A house can be an important and valuable asset to have in your financial portfolio. However, because a house is, well, a house and not a bank account, that value can be hard to get ahold of when you need it most.
Fortunately, there are several loan options that help you turn that home value into cold, hard cash. One such option is the home equity line of credit, which allows you to borrow against the equity in your home. How does this loan option work, and is it right for you? Let’s go over everything you need to know.
What Is A Home Equity Line Of Credit?
A home equity line of credit is a type of second mortgage that allows homeowners to borrow money against the equity they have in their home and receive that money as a line of credit. Borrowers can use HELOC funds for a variety of purposes, including home improvements, education and the consolidation of high-interest credit card debt.
Sound a little confusing? We’ll break that down for you.
First, what exactly is home equity? If you used a mortgage to purchase your home, you may joke that “I don’t own my home; the bank does.” But that’s actually not entirely true. Each time you make a payment on your mortgage, you add to the amount of your home that you own.
This doesn’t mean that, say, with this month’s payment you own the windows and with next month’s you’ll own the floorboards, but rather that you own a certain portion of the home’s value outright.
So, say your home is worth $250,000. When you purchased the house, you put down 20%, or $50,000. That means that as soon as your closing was completed, you had $50,000 of equity in your house. Then, after a few years of living in the house and making regular payments, you’ve got the balance of what you owe your lender down to $180,000. Assuming your home is still worth $250,000, that means you have $70,000 worth of equity built up in the house.
Put simply, your equity is the amount your house is worth minus what you currently owe your lender.
Once you have a good chunk of equity built up, you can let it sit and continue to grow, or you can utilize it if you have a need for a large sum of cash.
This is where HELOCs or other types of home equity financing come in. The equity you have in your home is used as collateral for the loan, meaning you’ll likely be able to get a lower interest rate than you would with an unsecured personal loan. Plus, depending on how much equity you have in your home, you may be able to borrow significantly more money than you could with a personal loan.
Often, loans that utilize the equity in a home are used for projects related to the home, such as doing a remodel or replacing vital components like the roof or HVAC system. However, these loans can also be useful for those who want to pay off high-interest debt. In fact, if you have a lot of credit card debt, using a second mortgage like a HELOC to pay it off can lower the amount you’re paying in interest each month and make your payments easier to manage.
An important reminder: Tapping into your home’s equity can be a helpful source of cash for homeowners, but it’s something that should be approached with a lot of caution and consideration for how it could affect your financial situation.
Rocket Mortgage® does not offer HELOCs. However, we do offer cash-out refinances, which can be a good option for those looking to use their home’s equity to their advantage and get the cash they need.
How Does A HELOC Work?
Of the two types of second mortgages, HELOCs work more like a credit card than a traditional installment loan. Instead of receiving a lump sum, you’re able to continuously borrow against a line of credit, up to a certain limit and within a certain time period.
Since a HELOC is a second mortgage, you’ll be adding another loan to your property, on top of your current mortgage loan. The other type of second mortgage, a home equity loan, works by lending you a lump sum of cash that you then pay off over a set amount of time. HELOCs are a little more complex than this.
With HELOCs, borrowing and repayment are separated into two distinct periods (beware, however, that you’ll make payments on the loan during both periods).
The first phase, called the draw period, is when your line of credit is open and available for use. During this period, you’ll be allowed to borrow from your line of credit as needed, making minimum payments or, possibly, interest-only payments, on the amount you’ve borrowed. If you reach your limit, you’ll have to pay off some of what you owe before you can continue borrowing.
If you want to extend your draw period, you may be able to refinance your HELOC to do so.
Once you reach the end of your draw period, you will no longer have access to the HELOC funds and will have to start making full monthly payments that cover both the principal and interest. This is the repayment period. If you’ve been making interest-only payments up to this point, be prepared for your payments to go up, potentially by a lot.
The length of both of these periods will depend on the loan you get. For example, you may decide that a 30-year HELOC, with a 10-year draw period and 20-year repayment period, makes the most sense for you.
Typically, lenders won’t allow you to borrow against all the equity you have in your home, in order to keep your loan-to-value ratio below a certain percentage. This is because lenders want you to have a certain amount of money in the home, since you’re less likely to default if you could lose the equity you’ve built up.
Going off our earlier example, let’s say you find a lender who’s willing to give you a HELOC with 80% LTV. Your home is worth $250,000 and you currently owe $180,000. To figure out how much your credit limit would be on this HELOC, multiply your home’s value by 80% and subtract your current balance.
- 250,000 X .80 = 200,000
- 200,000 – 180,000 = 20,000
In this scenario, you could potentially get a credit limit of up to $20,000.
HELOC Rates: What To Expect
The interest rate you’ll get for any debt you take on will vary depending on your own financial situation and what the economy is doing at the time. But in general, rates for second mortgages will be slightly higher than the rate you pay on your main mortgage – because the lender takes on more risk with a second mortgage – and lower than the average credit card rate (sometimes much lower, depending on your creditworthiness).
You should also be aware that most HELOCs have variable rates, meaning the interest rate you pay will change with fluctuations in the market. You may be able to get a HELOC with a fixed rate, or a hybrid that allows you to convert to a fixed rate from a variable rate, but these loans may come with restrictions on how many times you can withdraw money and the minimum amount you can withdraw each time.
Depending on your lender, you may also have to pay certain fees, such as an annual fee for the cost of having the account or an origination fee that covers the cost of setting up your loan.
If you decide to get a HELOC, be sure to shop around and compare costs among multiple lenders to make sure you’re getting the best deal. If you can’t find a lender that offers an attractive rate, it may be a good idea to work on your credit first, and then shop around again once you’ve improved your score.
Do You Qualify For A HELOC?
