tax bills, your homeowner’s insurance policy, and mortgage statements.
- Employment information. Mortgage professionals usually like to see up to two years of employment, verified by W-2s or pay stubs. For the self-employed, tax returns or cash flow into bank accounts may suffice.
- Your home equity situation. While the mortgage professional will probably want a home appraisal before determining the HELOC amount, you should have an estimate of how much you can borrow. So estimate your home’s value and subtract how much you still owe to get an idea of how much you can borrow. A HELOC calculator can help you there.