Home equity line of credit: Defined and explained

Your home is not just the place where you live. For most people, it’s their most valuable financial asset. However, the value of your home is typically locked away in equity, hard to access and use.

Home equity lines of credit (HELOCs) give homeowners a way to turn their equity into cash they can use for other purposes. We’ll break down how HELOCs work, why you might want one, and when one might be the right choice for you.

What is a home equity line of credit?

A home equity line of credit is a type of second mortgage that lets you borrow against the equity you’ve built in your home.

They work much like credit cards. You get a borrowing limit and can draw money from the HELOC multiple times, on an as-needed basis, up to that limit. You can pay down the balance to unlock more borrowing power or carry a balance from month to month.

The difference is that while a credit card is unsecured debt, HELOCs are secured by your home. That means they often have lower interest rates than credit cards.

While Rocket Mortgage^® does not currently offer HELOCs, there are many reasons you might consider getting one, such as:

• Make home improvements or repairs
• Consolidate debt
• Pay off medical bills
• Pay for higher education

How does a HELOC work?

HELOCs give you a line of credit that you can use to draw money from your home’s equity. It works more like a credit card, where you can borrow money multiple times than a typical loan, which gives you an up-front lump sum of cash.

We’ll break down some key features of HELOCs.

How much you can borrow with a HELOC

When it comes to any kind of loan secured by your home equity, the amount you can borrow depends largely on the equity you’ve built in your home.

Lenders will look at your current loan-to-value (LTV) ratio, the ratio of your current mortgage balances to your home’s value. For example, if you owe $300,000 on a home worth $500,000, your LTV ratio is $300,000 / $500,000 = 60%

Many lenders will give you HELOC limits up to 80% of your LTV, but some lenders will let you borrow as much as 90% of your LTV.

How HELOC interest rates work

Most HELOCs have variable interest rates, meaning the rate can change over time. If rates change, your payment will also change, even if you don’t borrow any more from the HELOC, so you need to be ready for your payments to rise if rates do.

Some lenders offer fixed-rate HELOCs or ways to convert portions of your HELOC balance to fixed-rate home equity loans.

Draw period vs. repayment period

When you get a HELOC, you’ll begin the line of credit’s draw period. During the draw period, which often lasts about 10 years, you can make withdrawals from the HELOC and typically make interest-only payments.

After the draw period, you enter the repayment period. You can no longer take money out of the HELOC and make fully amortizing payments until the loan is paid off. That means your payment will rise when repayment begins.

HELOC requirements

Qualifying for a HELOC requires more than just owning a home and having some home equity. Lenders will want to check your credit profile to make sure you’re a good borrower.

Common factors lenders will look at include:

• Credit score: This score shows how well you’ve handled previous debts.
• Home equity: The more equity you have, the lower the risk for the lender and the more you can borrow.
• Debt-to-income ratio (DTI): A low DTI ratio means you have more space in your monthly budget for new loan payments.
• Reliable income: Lenders want to see a reliable source of income so they know you have money coming in to handle payments.
• Home appraisal: Lenders will often do a home appraisal to determine the value of your home to confirm precisely how much equity you’ve built.

What are the pros and cons of a HELOC?

Before applying for a HELOC, make sure to consider both the pros and cons of using one.

Pros

Some of the benefits of using a HELOC include:

• Flexible borrowing: You can draw from the HELOC multiple times, whenever you need extra cash.
• Tap into home equity without refinancing: If you like your existing mortgage, you don’t need to replace it to get access to your equity.
• Lower interest rates than credit cards: Because your home serves as collateral, HELOC rates tend to be lower than credit card rates.
• Lower payments during the draw period: During the draw period, you usually only have to pay accrued interest each month.
• Potential interest tax deduction: You can deduct the interest on a HELOC in some cases, with rules dependent on when you got the HELOC and how you used the funds.

Cons

HELOCs aren’t right for every situation, so be sure to consider these downsides.

• Variable interest rates: If rates change, your payment could rise, so it’s important not to overborrow.
• Reduced home equity: HELOCs reduce your home equity, meaning you could pocket less money if you sell your home.
• Risk of foreclosure: Your home serves as collateral for a HELOC, so missing payments can lead to foreclosure.
• Payment fluctuation: Your payments can rise and fall if rates change or you make additional draws from the HELOC.
• May be subject to fees: Many lenders charge fees, such as origination fees or maintenance fees, to keep the HELOC open.

