What is HELOC?

A Home Equity Line of Credit (HELOC) is a flexible second mortgage with a variable interest rate that allows you to access a portion of your home’s value through a revolving line of credit. During a specified time frame, you can repeatedly borrow, pay down, and reuse the credit line as required.

The HELOC amount you qualify for is determined by your home’s value and your equity, which is calculated by subtracting your first mortgage balance from your home’s value. It’s essential to note that your home is used as collateral to secure the loan, so if you fail to make payments, your lender can foreclose on your property.

How does it work?

A Home Equity Line of Credit (HELOC) provides you with access to a portion of your home’s value through a line of credit. It works similarly to a credit card where you can borrow from the line of credit, repay it, and then use it again during the specified draw period, which can extend for up to 10 years. During this time, you’re only required to pay interest on the amount you withdraw.

Following the draw period, the repayment phase, usually spanning 20 years, commences, requiring you to settle the remaining principal and accrued interest. Should you sell your home before the loan term concludes, you’ll be responsible for repaying the entire HELOC balance.

How to use HELOC?

HELOCs provide flexibility for various legitimate expenses, including home renovations, clearing high-interest credit card debts, medical bills, educational expenses, and other significant outlays over time. Nevertheless, it’s essential to understand that the interest on the loan may not be tax-deductible unless the funds are utilized to purchase, construct, or make substantial improvements to your home.

Requirements for HELOC

Qualifications for a HELOC can differ between lenders, but some common prerequisites include:

A debt-to-income (DTI) ratio not exceeding 40%.
A minimum credit score of 620.
A history of consistent on-time payments.
Proven capacity to manage and repay a line of credit.
A home equity of at least 15%, assessed through a property appraisal.

Typically, a minimum credit score of 620 is required to be eligible for a HELOC, provided you also meet the equity and income prerequisites. It’s worth noting that some lenders might impose even higher minimum credit score requirements. Additionally, having a higher credit score will grant you access to more competitive interest rates.

How much finance does HELOC offer?

With a HELOC, many lenders permit you to tap into as much as 85% of your home’s total value. Your home’s equity plays a pivotal role in the HELOC application process. You can get an initial estimate of your home’s value by using real estate websites like Zillow.com or Realtor.com. Please keep in mind that these estimates are approximate, and your lender will typically require an official appraisal when you apply for a HELOC.

To calculate your equity, you’ll need to first assess your home’s market value. Then, add up the outstanding balances on your primary and secondary mortgages. The difference between your home’s market value and the combined mortgage balances will give you your equity amount.

Market value of your home – total mortgages = Home Equity amount

To find your equity percentage, simply divide your equity amount by your home’s appraised value. Most HELOC lenders seek equity ranging from 15% to 20% of the home’s value before granting approval.

Home Equity/ market value of home = Percentage of home equity

Let’s take an example: Imagine a home with a market value of $350,000 and outstanding mortgage balances of $200,000. In this scenario, the homeowner has $150,000, which is nearly 43% equity in the home. This level of equity makes them likely to qualify for a HELOC. However, if the same homeowner had $315,000 in outstanding mortgages on the same property, their equity would be only 10%, which is lower than what many lenders typically require for a HELOC.

HELOC Rates

Prior to seeking a HELOC, it’s advisable to do some comparison shopping among different lenders. This will help you evaluate HELOC rates and borrowing expenses, ensuring that you secure the most suitable deal for your specific requirements. As of now, the average interest rate for a HELOC is approximately 8%, as reported by Bankrate.

Repaying HELOC Loan

A HELOC differs from a standard loan in that it operates as a line of credit. This means you can access funds when necessary, rather than receiving a lump sum. Throughout the draw period, which typically extends for up to 10 years, borrowers are required to make monthly interest payments on the borrowed amount. Additionally, they have the flexibility to pay down the principal balance during this draw period.

Once the draw period ends, the repayment phase commences, and the line of credit is no longer available for use. This phase, typically lasting up to 20 years, requires borrowers to make monthly payments to cover the remaining principal amount and any outstanding interest. If you sell your home before the loan term concludes, you’ll need to repay the HELOC, and the lender may impose a cancellation fee. Therefore, if you don’t plan to stay in your home for an extended period, a HELOC may not be the most suitable choice.

