A Home Equity Line of Credit (HELOC) is a loan arrangement that allows a borrower to access a line of credit secured by the equity in their home. The borrower can then draw down the line of credit and use the funds as they wish, similar to a traditional loan.
The main difference is that the borrower can draw down and repay multiple times as long as they don’t exceed the maximum line of the credit limit.
HELOCs are popular because they typically offer lower interest rates than other loan products, making them attractive to borrowers who need access to cash quickly. They also provide flexibility in how the funds are used, allowing borrowers to use them for any purpose, such as home improvement projects, debt consolidation, or investing.
In today's article, let's take a closer look at HELOC and what you should know before taking one out.
How Does a HELOC Work?
A HELOC works similarly to a credit card, providing a revolving line of credit that can be drawn upon as needed. The credit limit for a HELOC is based on the value of the home and the amount still owed on the mortgage. Typically, a homeowner can borrow up to 85% of the home's value minus the outstanding mortgage balance.
Once approved for a HELOC, the homeowner can draw from the line of credit as needed. For example, if a homeowner has a $50,000 credit limit and needs to pay for a home renovation project that costs $20,000, they can withdraw $20,000 from the HELOC.
The HELOC's interest rate is typically variable based on the prime rate plus a margin. The interest rate can fluctuate throughout the life of the loan.
The homeowner is only required to make interest payments on the amount borrowed during the draw period, which typically lasts ten years.
After the draw period ends, the loan enters the repayment period, and the homeowner must make both principal and interest payments. The repayment typically lasts 20 years, but the homeowner can pay off the loan early without penalty.
Benefits of a HELOC
A HELOC can provide homeowners with low-cost financing for home improvement projects, debt consolidation, and other large expenses. The interest rate on a HELOC is typically lower than that of a traditional loan or credit card, making it an attractive option for borrowers.
A HELOC offers flexibility since the homeowner can draw on the line of credit as needed and only pay interest on the amount borrowed.
Since the HELOC is secured by the home, lenders may be willing to offer larger credit limits and lower interest rates than with an unsecured loan. The interest paid on a HELOC may also be tax deductible, depending on the borrower's situation.
A HELOC can also be used to provide a buffer against economic downturns. The homeowner can draw on the line of credit if their income is reduced and make interest-only payments until their financial situation improves.
Drawbacks of a HELOC
One of the main drawbacks of a HELOC is that the borrower often uses their home as collateral. If the borrower defaults on their payments, the lender may foreclose on the home, and the homeowner might lose their investment.
Borrowers should also be aware that the interest rate on a HELOC can vary. Many lenders use a variable rate, meaning the rate can change over time. This can make it difficult for borrowers to plan their budget and pay off the loan in a timely manner.
Finally, a HELOC is a form of revolving credit, meaning the borrower can draw on the line of credit multiple times. This can lead to overspending and can be challenging to get under control. Borrowers should be mindful of spending and only use the funds for necessary expenses.
How to Quality for a HELOC
1. Home Equity
The first requirement for qualifying for a HELOC is to have enough home equity. Home equity is the difference between the current market value of your home and the outstanding mortgage balance. Lenders usually require homeowners to have a minimum of 15% to 20% equity in their homes to qualify for a HELOC.
For example, if your home is worth $500,000 and you owe $300,000 on your mortgage, you have $200,000 in home equity. This means you may qualify for a HELOC of up to $40,000 if the lender allows you to borrow up to 80% of your home equity.
2. Credit Score
Your credit score is an essential factor in determining your eligibility for a HELOC. A credit score is a numerical representation of your creditworthiness based on your credit history. Lenders may use your credit score to assess the risk of lending you money.
Generally, a higher credit score means lower risk, which translates to better loan terms and interest rates. Many lenders require a credit score of at least 680 to qualify for a HELOC. However, some lenders may consider applicants with lower credit scores, but they may charge higher interest rates.
3. Debt-to-Income Ratio
Another factor that lenders typically consider when qualifying applicants for a HELOC is their debt-to-income ratio (DTI). DTI is the percentage of your monthly income that goes towards paying off debts such as credit cards, car loans, and mortgages.
Lenders tend to use DTI to determine your ability to repay the loan. Ideally, your DTI should be below 43% to qualify for a HELOC. However, some lenders may be more lenient and allow a higher DTI if you have a high credit score and a strong repayment history.
4. Income and Employment
Lenders also may consider your income and employment status when qualifying for a HELOC. You must have a steady income source to show that you can repay the loan. Lenders may ask for proof of income, such as pay stubs, W-2s, and tax returns.
If you are self-employed, you may need to provide additional documentation such as profit and loss statements and bank statements. Additionally, lenders prefer borrowers who have stable employment histories. If you have recently changed jobs or have gaps in your employment history, this may raise a red flag for lenders.
5. Loan-to-Value Ratio
Loan-to-value (LTV) ratio is the ratio of the loan amount to the appraised value of the property. Lenders use LTV to assess the risk of lending you money. The higher the LTV, the riskier the loan is for the lender. Most lenders have a maximum LTV of 80% for HELOCs.
This means you can borrow up to 80% of your home equity. For example, if your home is worth $500,000 and you have $200,000 in home equity, the maximum HELOC you can qualify for is $160,000.
6. Other Requirements
Apart from the above requirements, some lenders may have additional requirements for HELOC qualification. For instance, some lenders may require borrowers to have a minimum credit history, which is the length of time they have had credit accounts.
Additionally, some lenders may require borrowers to have a minimum loan amount, the minimum amount they can borrow. It is essential to check with your lender to understand their specific qualification requirements.
The Bottom Line
A HELOC loan allows homeowners to borrow against the equity in their homes. It provides flexibility and potential tax savings, but it also has drawbacks, such as a variable interest rate and the risk of foreclosure.
Homeowners should consider their financial situation and ability to make payments before taking out a HELOC. They should also shop for the best terms and interest rates before choosing a lender. There's no doubt that HELOCs are a useful tool for accessing funds based on your home equity.
Chloe transforms legacy HELOC processes into a frictionless credit card backed by home equity. We provide homeowners with powerful data-driven insights that contextualize the best and most effective ways for them to use home equity to build wealth or reduce expensive debt.
