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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    Man on Computer applying for a Home Equity Line of Credit

    When homeowners need money to help cover expenses, a home equity line of credit, or HELOC, is one way to rustle up some extra funds.

    HELOC funds can be used to remodel your home, pay for college or even take vacations. It also can be handy for people who need an alternative resource to pay mounting debts. People turn to HELOCs because they are an easy way to get money they need.

    It is wise to understand the process of using a HELOC to avoid financial trouble.

    What is a HELOC?

     A HELOC resembles a second mortgage but functions like a credit card. 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 could borrow on your HELOC to pay for a child’s wedding and later to buy a car. You can access HELOC funds when you want, but cannot exceed the amount set when you signed for the credit line.

    Some people confuse HELOCs with mortgage loans, but they are different. A mortgage is used for one purpose: to fund the purchase of a home. You never see the money, since it’s conveyed to the seller, and for the most part you stick to a repayment schedule that typically stretches from 15 to 30 years.

    HELOCs, by contrast, are revolving credit lines that use your home as collateral against default. What you spend HELOC funds on needn’t have anything to do with real estate. The only role of your home in a HELOC is to serve as collateral to secure the money you borrow.

    If you have a $100,000 HELOC, for example, you can borrow up to that amount at an adjustable interest rate. If you never use more than $20,000 of the HELOC line, you will only pay interest on the $20,000 you borrowed, not the $100,000 that is the maximum value of the line.

    HELOCs have advantages for those who use them wisely. Since the credit line is secured by a dwelling, the interest charged on what you borrow is generally far lower than what you would pay on an unsecured credit card. The catch, of course, is that the home secures the HELOC. If you default, the lender can foreclose on your home.

    How Do HELOCs work?

    Applying for a home equity line of credit is a lot like getting a primary mortgage. Lenders will want to know how much equity you have in your home, what its appraised value is, how much money you earn, what your outstanding debts are and your credit score. The lender’s goal is to vet you as a credit risk and know what your collateral is worth.

    Once the lender verifies your income and reviews an appraisal of your home, it will contact you with an offer. Say you have a home that appraises at $300,000, you still owe $100,000 and don’t have any other liens on your property. You need to demonstrate your ability to repay a HELOC, so you’ll need to submit proof of employment and other income and have a solid credit history. After the lender evaluates all the information, it decides how large a credit line you can manage. They might, for example, offer you a $100,000 credit line for 10 years with a variable interest rate starting at 4%.

    HELOCs come with different borrowing and repayment schedules, but the 30-year repayment period is quite common. Before you file an application, consider how long you want the credit line to remain active. Also consider whether the lender charges closing costs and fees for appraisals and filing official documents with the court. In some instances, lenders waive these fees, in others you pay them.

    Home equity lines of credit come with various terms, and many allow you to use the line for years without repaying principal. In our example, you could borrow up to the maximum $100,000 during the 10-year draw period, making interest payments on the balance. After that, the credit line is frozen and you’ll have to pay interest and principal for another 20 years. You must make minimum monthly payments on your borrowed money, but you can accelerate repayment if you desire.

    Once you’ve been approved, the lender might give you a HELOC account card or checks so you can use with your HELOC line conveniently.

    Terms vary from loan to loan. It’s very important to understand how your HELOC works before you enter in the agreement. Some loans might require immediate payment of all money owed at the end of the draw period. Others may extend repayment over decades. To avoid repayment and keep a credit line open, borrowers often seek a new HELOC at the end of the draw period, refinancing their HELOC so they can continue borrowing while avoiding a big increase in the minimum monthly payment.

    If you sell your home, you will be required to repay what you owe on the HELOC right away. This is usually easily done if the sale price exceeds what’s owed on the HELOC and any other mortgages. But it can mean trouble if the home is underwater, meaning it’s worth less than what is owed to the lenders. If that happens you’ll need to make up the difference from your other savings or negotiate a deal, called a short sale, with the lenders.