Advantages and Disadvantages of HELOC

Advantages

Lower Interest Rates: HELOCs typically have lower interest rates compared to credit cards and personal loans, potentially saving you money on borrowing costs.
Flexibility: You can use the equity from a HELOC for various purposes, providing you with financial flexibility.
Interest on Drawn Amount: Interest is charged only on the amount you actually withdraw from the line of credit, not on the entire lump sum.
Potential Tax Deductions: Depending on how you use the HELOC funds, you may be eligible for tax deductions on the interest payments, especially if the money is used to purchase, build, or substantially improve your home.

Disadvantages

Variable Interest Rates: HELOCs often come with variable interest rates that can increase over time, potentially leading to higher borrowing costs.
Upfront Costs: You may incur upfront closing costs and third-party fees during the application process, which can add to the overall expense.
Collateral Risk: Your home serves as collateral for a HELOC, meaning that if you default on payments, there’s a risk of foreclosure.
Credit Impact: Missing payments or failing to make them on time can harm your credit score, affecting your financial standing.
Initial Drawdown Requirements: Some lenders may require an initial minimum drawdown as a percentage of the total credit line, which may impact how you access your funds.

Applying for HELOC

The process of applying for a HELOC can vary depending on the lender, but it typically involves the following steps:

Review your credit: Lenders will assess your credit to determine your eligibility for a HELOC. Start by obtaining a free credit report and examining your credit scores to gauge your creditworthiness.
Determine your home equity: Obtain an online estimate of your home’s value. Next, tally up all outstanding mortgage balances and subtract this total from your home’s estimated value. Divide the outcome by the home’s value to calculate your home equity percentage.
Collect essential documents: As part of your HELOC application, lenders will request documentation related to your assets, income, employment, debts, and other factors that affect your ability to handle additional debt. Gathering these documents ahead of time can expedite the application process.
Compare lenders: Begin your search for the ideal HELOC lender by reaching out to your current bank or mortgage lender. Explore other lenders locally and online to assess interest rates and other conditions. Consider undergoing the prequalification process with each lender, as this will not affect your credit score and will allow you to evaluate their rates and terms.
Complete the application: Most lenders offer several ways to apply for a HELOC, whether it’s through an online application, over the phone, or in-person. Opt for the application method that is most convenient for you, and provide all the required information and documentation as per their request.
Undergo the underwriting process: Different lenders have varying response times for HELOC applications, with some providing quick responses within a few hours, while others may take a bit longer, spanning days or even weeks. After you’ve submitted your application, a representative from the lender will reach out to verify your employment and financial information. In some cases, they might schedule a home appraisal if deemed necessary.
Complete the closing process and access your funds: Once the underwriting process is complete, a loan officer will provide you with the final terms of your HELOC and schedule a closing appointment. Take the time to carefully review the terms and, when you’re ready, sign the necessary paperwork to access your newly approved line of credit.

Alternatives for HELOC

Depending on your specific financial situation and requirements, a Home Equity Line of Credit (HELOC) might not be the ideal choice for you. Before committing, it’s essential to explore these alternative options:

Home Equity loans

A home equity loan is essentially a second mortgage, where you can borrow against the value of your home, using your home as collateral, and receive a one-time lump sum payment. These loans usually have a fixed interest rate, and the repayment is made in regular monthly installments over a period of five to 30 years. If you qualify for a low, fixed interest rate, a home equity loan might be the more suitable option.

Personal Loans

Personal loans offer homeowners the opportunity to access funds without using their homes as collateral. Although they often come with higher interest rates compared to HELOCs, borrowers can secure a more favorable rate by using assets such as a car, real estate, or stocks and bonds as collateral. It’s important to note that the interest on a personal loan is not tax-deductible. Personal loans might not be the ideal choice if you possess significant home equity and can benefit from a HELOC or home equity loan.

Cash-out Refinance

Cash-out refinancing is a process where you secure a new, larger mortgage to replace your existing one. In this scenario, the new loan amount is higher than your current mortgage balance, and you receive the surplus as a lump sum. Cash-out refinances typically offer lower interest rates, but they may entail higher closing costs due to the larger loan size. Opt for a cash-out refinance when you need access to a significant amount of funds and can benefit from the lower interest rates it offers.