Home equity line of credit: Defined and explained

A house is more than a place to live your life and pursue your vision of the American Dream – it can be also an important asset in your financial portfolio. However, a house isn’t a bank account, and its value can be hard to access when you need it the most.

Fortunately, there are other ways to convert your home’s value into money for all sorts of meaningful expenses, from funding your child’s education to building that dream kitchen you’ve always wanted. One method of getting money out of your property is a home equity line of credit, which allows you to borrow against the equity you’ve accumulated in your home.

Although Rocket Mortgage^Ⓡ doesn't offer HELOCs, we can explain how they work and compare them to other home equity options to help you decide whether one is right for you.

What is a home equity line of credit?

A HELOC is a second mortgage that lets homeowners borrow their home equity as a line of credit. Think of it like a credit card that uses your home’s value as collateral, and you can access the funds as you need them.

Requirements for HELOCs

Qualifying for a home equity line of credit is a lot like qualifying for a mortgage refinance. Both involve lenders taking a close look at your credit score, income, and debts to make sure you can afford the loan. They’ll also check what your home is worth and what you still owe on it. You must meet certain requirements to qualify for a HELOC, and while these vary from lender to lender, you’ll typically need:

• Good credit. A credit score above 700 is considered ideal, but one into the mid-600s will likely get you approved for a HELOC.
• Qualifying amount of equity in your home. You should have at least 15% – 20% equity in your home.
• Responsible payment history. Lenders review your past payment history to check for late payments.
• A low debt-to-income ratio. The necessary DTI ratio varies, but here’s the bottom line: The lower your DTI ratio, the better.
• Reliable income: Many lenders require proof of income to confirm your ability to make your loan payments. Consistent, stable earnings are a large plus for lenders.

Varying HELOC rates

The interest rate you’re charged on a loan largely depends on two factors: your personal financial situation and the economy. In general, HELOC interest rates are slightly higher than mortgage rates but lower than personal loan or credit card rates. As of this writing, HELOC rates run from roughly 6% to near 11%.

Most HELOCs have variable rates, so interest rates will vary as the market fluctuates. It’s possible to get a HELOC with a fixed rate, but this type of loan can restrict how many times you can withdraw from it – as well as a maximum amount you can withdraw each time.

Before applying for a HELOC, shop around and compare lenders to find the best deal. If you can’t find a lender that offers an attractive rate, it may be a sign that you need to improve your credit before signing on the dotted line. If you're considering a cash-out refinance instead of a HELOC, be sure to familiarize yourself with current refinance rates.

How does a HELOC work?

A HELOC establishes a revolving line of credit that you can access whenever a financial need arises. Unlike other loans that provide a lump sum of money, HELOCs let you borrow only as much as you need – when you need it.

How to calculate your HELOC credit limit

Use the following formula to determine your maximum available equity and your HELOC credit limit:

1. Multiply: (Your home’s value) ✕ (Your lender’s loan to value percentage (LTV)) = Maximum amount of borrowable equity
2. Subtract: (Maximum amount of borrowable equity) − (What you currently owe on your mortgage) = Your HELOC credit limit

For example, if your home is worth $415,000 and you currently owe $298,880. Suppose a lender is willing to give a HELOC with 80% LTV. To determine your credit limit, you multiply your home’s value by 80% and subtract your current balance.

1. $415,000 x 80% = $332,000
2. $332,000 - $298,880 = $33,120

In this scenario, you could get a HELOC with a limit of up to $33,120.

The draw period

The first phase of your HELOC is the draw period, when your line of credit is open and ready for you to use. During this time, you can borrow from your line of credit as you need it and just make minimum or interest-only payments on what you’ve borrowed. If you hit your credit limit, you’ll need to repay some of your balance before you can borrow more money.

You may be able to refinance your HELOC to extend your draw period. You can do this by applying for a new HELOC, paying off your existing loan and establishing new terms with a new draw period. You might want to pursue this because you could get a lower interest rate or a higher credit limit.

The repayment period

Once you reach the end of the draw period, you’re officially in the repayment period. That means you won’t be able to borrow from your HELOC, and you must make full monthly payments that cover the HELOC’s principal and interest. If you’ve been making interest-only payments to this point, be prepared for your monthly payments to go up – potentially by a lot.

The length of both periods will depend on the length of the loan you take out. For example, you may take out a 30-year HELOC with a 10-year draw period and a 20-year repayment period. A longer repayment period typically means lower monthly payments, but you'll pay more in interest over time. Conversely, a shorter repayment period means higher monthly payments but less interest overall. Which is better for you? Only you can make that call.

What are the pros and cons of a HELOC?

HELOCs can be smart moves in the right circumstance, but they’re not ideal for everyone. Here are the most notable disadvantages and advantages of applying for a HELOC.