How to apply for a HELOC

If you’re ready to apply for a HELOC, follow these steps:

1. Calculate your home equity. Make sure you have enough to qualify and will be able to borrow enough to cover your needs.
2. Shop around for the best rates. Get prequalified with multiple lenders to see which deal is the best. You may land a lower rate by comparison shopping.
3. Apply for your HELOC. Apply with the lender of your choice. This will involve submitting a lot of financial documents, bank statements, loan statements, and the like.
4. Complete your home appraisal and approval. Let the lender conduct an appraisal of your home and wait for the HELOC to be approved.
5. Tap into your HELOC as needed. Once you’re approved, you can draw cash from the HELOC when you need to.

What are the alternatives to a HELOC?

HELOCs are just one way to get cash out of your home equity. They’re not right for every situation, so keep these alternatives in mind.

HELOC vs. home equity loan

Home equity loans are more traditional loans that give you a lump sum of cash upfront that you then pay back in regular payments. They usually have fixed interest rates.

Where HELOCs are good if you need flexibility or ongoing access to cash, home equity loans are one of the better options for covering one-time expenses.

HELOC vs. cash-out refinance

A cash-out refinance replaces your existing mortgage with a new one with a larger balance, letting you pocket the difference as cash. They’re quite similar to home equity loans in use, except that they also let you adjust the details of your mortgage, such as its rate or term.

That makes them one of the better options if you already want to refinance your existing mortgage and also want to tap your home equity.

HELOC vs. personal loan

Personal loans are flexible, unsecured loans that are available from many lenders and banks. Because they’re unsecured, they have higher rates than HELOCs or home equity loans, but they are usually faster to get and don’t put your home at risk, making them better than HELOCs for borrowing small amounts for immediate needs.

FAQ about HELOCs

Before you apply for a HELOC, it’s important to understand how they work.

Can I pay off a HELOC early?

Yes, you can pay a HELOC off early without paying a prepayment penalty. If you pay down your balance during the draw period, you can borrow that money again down the line, just like paying off your credit card.

How long does the closing process take for a HELOC?

Like mortgages, HELOCs have closing processes that can take quite some time. Typically, the process is a bit faster than a traditional mortgage, taking less than 45 days.

What’s the difference between a HELOC and a home equity loan?

HELOCs and home equity loans both let you access your home equity, but HELOCs let you make multiple withdrawals on an as-needed basis. Home equity loans offer one-time lump sums of cash. HELOC rates are usually variable, while home equity loan rates are usually fixed.

How does repayment on a HELOC work?

During the draw period of a HELOC, you typically only make interest payments each month. Once the repayment period begins, your payments increase, covering both principal and interest until the loan is paid off.

Can you refinance or extend a HELOC?

Yes, many lenders will let you refinance or extend a HELOC. In some cases, you can refinance a HELOC to a fixed-rate home equity loan and take out a new HELOC.

The bottom line: A HELOC can help you improve your financial situation

If you have sufficient equity and need access to cash, a HELOC is a flexible way to access your equity and use it for other purposes. If you have a more predictable, one-time expense, you may want to consider other equity-based options, like a home equity loan or cash-out refinance.

If you’re considering applying for a Home Equity Loan or cash-out refinance, you can start the application process with Rocket Mortgage today.

Home Equity Loan product requires full documentation of income and assets, credit score and max loan-to-value (LTV), combined loan-to-value (CLTV), and home equity combined loan-to-value (HCLTV) ratios. Requirements were updated 2/5/2024 and are tiered as follows: 680 minimum FICO with a max LTV/CLTV/HCLTV of 80%, 700 minimum FICO with a max LTV/CLTV/HCLTV of 85%, and 740 minimum FICO with a max LTV/CLTV/HCLTV of 90%. Your debt-to-income ratio (DTI) must be 50% or below. Valid for loan amounts between $45,000.00 and $500,000.00 (minimum loan amount for properties located in Michigan is $10,000.00). Product is a second standalone lien and may not be used for piggyback transactions. Product not available on Schwab products. Guidelines may vary for self-employed individuals. Some mortgages may be considered “higher priced” based on the APOR spread test. Higher priced loans are not allowed on properties located in New York. Additional restrictions apply. Not available in Texas. This is not a commitment to lend.

Refinancing may increase finance charges over the life of the loan.