Home Equity Line of Credit (HELOC)

A HELOC amounts to an open checkbook for people with equity in their home. However, there is a huge risk – foreclosing on your house – if you can’t repay the loan when it comes due.

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If you need extra cash, HELOCs are hot.

Those letters stand for Home Equity Line of Credit, which is a secured loan backed by your home. Instead of taking out a lump sum loan, borrowers get a credit line and use it similar to the way a credit card works

HELOCs have become an intriguing financial option as home prices and interest rates have increased. Google searches for “HELOC” jumped 305% in the first half of 2023, according to the real estate firm RubyHome.

HELOCs can be used to remodel your home, pay for college or even take vacations. They can also be a way to shrewdly pay off high-interest debts , like credit cards.

What Is a Home Equity Line of Credit?

A HELOC resembles a second mortgage but functions like a credit card (with a much better interest rate). HELOC funds can be drawn when you need the money instead of taken in a lump sum, as is common with second mortgages, which also are called home equity loans. You can access HELOC funds when you want but cannot exceed the amount set when you signed for the credit line.

HELOC Example

If you have a $100,000 HELOC, for example, you can borrow against it up to that amount. The interest rate is adjustable and based on the prime rate. . If you  only use $20,000 of the HELOC line, you will only pay interest on the $20,000 you used, not the $100,000 maximum value of the line.

Some people mix up HELOCs with mortgage loans. Let’s clear up the confusion. A mortgage is used for one purpose: to fund the purchase of a home. You never see the money. It goes straight to the seller, and you presumably stick to a monthly repayment schedule of up to 30 years.

HELOCs, by contrast, are revolving credit lines that use your home as collateral. You don’t have to use the money on your home or any type of real estate. Since the credit line is secured by your dwelling, the interest charged on what you borrow is lower than what you would pay on an unsecured credit card.

The catch, of course, is that the house secures the HELOC. If you default, the lender can foreclose on your home.

Common Uses for Home Equity Lines of Credit

You can use HELOC money for whatever you want, but it’s wise to consider options that will improve your financial position, not imperil it. In other words, we don’t recommend betting it all on the Raiders to win the Super Bowl.  A HELOC isn’t a lottery ticket, though it may feel like it at first. It’s money you have to pay back, so you want to spend it on your needs, not your wants. Your home is too valuable to put on the line without having a clear plan of action for those funds.

If you’re not sure what you could use a HELOC for, check out some of these recommendations:

  • Home improvements:  Replacing the garage door or remodeling the kitchen or bathroom could increase your home’s value. Or you could use a HELOC to pay for school or pay off student loans, which might have higher interest rates.
  • Education:  A HELOC could pay for school or pay off student loans, which may have higher interest rates
  • Debt consolidation: Combing debts like credit cards and car payments any paying them off could reduce your total monthly cost due to a lower interest rate. Having one monthly payment could also simplify your life and relieve stress.*
  • Start a business: Have you dreamed of starting your own restaurant or software writing business? Don’t let a lack of capital be the reason you never got your business off the ground. If you have a solid idea for a business, a HELOC can get your dream rolling.
  • Medical expenses: A HELOC can pay for an expensive medical procedure or pay off hospital bills that could be cramping your credit score.

How Do HELOCS Work?

A lender will need all your pertinent financial information (credit score, proof of employment, income, how much you owe on your mortgage, etc.) to start the application.

The lender will crunch those numbers to determine how large a credit line you can manage. HELOC terms vary, but they typically offer a 10-year period in which you can borrow the amount you’ve been authorized.

You’ll have to make minimum monthly payments. It’s often only interest charges, though you can pay principal since it will save you money in the long run.

After the draw period, borrowers usually have another 20 years to pay off the principal and interest. Interest rates are usually adjustable during the draw period but are frozen afterward.

To avoid repayment and keep a credit line open, borrowers often seek a new HELOC at the end of the draw period. They are refinancing their HELOC so they can continue borrowing while avoiding a big increase in the minimum monthly payment.