Although requirements vary from lender to lender, most lenders want HELOC applicants to have fairly strong credit profiles. While there is sometimes more leeway for applicants trying to obtain a first mortgage depending on what programs are available to them, there isn’t as much wiggle room for HELOCs.
Applicants with a 620 credit score – the standard for a first mortgage – may find getting a HELOC more difficult or not worth it due to the high interest rates they’re given. You may want to first work on getting your credit score into the 700s before applying for a HELOC. Likewise, while some mortgage loan programs allow borrowers to have a debt-to-income ratio up to 50%, HELOC lenders will likely only consider applicants with a much lower DTI, usually below 43%.
The most important puzzle piece, however, is how much equity you have built up in your home. Most lenders will want to see that you have at least 15-20% equity in your home before they can set you up with a HELOC.
Additionally, remember that like any debt, a HELOC can affect your credit positively or negatively. Be sure to always make on-time payments on your HELOC so it doesn’t cause your score to drop.
How To Apply For A HELOC
Much in the same way you applied for your first mortgage loan, you’ll want to start by gathering all the necessary documentation and shopping around for the lender that’s right for you.
To apply for a HELOC, you’ll need to submit documentation verifying your income, including W-2s, paystubs and tax returns, as well as documentation that proves you own the home in question. You may also need to provide statements for any accounts that belong to you, such as a savings account or retirement fund.
Once you’ve applied, the lender will provide you with information about the terms of the HELOC. Be sure to go over them carefully and make note of any requirements of when and how you can withdraw cash, how your monthly payments will be structured, how much you’ll pay in fees and any other pertinent information.
As your loan is being underwritten, your lender may require some form of appraisal to confirm that your home is worth what you say it is. This can be done in a variety of ways; with a simple calculation of value based on publicly available records, with what’s called a drive-by appraisal, where a person only visually appraises the exterior of your home to ensure that it’s still standing and appears to be in good condition, or with a more thorough, traditional appraisal.
Once everything has gone through and your loan is ready for your signature, you’ll close on the loan and your line of credit will be available to you, usually through a card or a checkbook.
HELOC Vs. Home Equity Loan
Why would someone choose a HELOC over the other second mortgage option, a home equity loan? While both options let you use the equity you’ve built up in your home, they’re structured differently, so you may find that one works better for your situation than the other.
With a home equity loan, you get one lump sum, one time. This can be useful if you have a project with a fixed cost that you need to cover up front, like if you’re replacing your roof. If you’re doing a single, expensive home improvement project (or something similar), it might not make sense to get a HELOC, since you’ll only need the money once, rather than having to continually borrow it.
A HELOC, on the other hand, is great if you have longer-term borrowing needs. For example, say you’ve purchased an investment property that you want to do significant renovations on. This will likely be an ongoing process with a variety of different costs, and you may not know up front how much you’ll need to borrow in total. In this case, getting a lump sum with a home equity loan wouldn’t make as much sense as opening a HELOC.
Another benefit to getting a HELOC is that you only pay interest on what you’re currently borrowing. With a home equity loan, you’re paying interest on the full amount, even if you don’t end up using all of the money. By getting a HELOC, you can take out only what you need at the time, so if a project ends up coming in under budget, you won’t have to worry about paying more than is necessary in interest.
However, home equity loans also come with more predictability, since they generally come with fixed rates and set monthly payments.
Pros Of A HELOC
A HELOC can be a useful choice if it allows you to consolidate your debts at a lower interest rate. They’re also flexible, and can be used for anything you need the cash for, including college tuition or other education-related costs.
A second mortgage of any kind may also be your best option for borrowing a large sum of cash, which can be useful for costly home improvement projects.
Speaking of home improvement, the interest you pay on a HELOC may be tax deductible if you use the funds to make improvements to your home.
Cons Of A HELOC
Any time you take on a debt, especially one that is tied to your home, there are risks. If you find yourself unable to make payments on your HELOC, you could end up losing your home, since it acts as collateral for the loan.
You also have to watch out for potential rate or payment increases. If your rate goes up, or your draw period ends and you have to go from making interest-only payments to full payments, your finances could suffer a shock from the increase. Make sure your finances are able to handle this unpredictability.
You should also be careful about using a HELOC to pay for everyday expenses. Though it might start to feel like a regular credit card, you’re trading valuable equity for the money you borrow from your HELOC. In general, it’s best to only use your HELOC for things that will help you financially, such as boosting the value of your home or paying for higher education.
Alternatives To A HELOC
If you aren’t interested in getting a second mortgage, you still have options for tapping into your home’s equity.
A cash-out refinance allows you to refinance your current mortgage loan, meaning you’re replacing your current mortgage with a new one, while also borrowing cash that you can use however you need. With a cash-out refinance, the new mortgage loan will be for a higher amount than what you currently owe, allowing you to pocket the difference.
Let’s go back to our first example one more time, with your $250,000 home and $180,000 balance. With a cash-out refinance, you could borrow up to $200,000, use $180,000 of that to pay off your current mortgage and then keep the other $20,000 (minus closing costs and other fees).
Like second mortgages and HELOCs, cash-out refinances have their own credit, LTV and DTI requirements. Generally, you can expect to need a minimum 620 credit score, a DTI less than 50%, and a max LTV of 80%.
A cash-out refinance can be a better choice than a HELOC if you want to have only one loan on your property and one mortgage payment to make each month. Cash-out refinances also typically come with more attractive rates, since they’re a first mortgage and thus are less risky.
Final Thoughts On HELOCs
If you’re in need of a large sum of cash on a revolving basis to keep up with your home improvement needs, a HELOC could be a good choice for you. However, it’s important to consider all the pros and cons first, as taking on a line of credit against your home’s equity is a financially significant, and potentially risky, move.
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