A home equity line of credit (HELOC) works a lot like a credit card — you can access money any time you need it, up to a certain limit. Your payments are based only on the amount you’ve used, and you can pay off the balance and reuse it for several years.
However, unlike a credit card, a HELOC is a secured loan tied to your home — so you’ll risk going through foreclosure if you can’t make your payments. Understanding how a HELOC works, and when it makes the most sense to use one, will help you decide if it’s the best option for you.
A HELOC is a type of second mortgage that allows you to access cash as you need it. You’ll be able to make as many purchases as you’d like, as long as they don’t exceed your credit limit. You can get a HELOC even if you still have a first (or primary) mortgage on your house; the HELOC will simply be second in line to be repaid in the event of a foreclosure.
Because a HELOC is a line of credit, it functions differently from a “regular” installment loan like your first mortgage, a home equity loan or personal loan.
Get Customized HELOC Rates and Offers
How a HELOC works
A HELOC has two different phases: a set period of time for you to use your credit line and another during which you repay the balance you owe.
Phase one: The HELOC draw period
Once you’re approved for a HELOC, the draw period starts. In this first phase (typically 10 years), you can borrow as much cash as you want each month up to your credit limit. To make withdrawals, you’ll have checks or a card you can swipe. And depending on your lender, you may have the option to make interest-only payments during this phase.
HELOC minimum withdrawal requirements and fees
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Many HELOC lenders require a minimum withdrawal — the amount will depend on your lender and credit limit. HELOC loan programs also often have fees, including one-time fees for closing costs and ongoing maintenance and membership charges.
The minimum payment required can change depending on how much you’ve borrowed and the current interest rate.
Phase two: The HELOC repayment period
Once the draw period ends, you can no longer borrow from the credit line and you’re required to repay your outstanding balance — both principal and interest. HELOCs can require repayment all at once or through monthly installments. A typical repayment period is 20 years.
How do I find the best HELOC rates and lenders?
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It’s crucial to shop for the lowest HELOC rates, which can save you thousands over the life of your HELOC. Get at least three to five loan estimates from HELOC lenders to compare costs.
Other steps you can take: Beef up your credit score and reduce the home equity amount you borrow. Both higher credit scores and lower LTV ratios are correlated with lower HELOC rates.
Your loan-to-value (LTV) ratio is a major factor for determining how much money you can access with a HELOC. An LTV is a borrowing limit your lender sets that’s based on your home’s appraised value, and it’s normally capped at 85%. For example, if your home is worth $100,000, then the combined total of your current mortgage and the new HELOC amount can’t exceed $85,000. Keep in mind that some lenders may set higher or lower LTV ratio limits.
You can use LendingTree’s HELOC calculator below to quickly estimate how much you could access with a HELOC.
Follow these steps to get an idea of how much you may qualify to borrow with a home equity line of credit:
- Estimate your home’s value. Try an online home value estimator or ask your real estate agent.
- Multiply your home’s value by 85%*. You’ll need to convert the percentage to a decimal; in this case you’ll multiply your value by 0.85.
- Subtract your mortgage balance from Step 2. The result is how much HELOC money you might be able to borrow.
*85% is the standard maximum LTV for a HELOC. However, if you know a specific lender’s maximum LTV is different, you can plug it in here to get a more accurate picture.
Let’s say your home is worth $400,000, your current loan balance is $250,000 and your lender sets their HELOC LTV limit at 85%.
| Enter your home’s value: | $400,000 |
| Multiply the value by .85: | X 0.85 $340,000 |
| Subtract your loan balance: | ($250,000) |
| Estimated HELOC money you may qualify for | = $90,000 |
HELOC pros and cons
HELOCs can be very convenient, though there are some pitfalls that can get you into trouble. Much like a credit card, an open credit line can make it easy to spend beyond your means. In addition, having the option to make low, interest-only monthly payments during the draw period can lead to a nasty shock when you eventually need to start making payments that include principal. And because a HELOC uses your home as collateral, in the worst-case scenario, the bank could foreclose on your home if you can’t repay it.
| Pros | Cons |
|---|---|
You can use the credit line as needed You'll likely pay a lower interest rate than personal loan or credit card APRs You can typically make low, interest-only payments for a set time period You may be able to write off your interest at tax time if your HELOC funds are used for home improvements You can avoid private mortgage insurance (PMI) even if you finance more than 80% of your home's value | You may have monthly maintenance and membership fees, and could be charged a prepayment penalty if you try to close out the loan early Your HELOC rate is usually variable You’ll usually have to pay closing costs ranging from 2% to 5% of the HELOC’s limit Your payments could become unaffordable once you enter the repayment period You could lose your home to foreclosure if you default on your HELOC |
To qualify for a HELOC, you’ll need to provide financial documents, like W-2s and bank statements — these allow the lender to verify your income, assets, employment and credit scores.
