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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A home equity line of credit, or HELOC, is a secured loan backed by your home. Instead of taking out a lump sum, borrowers are given access to a credit line, similar to how a credit card works, and only charged interest on the amount they use.

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 can access HELOC funds when you want but cannot exceed the amount set when you signed for the credit line.

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 used, not the $100,000 that is the 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 for the most part you stick to a repayment schedule that stretches from 15 to 30 years.

HELOCs, by contrast, are revolving credit lines that use your home as collateral. You don’t necessarily have to use the money on your home or any type of real estate. Since the credit line is secured by a 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

There are no restrictions on how you can use your HELOC. You can spend it all on vacation if you want, but we recommend using it in a way you won’t regret later on. Your home is too valuable to put on the line without first having a clear plan of action for your 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 repair damage to your home, especially damage not covered by insurance.
  • Education: You can use a HELOC to pay for school or pay off student loans, which may come with higher interest rates.
  • Debt consolidation: Using a HELOC to consolidate your debts could simplify your life by reducing your monthly payments and lowering the amount you lose on interest.
  • Start a 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, you can use a HELOC to get things rolling.
  • Medical expenses: You can use a HELOC to pay for an expensive medical procedure or to pay off medical debt that could be cramping your credit score.

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 (i.e. your house) 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 apply, 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.

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 of $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.

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

Terms vary from loan to loan. It’s very important to understand how your HELOC works before you agree. 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. 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 will be required to repay what you owe on the HELOC right away. This is 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. The interest rate can be low, but it’s often variable, meaning it will adjust with a chosen financial index. Interest on a loan may start at 4% annually, and then rise or fall in concert with changes in the index. 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 at the borrower’s discretion.

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 banks, credit 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 a role in determining the max credit line offered to you.

Qualifications for a HELOC

If you already have a mortgage, 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 want 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 to 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.

HELOCs and Interest Rates

Most HELOCs have variable interest rates averaging from 2.99%-21%.

If a lender offers you a 30-year HELOC with a 10-year draw period, you typically will pay interest only on the balance used 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. One you’ve probably heard of is the U.S Prime Rate. Many banks use the U.S. Prime Rate as an index. They add a fixed percentage (or margin) to the index rate to set your interest rate. This can change frequently.

In late 2020, annual HELOC rates averaged 4.52%, while home equity loan rates averaged near 5.10%.

Sometimes, lenders 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 work for you when 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

Here’s 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 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 are reminded 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, you’ll 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.
  • 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

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. 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 Cash-Out Refinancing

A 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 Cash-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 cost
  • You need less time to repay the loan
  • You’re borrowing less money
  • You’re unsure exactly 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.

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. Here we’ll 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 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 on your home.

Beware of HELOC Fraud

HELOC fraud is a type of mortgage fraud and it can happen when fraudsters get a 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 keeping tabs on your credit report. Starting in 2020, 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.

Federal Truth and Lending Act and HELOC Safeguards:

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 the 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; and
  • 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 can 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.

There are some exceptions to the three-day cancellation rule.

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.

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.

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 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.

The Effects of Covid-19 on HELOCs

Banks have reacted to Covid-19 by clamping down on their funds and chocking access to equity for homeowners and potential borrowers.

Wells Fargo stopped accepting applications for HELOCs  in April of 2020. JP Morgan has done the same along with requiring higher down payments and FICO scores to win approval for a loan. Chase has also stopped issuing HELOCs, and borrowers looking to win approval through Bank of America will need FICOs scores of at least 720 (up from 660).

Fannie Mae and Freddie Mac, which back about half of all mortgages in the U.S, are offering forbearance options that may allow borrows affected by the Covid-19 pandemic to suspend their loan payments for up to a year. If you’re falling behind on payments get in touch with your loan servicer and ask about relief options. Bank of America has said it is open to discussing deferments for those affected by the pandemic. These payments would then be tacked onto the back of the loan but will result in no negative reports to the credit bureaus.

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

About The Author

Bents Dulcio

Bents Dulcio graduated from Florida State University in 2016 with a degree in Political Science, and knows a thing or two about Millennial student loan debt. While in school, he developed a passion for classic literature, reading books by authors from Homer to Adam Smith and developed a penchant for dealing with tight financial circumstances. Bents used the student loan money to pursue a semester of language study in France that helped convince him to become a writer. Bents still hits the books – he read 70 in the past year – and still knows how to cut corners financially.

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