Homeowners juggling mortgage payments, utility bills, and other household costs may be struggling to find extra funds at the end of each month. If you’re a homeowner who needs cash to pay for a home renovation, emergency medical bills, or other big-ticket expenses, consider taking out a home equity line of credit (HELOC).
What is a HELOC?
A HELOC is similar to a home equity loan in that both allow you to borrow against the equity or value of your home for the funds you need. However, a HELOC is revolving credit, acting more like a personal line of credit or a credit card, with your home serving as the collateral. You receive a credit limit — the maximum amount you can use — and a specified borrowing period in which to use your funds. When you repay the amount you borrowed, you replenish your account so you can borrow against those funds again.
Home equity lines of credit are commonplace in the United States: The Federal Reserve Bank of New York estimated that in 2019 Americans’ balances on HELOCs totaled $406 billion, with the mean HELOC valued at $49,929.
To help you decide if a HELOC is right for you, let’s look at how a HELOC works, its pros and cons, and how to get your application approved.
How Much Can I Borrow With a HELOC?
During your HELOC’s borrowing period, you can access your line of credit to withdraw money as you need it (without going over your credit limit!). How much you can borrow depends on the equity you’ve built up in your home. Typically, homeowners can borrow between 60 percent and 85 percent of their home’s assessed value, minus their outstanding mortgage balance, according to Experian.
Say, for example, you bought your new home for $225,000, but it’s now worth $300,000. You’ve added $75,000 to your home’s equity without lifting a finger because your new build appreciated in value. If you’ve also paid down your mortgage by $25,000, you’ll have a total of $100,000 in home equity. Your borrowing amount will depend on your home equity, first and foremost, along with your income, credit score, and ability to make debt repayments.
You’re putting your home equity on the line, though. Because you are using your home as collateral, if you fall behind on payments or can’t repay the funds, you risk losing your home.
It’s worth noting that if your home decreases in value, your lender may decide to decrease your credit limit, so you may not have as much money in your line of credit as originally planned.
How Do I Qualify for a HELOC?
Each lender has its own set of eligibility criteria to meet to qualify for a HELOC, but overall, homeowners can expect these baseline requirements, according to American Express.
- Home equity. Most lenders want you to have at least 20 percent equity in your home. AMEX notes that the more equity you have, the more likely you’ll be able to take out a HELOC.
- Good credit and credit history. Your aim is to make sure you have good to excellent credit, in the mid-600s at least, to increase your odds of getting approved for a HELOC. Solid credit history also shows lenders that, historically, you’ve managed your debts well. With your home as collateral, you may still qualify with a fair credit score, but you’ll have to deal with higher interest rates.
- A reasonable monthly debt-to-income ratio. Lenders want to know that your income is sufficient to repay your HELOC. Debt-to-income ratio is the percentage of your gross monthly income that goes toward paying your existing debts. Make sure your debt-to-income ratio is low, 43 percent at the highest, but the lower the better. Add up your existing debts to see how much of your income is spent on debt repayments before making your case to lenders.
- Proof of employment. Finally, get your pay stubs, bank statements, or a letter of employment ready; your lender needs proof of employment and income to approve you for a HELOC.
Do HELOCs Come With a Fixed or Variable Interest Rate?
While home equity loans come with a lump sum of cash repaid in installments over a fixed period, HELOCs are more fluid. As mentioned, HELOCs are a line of credit, so you can withdraw funds whenever you want during your draw period. They come with a variable interest rate, so your rate — and, in turn, your repayments — will fluctuate from month to month, according to the Consumer Financial Protection Bureau (CFPB).
Your interest rate will tie closely to market conditions and the prime rate, which is the interest rate banks are charged to borrow. (The prime rate dictates interest rates for everything from mortgages to home loans and even savings accounts.)
AMEX says that historically, HELOCs have had interest rates averaging from 1.99 percent to 7.24 percent. But your credit score, location in the country, and the loan-to-value ratio (the percentage of your property’s value that you owe) of your HELOC all play a role in your interest rate too.