    Like other types of mortgages, the interest on a home equity line of credit is tax deductible. Interest rates can be low, but they also are usually variable, meaning the adjust in relation to a chosen financial index. Interest on a loan might start at 4% annually, but might rise or fall in concert with changes in the index. And since you are paying interest on the balance due, the monthly payment will change in tandem with the interest rate. Some HELOCs offer interest rate locks, which freeze rates until they are unlocked and the borrowers’ discretion.

    How Much Can You Borrow?

    Lenders use formulas to decide how large a home equity lines of credit you qualify for. Each lender is different, so it is often a good idea to apply to several banks, credit unions and online before choosing the best offer.

    During the years preceding the real estate market collapse of 2008, lenders were quite lax in their HELOC underwriting requirements, often allowing home owners to borrow as much as 100% of the equity in their homes. Changes in lending laws and a sense that overly permissive standards led to a collapse of the housing market led to stricter standards. Today, most borrowers are restricted to borrowing 80% of the equity in their homes. As mentioned, the borrowers’ income and credit history also play a role in determining the home equity credit line.

    HELOCs and Interest Rates

    Most HELOCs have variable interest rates that operate much like adjustable rate mortgages. If a lender offers you a 30-year HELOC with a 10-year draw period, you typically will pay interest only on the balance owed during the first 10 years, then interest and principal for the remaining 20 years.

    Banks use indexes and margins to set the variable rates. There are many indexes. All are assessments of changing market conditions placed in relation to financial instruments such as Treasury bills to set a rate. Many banks use the U.S. Prime Rate as an index and add a fixed percentage, called a margin, to the index rate to set your interest rate, which can change frequently.

    Lending rates can change, or adjust, almost daily.  The rate a lender offers you might vary from the rate it charges borrowers customers who have the best credit. Lenders consider how much equity you have in your home, your credit worthiness, your debt-to-income ratio and all your sources of income to determine how much you can borrow and the interest rate you’ll pay.

    In early 2019, annual HELOC rates averaged slightly more than 5.5%, while home equity loan rates averaged near 8.75%.

    To avoid the variability and allow borrowers to more accurately anticipate what they will be paying each month, lenders sometimes allow borrowers to lock their interest rates. A lock fixes the interest rate at a certain percentage until the borrower removes it. The bank usually charges a fee for a lock, which can be advantageous if interest rates are rising, but end up costing you more if interest rates drop. Locked interest rates are usually higher than variable rates on the same loans.

    How to Apply for a HELOC

    Lenders often solicit customers through direct mail or online, and some allow you to make an initial application electronically. But most will want an assortment of documents to verify income. The application likely will require that you provide recent tax returns and possibly investment and bank statements. The lender might also want to contact your employer to verify job status. The lender will almost certainly do a credit check. All these demands are used to establish creditworthiness and can take time – sometimes several weeks.

    Small lenders might talk to you in person, while national banks often call you and ask for copies of documents to be faxed or emailed. After you are approved and you accept an offer, the loan is closed in a procedure reminiscent of the one you went through when you signed for a mortgage on your home.

    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.
    • 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.

    See our list for the Best HELOC options.

    How to Get a Low Interest Rate

    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. Banks limit HELOCs to 80% of the equity in your home. Equity is based on the difference in the home’s current market value (not what you purchased the home for) and the balance you owe.

    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 to determine the value of your home could cost about $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 for 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 will charge up to $1000 or more to close the account.

    Minimum withdrawal: Some HELOCs may require a minimum withdrawal causing you to pay interest on more money than you actually need.

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

    HELOC vs. Home Equity Loan

    Consumers often mistake HELOCs and home equity loans for being the same thing. They are not.

    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.

    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

    Just like credit cards, HELOC credit lines are ripe for abuse. One of the reasons banks turned to restrictive underwriting standards after the 2007 financial crash is that many homeowners were using HELOCs as cash machines, assuming houses would increase rapidly in value and they could sell and pay off their HELOCs later.

    The post-2007 experience taught everyone a lesson: Housing prices usually rise, but they can easily fall. A lot of money borrowed on a HELOC put many people in what is called negative equity, meaning they owed more than their houses were worth. That led to widespread foreclosures as homeowners stopped paying their debts.

