All About HELOCs: How Does a Home Equity Line of Credit Work?

What is Home Equity?

Home equity is the difference between the value of your home and the amount you still owe on your mortgage. You can increase your home equity either by paying off more of your mortgage or by increasing the market value of your home (i.e., through home improvements).

How to value your current home equity

To calculate your home’s equity, subtract the remaining balance of your mortgage from your home’s value. For example, if your home is appraised for $300,000 and your loan balance is $120,000, then you have $180,000 in equity.

What Is a Home Equity Line of Credit?

Unlike a home equity loan, in which money is taken out in a lump sum, HELOCs function like credit cards. You can borrow on your HELOC as needed, but cannot take out more than your credit limit. You can spend the money you take out on whatever you want, and keep in mind that the interest on whatever you spend to increase the value of your home is tax-deductible.

The pros of HELOCs include:

• You only borrow (and pay interest) on the money you actually need
• Better interest rates than the majority of credit cards and personal loans
• Interest can be tax-deductible if used for home improvement

The cons of HELOCs include:

• Some HELOCs have transaction fees.
• The interest rates are variable and subject to the markets
• If you default on your loan, you could lose your home
• Unlike a credit card, the draw period is for a limited time (around 10 years)

When HELOCs are a good idea

HELOCs are a good idea when you need money for an upcoming expense but you aren’t sure how much you need, or when exactly you need it. People often use HELOCs to pay for home renovations or education.

When HELOCS are a bad idea

HELOCs are a bad idea if your income is unstable and you don’t have a lot in savings. Due to the variable interest rates of HELOCs, you’re at the whim of the markets. If you can’t pay back what you borrow, you could lose your house. HELOCs are also a bad idea if you want to pay for something like a new car or a vacation, since you’re taking on risk for items that won’t help you build wealth.

Am I Eligible for a HELOC?

HELOC eligibility requirements include:

• A credit score of 620 or higher (700 is preferable)
• Home equity of at least 20%
• A debt-to-income ratio of less than 43%
• Proof that you can pay your bills on time

When applying for a HELOC, you’ll be expected to provide tax returns and bank statements. The initial vetting process can take weeks to complete. Once you’re approved, the HELOC closing process is very similar to signing a home mortgage.

How do I pay back a HELOC?

There are two phases of a HELOC: the draw period and the repayment period.

• Draw period: The draw period normally lasts for 10 years, during which you can take out money by card or check. Your minimum payments are usually interest-only, but you’ll have the option to also pay principle.
• Repayment period: The repayment period normally lasts for 20 years, though this can vary. During the repayment period, you don’t borrow against the credit line anymore; you repay it monthly, including interest and principle.

Will a HELOC hurt my credit score?

Applying for any loan will most likely hurt your credit score in the short-term, so you should expect a HELOC to temporarily lower your score.

How Does a HELOC Work?

Banks generally allow borrowers to take out as much as 85% of their appraised home value, minus what’s still owed on your first mortgage.

What HELOC fees should I expect to pay?

Fees associated with getting a HELOC include, but are not limited, to:

1. Appraisal fees
2. Application fees
3. Credit check fees
4. Annual fees
5. Cancellation fees
6. Closing costs (including attorney, title insurance, and mortgage preparation fees)

Be sure to ask your lender for a complete list of fees upfront.

Is there a cap to HELOC interest rates?

If interest rates go up, your HELOC interest rate will increase. The majority of states don’t let HELOC rates go up the past 18%.