If you sell your home, you’ll have to pay off the HELOC right away. That’s usually not difficult if you’ve built equity over the years and not bet the house on the Raiders or otherwise been financially irresponsible.

How Much Can You Borrow?

Lenders use formulas to decide how much home equity you can borrow from with a home equity line of credit. Each lender is different, so it’s a good idea to apply to several bankscredit unions, and online lenders before choosing the best offer.

Before the market collapse of 2008, homeowners could often borrow as much as 100% of the equity in their homes. Lending laws have tightened since then. Today, most people are restricted to borrowing 80% of the equity in their homes. However, income and credit history still play roles in determining the max credit line you’ll be offered.

HELOC Requirements

Getting a HELOC is a lot like getting a mortgage, since it’s basically a second mortgage. You’ll need to provide the same documentation you did the first go-round.

Things lenders want do know include:

  • How much equity you have in your home? The lender will require an appraisal or electronically research your home’s value. It will subtract the amount you owe to determine your equity. In most cases, borrowers will potentially be eligible for 80% of that amount.
  • Your creditworthiness. The lender will review your borrowing history and credit score. The higher your score, the more likely you are to get a lower interest rate.
  • Other debts you might have, like car loans, credit card debt or second mortgages.

HELOCs and Interest Rates

Like all financial products, HELOCs have been impacted by the surge in interest rates since 2022. Alas, the days of 3% rates are gone. By September of 2023, the lowest rates were in the 8.5% range.

The rates borrowers pay are variable, meaning they fluctuate with market conditions. Lenders sometimes allow borrowers to lock their interest rates, for a fee.

That can be advantageous when interest rates are rising, but it will cost you more if rates drop. Also be aware that locked rates are generally higher than variable rates on the same loan.

How to Apply for a HELOC

  1. Establish eligibility: Check your credit score to get a ballpark idea of the rates you may qualify for, and then gather relevant documents like pay stubs, tax returns, and possibly investment and bank statements.
  2. Determine Your Home’s Equity: Find out how much equity you have in your home and whether a HELOC is the best option. This may require an appraisal. Remember, your home’s equity is determined by your home’s worth minus the amount you owe. For example, if you owed $100,000 on a home worth $250,000, your home’s equity would come out to $150,000.
  3. Shop around: Rate shop various lenders to compare rates and negotiate prices. Make sure to use any offer you receive as leverage against potential lenders and don’t be afraid to ask for a lower rate. If they know they’re competing for your service, they may be more willing to drop rates or cut a deal.
  4. Apply: Find the loan you like and apply. A lot of applications can be done online, though some smaller banks and credit unions may want you to apply in-person or mail in certain documents.
  5. Go over disclosure documents: Once approved, go over your loan disclosure agreement and make sure you agree with the terms and stipulations.
  6. Get funds: Depending on your lender, funds could take anywhere from 24 hours to a few weeks.

You should evaluate lenders before applying. Consider what the loan will cost, including:

  • The margin. This is the amount a lender might add to the rate used as an interest index for adjusting the loan. If the index is the prime rate and prime is 4%, the HELOC might stipulate that interest due will be prime plus 3.5%, so your interest rate would be 7.5%. The initial rate might not include the margin, which will be added after the introductory rate period ends. It’s extremely important to ask about margins.
  • Know what fees you’ll need to pay. These can include an application fee, documentary stamp fees, the cost of appraisals and credit checks, annual fees, cancelation fees, third-party fees, etc. Ask for a list of all fees and make sure you include them when comparing lenders. Some lenders waive fees, others add a lot.
  • Know how high can your HELOC interest rate climb if interest rates shoot up? Most states cap HELOC rates at 18%, but they can adjust monthly. Know how the adjustment structure works.
  • Remember that the interest rate you are quoted when you shop for a loan is a starter rate. Usually, the starter rate is only good for a few months. After that, the loan adjusts according to the system the lender uses to set interest.