    Another lesson from the 2007 meltdown is that banks can lower HELOC borrowing limits overnight if they choose. When real estate price plunged precipitously during the market meltdown, lenders did just that, and people who were planning to use their HELOCs for anticipated needs like paying college tuition often were forced to look for alternatives.

    Home equity lines of credit are also variable. The more you borrow, the larger you monthly payment, even if you are in an early period that only requires interest payments. Also, many HELOCs have adjustable rates, so your interest rate potentially could rise over time, adding to the monthly payment even if the balance doesn’t increase.

    There are alternatives to HELOCs if you don’t like the uncertainty or know you don’t handle credit well. You could apply for a conventional home equity loan, or second mortgage, which is a one-time loan with a fixed repayment schedule. Some lenders want to know what you plan to use the money for, and the home equity loans often come with interest rates that are higher than HELOCs because the interest rate is fixed, instead of variable.

    Cash-out refinancing is another option. It allows you to refinance your mortgage, borrowing more than you owed and taking the equity out in cash. In this case, you get cash to use as you wish and a fixed rate mortgage to repay. Obviously, you need to convince the lender that you can repay a larger loan.

    Before you use your HELOC, an act that can put your home at risk, consider what you need the money for and how capable you are to repay it. Even if a lender approves your application, you are responsible for repaying the loan.

    Qualifications for a HELOC

    If you already have a mortgage, or had one when you bought your home, you should be familiar with what it takes to qualify for a HELOC. Both HELOCs and home equity loans are technically second mortgages and require nearly the same documentation. Things lenders what to know include:

    • How much equity you have in your home. The lender will either require an appraiser or research the home’s value electronically. It then will subtract the amount you owe determine your equity. It will potentially issue a credit line for up to 85% percent of that amount.
    • Information about your employment and other income.
    • Your creditworthiness. The lender will review your borrowing history and credit score. The higher your credit score, the more likely you are to qualify for a loan with the best interest rate.
    • Other debts you might have. If you have car loans, credit card debts or own a mortgaged second home, the lender will want to know.

    Reasons to Avoid HELOCs

    The chance that you might lose your home if you can’t make HELOC payments on time is a major risk. Unlike personal debt, which is unsecured, HELOCs use your home as collateral. If you lose a job or become seriously ill and can’t make payments on time, the lender is entitled to foreclose.

    HELOCs are credit, not free money. Some people treat HELOCs like a savings account available for major purchases, vacations or home remodeling. Though HELOCs carry lower interest rates than credit cards, they are still borrowed money. You eventually must repay the HELOC, and the more you borrowed and used, the larger your payments will be. If you don’t, the lender will foreclose. Even if you have a HELOC that only charges interest on the outstanding debt during the first 10 years, the loan will go into repayment mode after that, requiring you to pay both principal and interest. Worse, the credit line will no longer be available unless you are able to refinance.

    Using a HELOC might throw your retirement plans into disarray. Many people try to pay off a mortgage before leaving the workforce, but they might forget the HELOC. Instead of having one mortgage to pay off, they have two. Home equity is the biggest asset many retirees have, but if it’s depleted by a HELOC, it might not be nearly a great as it could be.

    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 like 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.

    HELOCs and Debt

    A HELOC can be a solution to rising debts, but it also can become the reason people end up mired in debt. Homeowners must be clear on both the advantages of taking out a HELOC and the potential problems that can come from it.

    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, in which the homeowner must borrow money repeatedly to make ends meet.

    Max Fay

    Max Fay is an entrepreneurial Millennial whose thoughtful writing shows he has a keen eye on both. Max has a genetic predisposition to being tight with his money and free with financial advice. At 25, he not only knows what an “emergency fund” is, he already has one. He wrote high school and college sports for every major newspaper in Florida while working his way through Florida State University. That experience was motivation to find another way to succeed financially and he has at Debt.org. Max can be reached at mfay@debt.org.

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