Some lenders allow borrowers to lock in a portion of their HELOC balance under a fixed rate. If this is important to you, ask lenders if they offer this feature.
How Do I Repay my HELOC?
Your HELOC comes with a draw period, which is the time frame when you can withdraw cash from your account. During the draw period, you’re responsible for making at least the minimum payments on your HELOC, the CFPB says. Typically, these payments are interest only, but some lenders also may allow you to make payments on the principal. The draw period is typically 10 years, and once it ends, you will no longer be able to borrow money on your line of credit.
At that point, you’ll need to repay the balance either all at once (a balloon payment) or over a certain time frame, typically another 10 to 20 years. The CFPB notes that this period, called the repayment period, may come with much more substantial repayments compared to the draw period, so you should make sure your monthly budget can manage this debt, especially with your home on the line. Some homeowners refinance their HELOC as it can be a way to repay the remaining balance on the first one (particularly if interest rates are lower).
Do HELOCs Come with Additional Fees?
When you’re shopping for a HELOC, be sure to zero in on the fine print, including any additional fees and charges you may be on the hook for. This is a great way to compare lenders before you make a decision, too.
While HELOCs are convenient, getting them set up comes at a premium. Here are some of the fees you may incur when dealing with a HELOC (some may be included as part of the HELOC’s closing costs):
- Appraisal fee (for getting your property’s value assessed)
- Origination fee
- Mortgage preparation, filing, and administrative fees
- Attorney fees
- Title search fee (to prove you own the property free and clear)
- Transaction fees
- Cancellation fees
- Non-sufficient funds and late or missed payment fees
Get up to speed on what your lender may be charging you well before signing off on your HELOC.
What Are the Risks of Taking Out a HELOC?
Homeowners need to think carefully before deciding to shoulder more debt. Before taking out a HELOC, here are the potential risks to consider:
- You’ve used your home as collateral. If you can’t repay your balance, you run the risk of losing your property.
- Your lender may reduce or freeze your line of credit. If you make late payments or your home’s assessed value takes a dip, your lender may reduce your line of credit or freeze your account. This is a caveat worth paying attention to, especially if you’re relying on your HELOC to pay for key expenses.
- Your fluctuating interest rate may tamper with your budget. If your monthly budget is already stretched thin, an increase in interest rates — and, in turn, a higher monthly payment, may put you in a precarious situation.
- Your equity takes a hit. A HELOC can erase a huge amount of the equity in your home that you’ve built up, which can particularly be an issue if home values in your area drop significantly.
What Can I Use my HELOC For?
Well, virtually anything! Once your lender approves your HELOC application and sets up your account, you’ll have access to your funds for the entirety of your draw period. It can be tempting to use it for discretionary spending, like splurging on new clothes, the latest iPhone, or a lavish vacation. However, always keep in mind that you’re putting your home at risk, so be sure to weigh the consequences.
Some of the more common reasons to use a HELOC include:
- Paying for major home improvements and renovations. This is the No. 1 reason why homeowners leverage their home equity to take out a HELOC. Kitchen renovations, roof repairs, adding an extension to the property — these are all costly endeavors. HELOCs are a great way to finance home improvements because you can withdraw funds as needed, and overall, the result will add to your home’s value.
- Financial emergencies. Whether you’re dealing with unemployment or unforeseen medical bills, a HELOC can help you get through financial difficulties.
- Paying off credit card debt. With interest rates of up to 7.24 percent, managing debt on a HELOC is much easier than on a credit card with interest rates in excess of 19.99 percent. Some people choose to consolidate their high-interest debts, so they only have their HELOC to pay.
Carmen Chai is an award-winning Canadian journalist who has lived and reported from major cities such as Vancouver, Toronto, London and Paris. For NewHomeSource, Carmen covers a variety of topics, including insurance, mortgages, and more.