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Home Equity Line Of Credit (HELOC): Defined And Explained

June 05, 2024 8-minute read

Author: Victoria Araj

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A home equity line of credit, also called a HELOC, allows you to borrow against the equity in your home. You can use your home equity as cash for various purposes.

Although Rocket Mortgage® doesn't offer HELOCs, it’s important to know how they work and compare them to other borrowing options so you can decide what’s right for you.

Table Of Contents

    What Is A Home Equity Line Of Credit?

    A HELOC is a type of second mortgage that lets homeowners borrow against their home equity as a line of credit. Borrowers can use the cash from a HELOC to pay for home improvement projects or education expenses, or to consolidate high-interest credit card debt. And, these are just a few examples of how you can utilize HELOC funds.

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    How To Get A HELOC

    Qualifying for a home equity line of credit is a lot like qualifying for a mortgage refinance. You must have certain HELOC qualifications.

    HELOC requirements will vary from lender to lender, but you typically need:

    • A decent credit score: The minimum credit score for HELOC approval is typically in the mid-600s.
    • A qualifying amount of equity in your home: You should have at least 15% – 20% equity in your home.
    • A responsible payment history: Lenders may review your payment history to check for late mortgage payments.
    • A low debt-to-income ratio (DTI): The lower your debt-to-income ratio, the better. Ask your lender about the DTI you’ll need to qualify.
    • Reliable income: Many lenders require proof of income to confirm a borrower’s ability to make loan payments.
    • A reasonably good combined loan-to-value ratio (LTV): Your combined LTV measures how much you’ll owe on your home – based on the combined total of your remaining principal mortgage balance and the size of your HELOC – versus the home’s value. Lenders may require a combined LTV of no more than 80%, but some allow for a combined LTV of up to 90%.

    Overall, qualifying for a HELOC isn’t that different from qualifying to refinance a mortgage. Review your lender’s requirements to get the best understanding of the options available to you.

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    How Does A HELOC Work?

    A home equity line of credit has two separate phases: the draw period and repayment period. You’ll make payments on the HELOC during both periods.

    Phase 1: The Draw Period

    The first phase is the draw period. It’s when your line of credit is open and available for use. During this period, you can borrow from your line of credit as needed and make minimum or interest-only payments on the amount you borrow.

    If you reach 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.

    Phase 2: The Repayment Period

    Once you reach the end of the draw period, you’re in the repayment period. You won’t be able to borrow from your home equity line of credit, and you must begin making 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 loan you get. For example, you may decide a 30-year HELOC with a 10-year draw period and a 20-year repayment period makes the most sense for you.

    What Are The Pros And Cons Of A HELOC?

    A home equity line of credit can be a beneficial tool, but it’s not ideal for every financial situation. Next up are the most important disadvantages and advantages to be aware of before applying for a HELOC.

    Pros Of A HELOC

    • Lower interest rates: HELOCs often have lower interest rates than credit cards.
    • Flexible spending: A HELOC can be used for a variety of reasons, such as funding home improvements, paying medical bills or consolidating debt.
    • The opportunity to borrow as needed: As you repay the balance during the draw period, you can continuously withdraw from your line of credit and only pay back what you use.
    • Tax-deductible interest: The interest you pay on a HELOC or other home equity loan1 may be tax-deductible if you use the funds for home improvements.

    Cons Of A HELOC

    • Upfront costs: You may pay an annual fee for the account or an origination fee to cover the cost of setting up the HELOC. Your upfront costs can also include fees for a home appraisal, a title search and an attorney. Depending on your lender, the upfront costs may not be worthwhile if you only need a relatively small amount of money.
    • The risk of losing your home: If you can’t make payments and you default on your HELOC, you may lose your home because it serves as collateral for the credit line.
    • A potential increase in rates and payments: You must also watch out for potential rate or payment increases based on market fluctuations. Your monthly payments will go up if your variable rate rises and when your draw period ends.
    • The possibility of not being practical: It’s best to only use a home equity financing for undertakings that will help you financially. Examples include boosting the value of your home and paying for higher education.

    How To Calculate Your HELOC Loan Amount

    Use the following formulas to determine your HELOC credit limit.

    To begin, figure out how much of your home’s value you can borrow against. Then, subtract your remaining mortgage balance to calculate your HELOC amount.