Expect to meet these HELOC loan requirements:
Minimum 620 credit score
You’ll need a minimum 620 score, though the most competitive rates typically go to borrowers with scores of 780 or higher. You can get your free credit score here.
Can I get a HELOC with bad credit?
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It’s not easy to find a lender who will offer you a HELOC when you have a credit score below 680, and most home equity lenders won’t go lower than 620. If your credit isn’t up to snuff, it may be wise to put the idea of taking out a new loan on hold and focus on repairing your credit first.
Debt-to-income (DTI) ratio under 43%
This is your total debt (including your housing payments) divided by your gross monthly income. Typically, your DTI ratio shouldn’t exceed 43% for a HELOC, but some lenders may stretch the limit to 50%. Here’s how to calculate your DTI.
Loan-to-value (LTV) ratio under 85%
Your potential lender will order a home appraisal and compare your home’s value to how much you want to borrow. The LTV ratio is normally capped at 85%, according to the Federal Trade Commission (FTC).
Watch out for falling home values
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Borrowers should watch out for freezes or reductions in available HELOC funds if home values drop significantly during the HELOC’s term, according to the Consumer Financial Protection Bureau (CFPB). Lenders may do ongoing home value checks and adjust how much you can borrow.
How to get a home equity line of credit
Getting a HELOC is similar to getting a mortgage or any other loan secured by your home. You’ll need to provide information about yourself (as well as any co-borrowers) and your home.
Step 1. Make sure a HELOC is the right move for you
HELOCs are best when you need large amounts of cash on an ongoing basis: for example, covering home improvement projects or paying off medical bills. If you’re unsure what option is best for you, compare different loan types, such as a cash-out refinance or home equity loan.
But whatever you choose, make sure you have a plan to repay the HELOC.
Step 2. Gather documents
You’ll need to provide lenders with documentation about your home, your finances — including your income and employment status — and any other debt you’re carrying.
Step 3. Apply to HELOC lenders
Apply with a few lenders and compare what they offer regarding rates, fees, maximum loan amounts and repayment periods. It doesn’t hurt your credit to apply with multiple HELOC lenders any more than it does to apply with just one, as long as you do the applications within a 45-day window. You could get up to five HELOC offers from lenders at once using LendingTree.
Step 4. Compare offers
Take a critical look at the offers on your plate. Consider total costs, the length of the phases and any minimums and maximums.
Step 5. Close on your HELOC
If everything looks good and it’s the right move, sign on the dotted line! Make sure you’re prepared to cover closing costs, which can range from 2% to 5% of the HELOC’s credit line amount. (However, you might be able to get a discount on these costs if you work with a lender you have an existing relationship with.)
Compare HELOC Rates and Loan Offers
A home equity loan is another second mortgage option that allows you to tap your home equity. Instead of a line of credit, though, you’ll receive an upfront lump sum and make fixed payments in equal installments for the life of the loan. Since you can usually borrow roughly the same amount of money with both loan types, deciding on a home equity loan versus HELOC may depend largely on whether you want a fixed or variable interest rate and how often you want to access funds.
Is a home equity loan better than a HELOC?
The answer to this question will depend on your needs. A home equity loan is good when you need a large sum of cash upfront and you like fixed monthly payments, while a HELOC may work better if you have ongoing expenses.
Cash-out refinance vs. HELOC
A cash-out refinance replaces your current mortgage with a larger loan, allowing you to “cash out” the difference between the two amounts. The maximum LTV ratio for most cash-out refinance programs is 80% — however, the VA cash-out refinance program is an exception, allowing military borrowers to tap up to 90% of their home’s value with a loan backed by the U.S. Department of Veterans Affairs (VA).
