How does a HELOC work?
A HELOC is a line of credit that uses your house as collateral by allowing you to borrow money against the equity you’ve built in your home. The more equity you have, the more money you can access.
Typically, you can apply for a HELOC up to 85% of your home’s value. The appraised market value of your home and the amount you owe will influence the credit line you apply for and the amount you receive.
Draw and repayment phases
There will be a specified time where you can take out money called the draw period, which typically lasts between five and 10 years. During the draw period, you can spend the funds as needed and make monthly interest payments on the amount you borrow.
Once the draw period ends, you’ll move into the repayment period, which can last between 10 and 20 years. You’ll no longer be able to access or spend the funds and will instead make monthly payments on principal and interest until your balance is paid off fully.
HELOC interest rates
HELOCs come with variable interest rates, meaning they can fluctuate based on factors like the prime rate. The prime rate is a national average calculated based on what banks charge their most creditworthy customers. Because HELOCs have variable interest rates, the amount you’re expected to pay each month can change.
HELOC interest rates are normally calculated using the prime rate plus a margin, which is set by the lender based on the customer’s risk profile.
Some HELOCs (called interest-only HELOCs) allow you to start by paying back only interest, which keeps your repayment amount very low. Other lenders will offer a short-term introductory rate that is fixed for a certain amount of time, said Pahm Foxley, vice president of mortgage lending at Wasatch Peaks Credit Union. “Interest rates are normally tied to the prime interest rate set by the Federal Reserve,” Foxley told us.
HELOC vs. home equity loan
When it comes to borrowing against your home’s equity, many homeowners find they don’t understand the difference between a home equity line of credit and a home equity loan. The main difference, according to Foxley, is the way you receive the money.
“A HELOC is a variable open-ended line of credit you can draw on and take advances from whenever you need money,” Foxley said. “Whereas a home equity loan is a fixed-rate loan where you receive all the funds up front when you close on the loan. A home equity loan is typically a fixed rate whereas a HELOC has a variable rate based on prime.”
Pros and cons of a HELOC
If you have built equity in your home and need access to cash quickly, a home equity line of credit might seem like an ideal solution. A great benefit of a HELOC is flexible spending and a lower interest rate, said Foxley. But it’s not without drawbacks. Here are some pros and cons of taking on a home equity line of credit:
Pros
- It can be used to consolidate high-interest credit cards or personal loans.
- You can draw funds as you need them over time.
- It often allows you to pay only interest for a certain period of time.
- Interest is tax deductible if used for home improvements.
Cons
- If you default on a HELOC, your home could be at risk.
- If you sell the property on which the HELOC is drawn, you have to pay it in full.
- You’ll have to pay back both interest and principal.
- HELOC interest rates are subject to fluctuation, which means the amount you pay could change from month to month (but you can refinance a HELOC for better terms).
If you’re tempted to use a HELOC to improve your financial situation, like using the funds for debt consolidation or emergency expenses you’re unable to cover, Foxley advises you to use caution.
“Taking out a HELOC to pay for a vacation or to purchase a vehicle may not be the smartest move,” Foxley said. “Many people use HELOC for debt consolidation, only to run their credit cards back up because they cannot control their spending, which can put them in a worse financial situation.”
Before applying for a HELOC, make sure you have a solid plan on how to use and repay the HELOC before you start, especially if you are looking at an interest-only HELOC.
Is a HELOC right for you?
Some homeowners are in a strong position to use a HELOC wisely. Others risk putting their homes on the line for short-term gains. A HELOC could be right for you if the following criteria apply to your situation:
- Equity: You have at least 20% equity in your home.
- Credit score: Your credit score is approximately 620 or higher.
- Debt-to-income (DTI) threshold: Your DTI is 43% or lower.
- Intended use: You plan to use the HELOC funds for an essential need or emergency instead of a luxury or short-term want.
- Repayment plan: You have considered how you plan to repay the HELOC’s principal and interest during the draw and repayment periods.
The following scenarios provide examples of when a HELOC is a good idea and when it isn’t the best option:
Alex and Maya
Alex and Maya have lived in their home for 10 years and built $200,000 in equity. With a stable budget and a track record of on-time payments, they’re considering a $60,000 HELOC to pay for a kitchen renovation likely to increase their home’s value.
Should Alex and Maya get a HELOC?
Yes. With strong equity, reliable finances and a plan to invest in their home, Alex and Maya are in a good position to use a HELOC wisely.
Derek
Derek has $34,000 in equity but poor credit, high-interest debt and multiple personal loans. He’s considering using a HELOC to buy a new car, even though his current one is reliable.
