A Home Equity Line of Credit or HELOC, is mainly a financial product that allows you to tap into home equity and later repay the loan in a simple revolving basis. HELOCs are widely preferred in USA. In 2017, over 1.2 million HELOCs were originated compared to 800,000 home equity loans (HEL) and 600,000 cash-out refinances, reports TransUnion. Home equity, calculated by subtracting total liens from a home’s market value, can provide a borrowing limit. For instance, if a home is worth $300,000 and the mortgage owed is $100,000, the equity is $200,000, which could be accessed via a HELOC loan.

Home Equity Loans (HELs) and HELOCs, are two forms of borrowing against home equity, differing primarily in their structure. A Home Equity Line of Credit (HELOC) operates as an open-end line of credit, allowing borrowers to access funds up to a set credit limit at their discretion. On the other hand, a Home Equity Loan (HEL) is a fixed-term loan where the lender provides a lump sum to the borrower, to be repaid over an agreed period.

Advantages

• Accessible qualification even with a low credit score, compared to unsecured personal loans.
• Offers more competitive rates in comparison to various financing options.
• Interest paid on eligible home improvements could be tax-deductible.

Disadvantages

• Potential requirement for a lump sum payment at the end of the loan term
• Obligation for full repayment if the property is sold
• Substantial initial expenses involving application, appraisal, title search, and attorney fees

A HELOC loan is structured with two main phases: the draw period and the repayment period. Lasting generally 5 to 10 years, the draw period allows borrowers to access funds within their approved credit limit. While making minimum interest-only payments is common during the draw phase, borrowers can also opt to pay down the principal if they choose to do so.

Following the draw period, the repayment phase of a HELOC starts, generally spanning from 10 to 20 years. While the standard practice is making equal monthly payments, some lenders may propose a balloon payment, allowing borrowers to pay off the total sum in one installment. During this phase, borrowers repay the principal amount borrowed along with the accrued interest in regular, fixed monthly payments.

Applying for a HELOC involves a process akin to a typical mortgage application, but with a crucial distinction: HELOC applications necessitate meeting specific loan-to-value requirements.

Main criteria to qualify for HELOC

Income: Similar to a mortgage assessment, lenders review income and employment history to assess your creditworthiness when you apply for a HELOC. This data helps the lender determine the maximum credit limit available to you. Typically, lenders allow a maximum debt-to-income ratio of about 43% to 50%, which calculates the percentage of your gross monthly income dedicated to payments.

Credit Score: Similar to applying for other loans, when seeking a HELOC, the lender conducts a hard credit check. While the minimum credit score required is generally about 620, the exact score may differ among different lenders.

Combined Loan-to-value (CLTV): When applying for a HELOC, the key aspect is the CLTV, which stands for combined loan-to-value ratio. Most lenders typically allow a maximum CLTV of 80% to 90%. This percentage signifies the amount you can borrow based on your home’s value, considering existing liens. For instance, if your home is valued at $200,000 with a $100,000 mortgage balance, your current LTV stands at 50%. In such a scenario, you might be eligible to borrow between $60,000 to $80,000 against your home equity, reaching a CLTV of 80% or 90%.

HELOCs typically offer an adjustable rate, while HELs provide a fixed rate. Although some lenders now offer hybrid HELOCs combining adjustable and fixed rates, adjustable-rate HELOCs are more common. Deciding between variable and fixed-rate HELOCs relies on personal preference. Opting for a variable rate may suit those seeking a lower initial rate or flexible terms, while a fixed rate might appeal to individuals looking for stability and predictability. There’s no one-size-fits-all choice; it’s about finding what aligns with your financial priorities and comfort levels, making either variable or fixed-rate HELOCs a suitable choice based on your needs and preferences.

As the federal interest rates fluctuate, lenders correspondingly adjust the interest rates on loans. In the case of a fixed-rate HELOC or HEL, the lender locks in the interest rate for the loan’s entire duration. This means that regardless of market changes, the borrower’s rate remains constant. If interest rates rise, the lender absorbs the impact rather than passing on the increase to the borrower, providing stability and predictability for the borrower’s payments throughout the loan term.

Opting for a variable rate with a HELOC means the lender can adjust the borrower’s interest rate at specific intervals, like every 1 or 3 years. Consequently, when federal rates rise, the lender may increase the borrower’s rate. By choosing a variable-rate HELOC, borrowers share some risk with the lender. In exchange for accepting the variable rate, the lender typically offers a lower interest rate compared to a fixed-rate HELOC. This means borrowers get a lower initial rate but also face the potential for rate increases if market rates go up.

In essence, a HELOC loan is quite flexible and can be used for various purposes. However, since it’s secured against your home, it’s advisable to consider significant, necessary expenses or financial enhancements. These might involve consolidating debt or undertaking home improvements to increase the overall value of your property. Using a HELOC for major expenses or financial enhancements aligns with the collateral nature of this type of loan.

Based on TransUnion’s analysis, HELOC borrowers categorize into five primary groups based on their usage: 30% for debt consolidation, 29% for financing significant expenses like home renovations, 25% for refinancing an existing HELOC, 9% for a new mortgage down payment, and 7% for maintaining emergency reserve funds. Many homeowners prefer HELOCs due to their flexibility, enabling borrowers to draw only what they need and pay interest solely on the amount withdrawn. The draw period allows easy access to funds in emergencies.