Home Equity Line Of Credit (HELOC) Defined & Explained
Molly Grace14-minute read
December 20, 2021
Table Of Contents
A house can be an important asset to have in your financial portfolio. However, because a house is not a bank account, that value can be hard to access when you need it most.
Fortunately, there are several loan options that can help you turn that home value into cold, hard cash. These options include the home equity line of credit, or HELOC, which allows you to borrow against the equity in your home, as well as a home equity loan. Equity is the difference between the present market value of the home and what you owe on your mortgage loan.
While Rocket Mortgage® does not offer HELOCs or home equity loans, we’ll review how these loan options work so you can decide if it’s right for you while you refinance your assets. Let’s go over everything you need to know.
- Home equity lines of credit and home equity loans both allow you to use the equity you’ve built up in your home.
- Interest rates for home equity loans are fixed, whereas HELOC interest rates vary.
- Home equity loans give you one lump sum, whereas HELOCs provide funds as needed.
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 it down for you.
Qualification Requirements For HELOCs
HELOCs have their disadvantages and advantages, so consider your financial needs for your investment or venture.
These requirements may adjust depending on your lender, but you typically need:
- Reliable income: Many lenders will need proof of income to confirm you’ll be able to pay off your loan payments.
- Good credit: A credit score above the mid-600s will likely approve you for a loan. A credit score above 700 is considered ideal.
- Qualifying amount of equity in your home: You should have at least 15 – 20% home equity.
- Responsible payment history: Lenders may evaluate your previous payment history to make sure you haven’t made any late payments in the past.
- A low debt-to-income ratio (DTI): The lower your DTI, the better. Discuss with your lender what their qualifying DTI ratios are to potentially receive a loan.
How To Pay Back Home Equity Line Of Credit
A HELOC has two phases that separate borrowing and repayment, also known as the draw period and the repayment period. Be aware, however, that you’ll make payments on the loan during both periods.
Phase 1: The Draw Period
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.
Phase 2: The Repayment Period
Once you reach the end of your draw period, you’ll 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 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 (LTV) ratio below a certain percentage. This is because lenders want you to have a certain amount of equity in the home, since you’re less likely to default if you could possibly lose the equity you’ve built up.
Disadvantages And Advantages Of A HELOC Loan
HELOCs can be useful financial tools, but they don’t come without risks. Here are the most important disadvantages and advantages to be aware of before applying for a HELOC loan.
- Be prepared for the upfront costs. Before receiving a HELOC, you may be required to pay an application fee, for a home appraisal, title search and attorney fees. If you don’t need to borrow a large sum of money, these additional up-front costs may not be worthwhile. If you need help paying off your mortgage, using a credit card may be more ideal for your situation.
- Your home is used as collateral. 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.
- Your rates and payments may increase. You also must watch out for potential rate or payment increases based on market fluctuation. If your rate goes up, or your draw period ends and you must go from making interest-only payments to full payments, your finances could suffer a shock from the increase. Make sure your finances can handle this unpredictability.
- It’s not always the most practical option. 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.
- You can consolidate debt at a low interest rate. A HELOC can be a useful choice if it allows you to consolidate your debts at a lower interest rate. You only need to pay interest on what you’re currently borrowing.
- The money can be used for anything. HELOCs are also flexible, and can be used for anything you need the cash for, including college tuition or other education-related costs.
- Gives you access to a large sum of cash. A second mortgage of any kind may be your best option for borrowing a large sum of cash, which can be useful for costly home improvement projects.
- Borrow as much as you need. Along with their flexibility, HELOCs allow you to borrow as much money as you require. This is favorable if you aren’t sure how much money your project or investment will cost in the long run. So if a project ends up being under budget, you won’t have to worry about paying more than necessary in interest.
- It can be tax-deductible. 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.
To calculate your estimated line of credit for a HELOC, you will want to use the following calculation:
- Multiply: (Your home’s value) x (your lender’s LTV percentage) = maximum amount of borrowable equity
- Subtract: (Maximum amount of borrowable equity) – (what you currently owe on your mortgage) = your HELOC credit limit
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.
What Rates Can Be Expected With A HELOC?
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 maximum 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.
According to NerdWallet, the average HELOC rate was around 4.418% as of October 18, 2021.
What Can You Use A HELOC For?
Let’s go a little more in-depth about some of the things it might make sense to use a HELOC for.
Home Improvement Or Repairs
If you’re going to be using the money to improve or even increase the value of your home, it can make sense to tap into your home’s existing equity using a HELOC.
Some improvements are more valuable than others. While you may think that a full kitchen renovation will give you a dollar-for-dollar return on your investment, that’s not always the case. You’ll likely get more bang for your buck with something that increases your home’s square footage, such as finishing your basement.
You can also see good returns by making changes to your home’s exterior to increase its curb appeal, such as upgrading your landscaping.