Is a cash-out refinance better than a HELOC?
A cash-out refinance may be better if changing the terms of your current home loan will benefit you financially. However, since interest rates are currently high, it’s unlikely that right now you’ll get a rate lower than your original mortgage’s.
A HELOC may make more sense for you if you want to leave your original mortgage untouched, but in exchange you’ll usually have to pay a higher interest rate and may also have to accept a variable rate. For a more in-depth comparison of your options for tapping your home equity, check out our article comparing cash-out refinance versus HELOC versus home equity loan.
A personal loan isn’t secured by any collateral and is available through private lenders. Personal loan repayment terms are usually shorter, though the interest rates are higher than HELOCs.
Is a HELOC a good idea?
A HELOC can be a good idea if you have ongoing expenses and a set plan to pay off the loan. It can be a great funding source for home improvement projects, debt consolidation, education expenses or medical bills.
But a HELOC isn’t a good idea if you don’t have a solid financial plan to repay it — you could lose your home.
As a seasoned financial expert with a comprehensive understanding of home equity lines of credit (HELOCs), I'll provide an in-depth analysis of the concepts presented in the article.
Home Equity Line of Credit (HELOC): Understanding the Basics
A HELOC functions akin to a credit card, allowing users to access funds up to a predetermined limit at any time. This form of revolving credit requires payments based only on the amount utilized, providing the flexibility to pay off the balance and reuse it over several years. However, it differs from credit cards as it is a secured loan tied to the borrower's home, posing the risk of foreclosure in case of payment default.
Key Concepts in HELOC Operation:
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Secured Loan: A HELOC is a type of second mortgage secured by the borrower's home, making it imperative to understand the potential risk of foreclosure if payments are not met.
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Draw Period: The HELOC has two phases. The draw period, usually spanning ten years, allows borrowers to access cash up to the credit limit. During this period, withdrawals can be made through checks or a card, and some lenders may permit interest-only payments.
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Repayment Period: After the draw period concludes, borrowers enter the repayment phase, where the outstanding balance (principal and interest) must be repaid. Repayment can occur in a lump sum or through monthly installments over a typical period of 20 years.
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Minimum Withdrawal and Fees: Many HELOC lenders stipulate a minimum withdrawal amount, and fees such as closing costs, maintenance charges, and membership fees may apply.
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Variable Interest Rates: Unlike traditional installment loans, HELOCs often come with variable interest rates, making it essential for borrowers to monitor market conditions.
Factors Influencing HELOCs:
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Credit Score: A minimum credit score, often 620, is required to qualify for a HELOC. Higher scores, typically 780 or above, may secure more competitive rates.
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Debt-to-Income (DTI) Ratio: Lenders consider the borrower's total debt, including housing payments, relative to their gross monthly income. DTI ratios are usually capped at 43%, though some lenders may stretch it to 50%.
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Loan-to-Value (LTV) Ratio: The LTV ratio, capped at 85%, is determined by comparing the home's appraised value to the amount to be borrowed.
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Home Value Fluctuations: Home values' fluctuations during the HELOC term may impact the available funds, potentially leading to freezes or reductions.
Calculating HELOC Borrowing Limits:
The article provides a step-by-step guide to estimating the amount one might qualify to borrow using a HELOC, involving the home's value, multiplying it by the LTV ratio, and subtracting the existing mortgage balance.
Pros and Cons of HELOCs:
The article outlines the advantages and disadvantages of HELOCs, emphasizing convenience, potential tax benefits for home improvement expenses, and the risk of foreclosure in case of default.
HELOC vs. Other Options:
The article compares HELOCs with home equity loans, cash-out refinances, and personal loans, discussing scenarios where each option might be more suitable based on individual needs.
Qualifying and Applying for a HELOC:
Requirements for obtaining a HELOC include a minimum credit score, DTI ratio, and LTV ratio. The application process involves gathering relevant documentation, applying to multiple lenders for comparison, and carefully assessing offers before closing the HELOC.
Conclusion:
In conclusion, a HELOC can be a valuable financial tool if used judiciously, catering to ongoing expenses with a well-defined repayment plan. However, potential borrowers must be aware of the associated risks, including foreclosure in case of financial instability. Thorough consideration of individual financial situations and needs is crucial when determining if a HELOC is the right choice.