How to Get a Low Interest Rate

Follow these steps to get the best interest rate on a HELOC:

  1. Have good credit: The best interest rates go to those with great credit scores. Order your free annual credit report from one of the three credit bureaus (Experian, TransUnion or Equifax) and check your credit standing. If you’re close to the cutoff lines between good and excellent, for example, spend some time and boost your score before applying for the HELOC. Research some tips and tricks to boost a credit score if needed.
  2. Compare interest rates: Don’t settle for the same lender that issued your mortgage. Check other rates from the big national banks, community banks, credit unions and online lenders. Even 1% can be a big difference in the final payoff.
  3. Beware of introductory rates: Be sure to ask how long the teaser rate will last and what it might be after it adjusts. Check if your lender has rate caps that limit the APR in case the variable rate goes through the roof.
  4. Factor in fees: Don’t forget about fees. Upfront lender fees, annual fees, inactivity fees and early termination fees might negate any money you thought you saved by going with the lowest interest rate. Look for lenders willing to waive fees.
  5. Have enough equity: Figure out how much you need to borrow from a HELOC and make sure you have enough equity in your home to make that happen.

Closing Costs

Here is a list of closing costs associated with HELOCS:

Upfront lender fees:

  • Application and processing fees – simply applying for a loan application could cost $100 or more. Some lenders will refund this money if your application is denied.
  • Origination fees – opening an account will usually cost 1% of the amount borrowed.
  • Appraisal fees – hiring a professional appraiser to determine your home’s value could cost $150-$250.
  • Attorney’s fees – cost of preparing documents related to the HELOC.

Annual or membership fees: Some lenders charge up to $75 each year for keeping the account open.

Transaction fees: Fee each time you borrow money.

Inactivity fees: Penalty for not using the account.

Early termination fees: Also referred to as prepayment or cancellation fees. Most lenders require the account to be open for 3-5 years. Otherwise, they’ll charge up to 1,000 or more to close the account.

Minimum withdrawal: Some HELOCs require a minimum withdrawal, which causes you to pay interest on more money than you actually need.

Minimum or required balance: There may be required balance which would force you to pay a certain amount of interest each month.

HELOC vs. Cash-Out Refinancing

cash-out refinance is another way to use the equity in your home. It’s a new loan you take out to pay off your mortgage. The amount you borrow is greater than what you currently owe on your mortgage. This means there will be cash left over, which is the amount you pocket.

For example, say your home is worth $200,000 and you still owe $100,000. This means you have $100,000 in equity. If you needed $50,000 of that equity, you could take out a cash-out refinance for $150,000. So, $100,000 would pay off your original mortgage, while leaving you with $50,000 in cash.

You now have a new mortgage of $150,000, and assuming the value of your house stays the same, your equity falls from $100,000 to $50,000. This isn’t necessarily bad, but it’s important to know what consequences a cash-out refinance will have on your home before going through with one.

A Cast-Out Refinance makes sense if:

  • You’re looking for lower interest rates
  • You plan to stay in your home longer
  • You want more time to repay the loan
  • You need a larger loan amount
  • You want to pay a fixed rate

Go with a HELOC if:

  • You want lower closing costs
  • You need less time to repay the loan
  • You’re borrowing less money
  • You’re unsure how much you need to borrow
  • You prefer or don’t mind a variable rate

HELOC vs. Home Equity Loan

A home equity loan is a lump-sum payment, usually for a large project like remodeling or installing a pool. You start repaying the loan with fixed-monthly installments right away. You could also use a home equity loan for debt consolidation if you have a large amount of credit card debt.

A HELOC, on the other hand, is a line of credit that usually lasts 10 years. You can nibble away at it to pay for several, small home-improvement projects, or you can use it in big chunks to pay for a vacation or wedding. The interest rate on HELOCs is variable and you could take as long as 30 years to repay them.