    1. Multiply: Home value × lender’s loan-to-value percentage (LTV) = maximum amount of home value you can borrow in dollars
    2. Subtract: Maximum amount of home value you can borrow in dollars minus current mortgage balance = HELOC credit limit

    Home Equity Line Of Credit Example

    Let’s say you find a lender willing to give you a HELOC with 80% LTV. Suppose 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.

    1. 250,000 × 80% = 200,000
    2. 200,000 − 180,000 = 20,000

    In this scenario, you could potentially get a credit limit of up to $20,000.

    How To Determine Your Estimated Line Of Credit formula.

    Home value

    $250,000

    LTV

    80%

    Maximum amount of home value you can borrow in dollars

    $200,00

    Current mortgage balance

    $180,000

    HELOC credit limit

    $20,000

    What Kind Of Interest Rate Can You Expect With A HELOC?

    The interest rate you’re charged on debt typically depends on your financial situation and overall market rates. But, in general, HELOC interest rates are slightly higher than mortgage loan rates. However, they’re usually lower than personal loan or credit card rates.

    Do HELOCs Have Fixed Or Variable Interest Rates?

    Most HELOCs have variable rates, meaning your interest rate will change with fluctuations in the market. It’s also possible to get a HELOC with a fixed rate. However, keep in mind that fixed-rate HELOCs typically restrict how many times you can withdraw money, as well as the maximum amount you can withdraw each time.

    How Can You Get The Best Rate For A HELOC?

    Before applying for a home equity line of credit, shop around and compare lenders in order to get 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 moving forward on a HELOC application.

    If you’re thinking of a cash-out refinance instead of a HELOC, familiarize yourself with current refinance rates.

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    4 Common Ways To Use A HELOC

    HELOCs are a flexible way to leverage the equity in your home since you’re not limited in how you can use the funds. Let’s take a more in-depth look at some already mentioned ways to use a home equity line of credit.

    You can:

    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 home equity line of credit.
    2. Consolidate debt: If you have a lot of high-interest debt, such as credit card debt, a HELOC can help you consolidate it into a single, lower-interest loan to save you hundreds or perhaps even thousands of dollars in interest.
    3. Pay off medical bills: Medical bills can easily 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 a single monthly payment on your line of credit instead.
    4. Pay for higher education: Some homeowners use home equity to pay for their college education or someone else’s. While this can make sense in some situations, it’s wise to explore all your options. Federal student loans may offer a lower interest rate and a more flexible repayment term.

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    What Are Alternatives To A HELOC?

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

    Cash-Out Refinance Vs. HELOC

    A cash-out refinance replaces your existing mortgage with a new one for a higher amount so you can 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. And, cash-out refinances typically have more attractive interest rates.

    Home Equity Loan Vs. HELOC

    A home equity loan and a home equity line of credit are similar in that they’re both secured by your home equity. With a home equity loan, you borrow a lump sum and pay it back at a fixed interest rate. Like a HELOC, a home equity loan uses your home as collateral.

    But unlike a HELOC, which is a revolving credit line, a home equity loan doesn’t allow you to access more money than your original loan amount. As a result, you must know how much money you need upfront.

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    FAQs About HELOCs

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

    How does home equity work?

    Home equity is your home’s value minus what you owe your lender. Each time you make a payment on your mortgage, you add to the amount of your home that you own. With a HELOC, you can borrow against the home equity you’ve built.

    Can I pay off a HELOC early?

    Yes, you can pay off a HELOC early. HELOCs typically don’t have a prepayment penalty.

    The best time to pay off the principal is during the draw period when borrowers typically make interest-only payments. Paying toward your principal during this time can help you avoid paying more during the repayment period.

    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 doesn’t. Because of this, home improvement loans have lower borrowing limits. And, they may have higher interest rates than HELOCs.

    The Bottom Line: A HELOC May Or May Not Be Your Best Option

    If you need a large sum of cash on a revolving basis, a HELOC may be a good choice. However, a home equity loan may be a better option if you know exactly how much money you need and prefer a fixed monthly payment.

    Talk with a Rocket Mortgage Home Loan Expert to learn more about tapping into your home’s equity. Or, you can start an online application today and learn about your home equity loan options.

    1Home 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 Iowa is $61,000). 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.

    Victoria Araj

    Victoria Araj is a Section Editor for Rocket Mortgage and held roles in mortgage banking, public relations and more in her 15+ years with the company. She holds a bachelor’s degree in journalism with an emphasis in political science from Michigan State University, and a master’s degree in public administration from the University of Michigan.