Should Derek get a HELOC?
No. Using a HELOC for a nonessential purchase and existing debt puts Derek’s home at unnecessary risk. What’s more, his poor credit score could cause his monthly repayment amount to be more than it otherwise would be, and could potentially lower his score even more, thanks to an even higher debt load. Derek should look into HELOC alternatives.
Joe and Dave
Joe and Dave have $75,000 in equity but haven’t been able to build an emergency fund. They’re thinking about using a $10,000 HELOC to help jump-start their savings. The monthly payment currently fits their budget, but because HELOC rates can change over time, it’s possible their payments may be higher in the future.
Should Joe and Dave get a HELOC?
Yes, but Joe and Dave should proceed with caution. If the payments stay manageable, a HELOC can be a reasonable way to create a financial cushion. But they’ll need to watch for any rate increases that could stretch their budget.
» COMPARE: Best HELOC lenders
How to apply for a HELOC
Before you apply for a HELOC, review your finances to get a clear understanding of your credit score, DTI ratio and home equity. You’ll need several documents during the application process, including W-2s, tax returns and mortgage statements.
You can apply for a home equity line of credit through your established bank or compare options from different lenders. Once you’re ready to apply, it will likely be a relatively simple application process since you’re borrowing against your own equity. You’ll need to decide how much you’d like to request during the application process.
After applying, the lender will appraise your home to determine its market value. If everything goes smoothly, you’ll go through a closing process and receive a credit limit based on your home equity. The entire process will likely take two to six weeks.
Alternatives to a HELOC
If a home equity line of credit doesn’t seem like the best option for you, consider these potential alternatives as a way to gain access to additional funds in a relatively quick amount of time.
Cash-out refinance
A cash-out refinance is when you replace your current mortgage with a larger one and take the difference in cash. You decide how much you need, and that amount will be rolled into your new monthly mortgage payment.
Home equity loan
A home equity loan works much like a HELOC in that your home serves as collateral for a loan you take out against the equity you’ve built. The major difference is that a home equity loan gives you a lump sum of money upfront rather than a line of credit that you can draw upon over a period of time whenever you need it.
Personal loan
A personal loan is simply a loan that doesn’t have anything held as collateral. As such, you’ll need to have a decent credit score in order to obtain a personal loan, especially if it’s a large amount you’re seeking. In addition, personal loans often carry higher interest rates than HELOCs since they’re unsecured debt.
However, said Foxley, “a personal loan may be advisable if you do not have enough equity in your home and typically have fixed interest rates and payments.”
Credit card
Credit cards can be an alternative to a home equity line of credit. Assuming your credit score is high enough, you can apply for a credit card in any amount you need and pay down the balance monthly — or pay it off all at once. Of course, credit cards will have the highest interest rates of any of the other alternatives we’ve mentioned here.
FAQ
Is a HELOC a good idea for home renovations?
As long as you’re certain you’ll be able to repay the loan over time, a HELOC can be a good way to fund home repairs or home improvement projects, both large and small. This is especially true when you consider that these improvements may actually increase the value of your home and that the interest you pay on a HELOC is tax deductible.
Are there tax benefits to using a HELOC?
As long as you are using the HELOC for repairs or improvements on your primary or secondary residence, the interest you pay on it all year is tax deductible. This can be hugely helpful if you itemize deductions rather than claiming the standard deduction.
How does a HELOC affect my credit score?
Opening any new line of credit will have an impact on your credit score, and that’s the case with a HELOC as well. But as long as you don’t have a huge balance that drags on for a long time or default on your HELOC, the impact should be relatively minor.
What are the costs associated with a HELOC?
Different banks charge different fees, so there isn’t one right answer. Some of the fees you might incur when opening a home equity line of credit are origination fees, title fees, deed recording fees, processing fees and even an appraisal fee if your lender requires it.
When is a HELOC not a good idea?
A HELOC may not be a good idea if you are experiencing financial instability, home values in your area are declining, or you want to use the funds for an unnecessary expense. In these cases, it’s worth considering alternatives to a HELOC.
Is a HELOC worth it?
A HELOC is worth it if you have solid home equity, reliable income and a plan to repay what you borrow. It can be a smart way to fund home improvements, cover big expenses or consolidate high-interest debt — as long as you’re confident you can keep up with payments.
But if you’re struggling with credit card debt, tempted to spend on nonessentials or unsure about your budget, you might want to look into other financing options, like a personal loan, that won’t put your home on the line.