HELOCs and home equity loans share a key similarity: Both allow you to borrow against the equity you’ve built in your home and charge interest on the proceeds. But the way you borrow, how you repay, and the way interest is charged, differs considerably between the two.

The Pros and Cons of HELOCs

Financial products can get complicated, so it’s sometimes nice to break things down under simple terms. Let’s go over the pros and cons of a HELOC, so you can weigh the good against the bad and decide what’s best for your current goals.

Pros of HELOCs

  • Flexible terms: Borrow only on what you need. You may have access to a $20,000 credit line, but if you only need half of it, there’s no reason to pull out the rest, which would cost you needless interest.
  • Tax-deductible: A HELOC is tax-deductible if you use the money to renovate your home.
  • No restrictions: Use the money however you want, but we caution against taking out a HELOC without first setting a plan for how you will use (and repay) the funds.
  • Low-interest rates: Since your loan is backed by collateral (your home), HELOC rates tend to be much lower than those of personal loans or credit cards.

Cons of HELOCs

  • Easy access to credit line: In most instances, this is a pro, but it does have the potential for abuse. You might use more money than you can afford to repay since you will have access to a line of credit that’s easy to pull from. It may be years before you realize how much you’ve gone in over your head.
  • Putting your home at risk: A HELOC is a secured loan that uses your home as collateral. This means defaulting on your loan could leave you homeless.
  • Variable interest rates: Many HELOCs have adjustable rates, so your interest rate could rise over time, adding to the monthly payment, even if the balance doesn’t increase.
  • Reducing the equity in your home: Taking out a HELOC means diminishing the equity you’ve worked so hard to build. If the housing market slows down and prices fall, you could end up underwater in your home.

HELOC Fraud

HELOC fraud is a type of mortgage fraud. It can happen when criminals get hold of your personal information like your social security or account number.

Identity thieves often gain access to your sensitive information through phishing on the internet. This is when a fraudster pretends to be a certain entity to trick you into sharing account info. This could be a scammer pretending to be Netflix and asking you for your login info. Or it could be someone posing as a government agency asking to verify your SSN.

Since a lot of banks will issue HELOCs with relatively few documentation requirements, they’re often a ripe target for scammers. Probably, you won’t even know about the scam until you start receiving missed payment notifications.

You can minimize the risk of succumbing to HELOC fraud by checking your financial statements regularly and tracking your credit report. Everyone in the U.S. can get 6 free credit reports per year through 2026 by visiting the Equifax website or by calling 1-866-349-5191.

Harmful Home Equity Practices to Watch For

Lenders sometimes act more like scammers than reputable financial institutions. Desperate or unscrupulous creditors have a whole bag of tricks they can pull from to dupe you into a bad deal.

Here are a few sketchy lending practices to be on guard for:

  • Loan Flipping: The lender gets you to refinance the loan, repeatedly. By overstating the value of refinancing and understating the costs, the lender can continue to milk you for more service and interest fees.
  • Insurance Packing: The lender includes insurance packages that you did not ask for and do not need.
  • Bait and Switch:The lender greets you with a set of highly favorable terms, but later when it’s time to sign, you’re met with and pressured into accepting higher charges.
  • Equity Stripping: The lender offers a loan based on your home’s equity instead of on your ability to repay. This could lead to payments that are too high for your budget, eventually jeopardizing your home’s security.

Best HELOC Lenders

The best HELOC lenders will offer borrowers competitive interest rates with high, flexible loan amounts. If you have good credit, look for lenders that incentivize high credit, you’ll be rewarded with the lowest rates. Borrowers without good credit should look for lenders who focus on aspects like income, employment history or education.

HELOC Safeguards and the Truth in Lending Act

The Truth in Lending Act forces lenders to be upfront with you regarding the costs and details of your loan. Lenders have to tell you the APR and payment terms, and any other charges associated with opening an account, like an appraisal or attorneys’ fees. Also, lenders have to tell you about any variable-rate feature and give you a brochure describing the general features of home equity plans.