Pros

• Consolidate debt: You can use a HELOC to consolidate your debt at a lower interest rate than most credit cards and personal loans, potentially saving thousands in interest payments.
• Flexible use: HELOCs can be used for anything that requires cash, including medical bills, college tuition, home repairs and other expenses.
• The ability to borrow against available credit: As you repay the balance of your HELOC during the draw period, you can continue to withdraw from your line of credit. This is especially beneficial if you aren’t sure how much a project or investment will cost up front.
• Tax-deductible interest: The interest you pay on a HELOC or other home equity loan may be tax-deductible if you use the funds for projects like home improvements.

Cons

• Up-front costs: You may pay an annual fee for the account or an origination fee to cover the cost of setting up the HELOC, a home appraisal, a title search and an attorney. Depending on your lender, the up-front costs may not be worthwhile if you don’t need to borrow a significant amount of money.
• Risk of losing your home: Your home serves as collateral when you get a HELOC. Put simply, if you can’t make payments on your HELOC, you may lose your home.
• Rates and payments may increase: Your payments will fluctuate based on changes in the market. Be prepared for these changes when your interest rates go up or when your draw period ends.

Four common ways to use a HELOC

There are no restrictions on how you use the funds, so let’s look at some typical ways people use the money from a HELOC.

1. Make home improvements or repairs

If you need money to improve your home and increase its value, it can make sense to tap into your home’s existing equity using a HELOC.

That said, some improvements are more valuable than others. A full kitchen remodel will likely earn you a dollar-for-dollar return on your investment, while finishing your basement or updating your home’s interior with a fresh coat of paint can also boost your home’s value. Meanwhile, less-extensive improvements can add value to a home but there might not be such a close connection between the initial cost and the amount you make from the eventual sale.

2. Consolidate debt

If you have several high-interest obligations such as credit card debt, a HELOC can help you consolidate all that debt into a single, lower-interest loan. But remember that when you use a HELOC to consolidate credit card debt, for instance, you’re trading unsecured debt for debt secured by your home. There are strong ramifications to that scenario – you could conceivably lose your home if you default on the HELOC.

3. Pay off medical bills

Medical bills can cost thousands of dollars for even the most basic procedures and care. With a HELOC, you may be able to pay off your medical bills and make repayments on your line of credit at a lower interest rate, saving you money in the long run. Using a HELOC instead of other higher-interest options can significantly reduce your total interest costs while giving you a longer repayment timeline.

4. Pay for higher education

Some homeowners use home equity to pay for their own – or their children’s – college education. This can make sense in some situations, but you should explore all your options because some other loan types may be better suited for your situation. For example, if you or your child qualify for federal student loans, you may get a lower interest rate than what you’ll get with a HELOC. And federal student loan protections and flexible payment plans may make federal loans more advantageous.

What are the alternatives to a HELOC?

If you aren’t interested in opening a home equity line of credit, there are other ways to tap into your home’s equity. For instance, a cash-out refinance and home equity loan are two possible options.

Cash-out refinance vs. HELOC

A cash-out refinance allows you the opportunity to refinance your current mortgage loan with a new, different loan. In this case, you replace your existing mortgage with a new one for a higher amount, allowing you to pocket the difference.

A cash-out refinance may be a better choice than a HELOC if you only want one loan on your property and one mortgage payment to make each month. Also, cash-out refinances often have more attractive interest rates.

Home equity loan vs. HELOC

Home equity loans and HELOCs are similar because they’re both secured by your home equity and both types of loans use your home as collateral. In the case of a home equity loan, however, you borrow a lump sum and pay it back at a fixed interest rate. In the case of a HELOC, you have a revolving line of credit that you can draw from as needed – and it typically offers a variable interest rate. And unlike HELOCs, however, you can’t add additional funds to a home equity loan, so you need to know how much money you need up front.

FAQs about HELOCs

We’ve gathered a few commonly asked questions about HELOCs.

Can I pay off a HELOC early?

Yes, you can pay off a HELOC early – and often without prepayment penalties. The best time to pay off the principal is during what’s known as “the draw period,” when you only pay back interest and not the principal. This can be a smart financial move, because paying extra toward your principal now can help you avoid paying more later.

How long does the closing process take for a HELOC?

It typically takes less time to close on a HELOC than a traditional mortgage. In most cases, you should expect to close within 45 days of submitting your application.

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 a home improvement loan borrows against your future income. Because of this, home improvement loans have lower borrowing limits, and they often have higher interest rates than HELOCs.

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

Your home can be both a foundation for your family’s memories and a powerful financial resource that can help you achieve important life goals. With options like HELOCs, you have flexible ways to tap into your property's value without selling or moving. Whether you're looking to fund higher education, tackle that renovation project or consolidate debt, understanding how to access your home equity gives you more control over your financial future.

There are other options that might be a better fit for your situation, such as home equity loans, but Rocket Mortgage is committed to helping you explore all available options so you can make informed decisions about leveraging your home’s value.

Talk to a Rocket Mortgage Home Loan Expert to learn more about tapping into your home’s equity, navigating home equity and exploring refinancing options. Start a refinance application online today to learn more.