If you have a lot of high-interest debt, such as credit card debt, a lower-interest HELOC can help you consolidate all that debt into a single loan and potentially save you hundreds of dollars in interest.
Beware, though, that when you use a HELOC to consolidate credit card debt, you’re trading an unsecured loan for one that’s secured by your home. If you default on this loan, you could lose your home.
Some people will use their home’s equity to pay for their own or their child’s college education. While this can make sense in some situations, it’s important to explore all your options.
If the student is able to get federal student loans, they may be able to get a better interest rate than what you’d get with a HELOC.
Plus, federal student loans come with certain protections and flexible payment plans that might make them more advantageous.
Alternative 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 are therefore less risky.
What Is A Home Equity Loan?
A home equity loan is similar to a HELOC in that it is a loan that is offered by a lender based on your home equity. Home equity loans also use your home as collateral, so if you’re unable to make your monthly payments, you may lose your home.
Home equity loans are fixed, with preset monthly payments with a fixed interest rate. Unlike HELOCs, you are unable to add on loan funds to your home equity loan, so it’s ideal if you know how much funding you need to the dollar.
Disadvantages and Advantages of A Home Equity Loan
Home equity loans allow you to convert the home equity you’ve built into cash, but you should weigh the disadvantages and advantages against your personal financial situation and goals before making any decisions.
- You’re unable to receive more loan funds than what was originally offered. If you’re planning on a significant home renovation on an investment property, there may be unexpected costs and you may not know how much you’ll need to borrow in total. Home equity loans may not be the most practical choice in these circumstances.
- Be wary of real estate value fluctuations. If the real estate values decrease, your home market value could also decrease. You may then owe more than what your property is worth. If you’re planning to sell your home during this time, you may lose money on the sale.
- You receive your loan in one lump sum. This is useful if you have a project with a fixed cost that you need to cover up front, like if you’re replacing your roof.
- The element of predictability. Home equity loans come with more predictability since they generally come with fixed rates and set monthly payments. If you’re someone that prefers to budget their monthly income and knows exactly how much they need, home equity loans are the more reliable choice for you.
- You’re able to pay off the loan early. With home equity loans, you may refinance the loan at a lower rate, allowing you to pay off the loan sooner and save on your monthly payment.
What Are The Differences Between A Home Equity Loan and HELOC?
Here are the main differences between HELOCs and home equity loans:
|HELOC||Home Equity Loan|
|What It’s Best For||If you require access to your assets at various times||One-time need|
|Disbursement||As needed||One lump sum|
|Repayment||Commonly interest-only payments during the draw period, then monthly payments during the repayment period||Begins when the loan is disbursed|
|Monthly Payments||Varies over time||Set|
|Points||Doesn’t utilize points||May see up-front points that are used to lower your interest rate|
|Closing Costs||Closing costs may be less than if using a one-time loan||Generally 2 – 5% of the loan amount|
Here are a few commonly asked questions regarding HELOC loans.
How Does Home Equity Work?
First, what exactly is home equity? If you used a mortgage to purchase your home, you may joke that you don’t own the home, the bank does. But that’s 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.
Simply put, your equity is the amount your house is worth minus what you currently owe your lender.
How Can You Use Your Home Equity?
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 money, like for an expensive home renovation project or paying off student loans.
With HELOCs and home equity loans, you’ll likely be able to get a lower interest rate than you would with an unsecured personal loan. 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.
Keep in mind that your home is used as collateral for this type of loan, so if you’re unable to pay off the loans, you may lose your home as a consequence.
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 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.
Can you pay off a HELOC early?
Yes, you can pay off a HELOC early. There are no associated prepayment penalties with these loans.
The best time to pay off the principal of your loan is during the draw period. You are only required to pay the interest during this time, but paying extra toward your principal as well during this period can help you avoid paying more during the repayment period.
How long does the closing process take for a HELOC?
The time to closing for a HELOC line is typically less than the closing process on a traditional mortgage. In most cases, you should expect to close within 45 days of submitting your application for a HELOC loan.
What’s the difference between a HELOC and a home improvement loan?
The biggest difference between a HELOC and a home improvement loan is that a HELOC borrows against the existing equity in your home, while the latter does not. Because of this, home improvement loans have a lower limit that you can borrow. These loans can also carry higher interest rates than HELOCs.
The money from HELOCs also doesn’t have to be used for home improvement. It can be used in other ways, from debt consolidation to making major purchases.
The Bottom Line
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. If you know the exact amount of money you need for a project and prefer a fixed monthly payment plan, then a home equity loan may work better for your venture.
Consider all the disadvantages and advantages first, as either type of loan can be a financially significant, and potentially risky, move.
If you want to learn more about tapping into your home’s equity without taking out a second mortgage, talk to a Home Loan Expert who can help you understand the home equity and refinancing options that are available to you.
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