If you’re keeping up to date with payments, the lender cannot terminate your plan, accelerate payment of your outstanding balance, or change the terms of your account.

The three-day cancellation rule: This lets you cancel your loan for any reason up to three days after signing the contract. In other words, this gives you three days to ask yourself, one last time, whether a HELOC is the wisest move for what you’re trying to accomplish.

Here’s how it works:

  • You sign a credit contract.
  • You get a Truth in Lending disclosure form containing key information about the credit contract, including the APR, finance charge, amount financed, and payment schedule.
  • You get two copies of a Truth in Lending notice explaining your right to cancel. The rule counts Saturdays, but not Sundays or public holidays. For example, if you sign on a Thursday, you have until midnight on the next Monday to cancel.

How to Cancel a Home Equity Line of Credit

You have to cancel a HELOC in writing. You can’t do it over the phone or even in person. Your written notice must be mailed, filed electronically, or delivered, before midnight of the third business day.

After canceling, the lender has 20 days to return whatever you paid as part of the transaction, even the cost of financing. If you already got money from the lender, you could keep it until you get proof (ideally a statement in writing) that your home is no longer being used as collateral.

Then, you have to return the money to the lender, but if the lender doesn’t claim it within 20 days, it’s all yours.

In these instances, you won’t have a grace period to hash things over:

  • You apply for a loan to buy or build your principal residence.
  • You refinance your loan with the same lender who holds your loan, and you don’t borrow additional funds.
  • A state agency is the lender for a loan.

How Will a HELOC Impact My Credit Score?

HELOCs are classified as a revolving type of credit on most credit reports, the same designation as credit cards. However, they don’t impact credit scores in the same way.

The issue boils down to the credit utilization ratio, which accounts for 30% of a credit score. Credit bureaus recommend you keep your revolving balance under 30% of your credit limit. That presented a major problem when HELOCs became popular in the 1990s.

HELOC borrowers tend to use up most of the balance right away for things like putting a down payment on a second home or renovating a kitchen. That would put a major dent in your credit score if it were treated as a regular revolving line of credit. For this reason, HELOCs over $35k probably are not factored into credit utilization.

However, different credit bureaus have different rules, and none of them have released an official cutoff. Evidence suggests it is a safe bet that a HELOC over $35k won’t affect credit utilization, but anything under that number might count.  Thus, for smaller HELOCs, keep your utilization under 30% of your credit limit, and you should have nothing to worry about.

Is a HELOC a Good Idea?

A HELOC can be a solution to rising debts, but it also can become the reason people end up mired in debt. If you are using a HELOC to pay off your debt, you should contact a debt counselor and work out a program to manage your finances in a way that leads you out of your debt problem.

People in debt often see a HELOC as an easy solution. Indeed, it can be a backup if emergency funds are not available to help you get through a debt problem. The line of credit can be preferable to using credit cards, which can have much higher interest rates and late fees.

A HELOC can add to debt woes, however, if homeowners take out a line of credit on their home to pay off other debts, then continue to spend more than their incomes justify.  This ongoing cycle is called reloading, when the homeowner must borrow money repeatedly to make ends meet.

That’s the last thing you want to do. HELOCs are hot for a lot of reasons. But like all loans, you need to be responsible, or you might very well get burned.

About The Author

Bents Dulcio

Bents Dulcio writes with a humble, field-level view on personal finance. He learned how to cut financial corners while acquiring a B.S. degree in Political Science at Florida State University. Bents has experience with student loans, affordable housing, budgeting to include an auto loan and other personal finance matters that greet all Millennials when they graduate. He has a prodigious appetite for reading, which he helps feed with writing from Scottish philosopher Adam Smith, the “Father of Capitalism.” Bents writing also has been published by JPMorgan Chase, TheSimpleDollar and Interest.com.

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