All You Need to Know About HELOCs

If you’re a homeowner in need of a bundle of cash, look no further than your own home. By tapping into your home’s equity, you’re eligible for a loan with a, generally, lower interest rate and easier eligibility requirements. One way to do this is by opening up a home equity line of credit, or a HELOC. Let’s take a closer look at HELOCs and why they can be an excellent option for cash-strapped homeowners.

What is a HELOC?

A HELOC is a revolving credit line that allows homeowners to borrow money against the equity of their home, as needed. The HELOC is like a second mortgage on a home; if the borrower owns the entire home, the HELOC is a primary mortgage. Since it is backed by a valuable asset (the borrower’s home), the HELOC is secured debt and will generally have a lower interest rate than unsecured debt, like credit cards. You will need to pay closing costs for the line of credit, which are generally equal to 2-5% of the total value of the loan.

How much money can I borrow through a HELOC?

The amount of money you can take out through a HELOC will depend on your home’s total value, the percentage of that value the lender allows you to borrow against and how much you currently owe on your home.
Many lenders will only offer homeowners a HELOC that allows the borrower to maintain a loan-to-value (LTV) ratio of 80% or lower.
A quick way to find a good estimate of the maximum amount you can borrow with a HELOC is to multiply your home’s value by the highest LTV the lender allows. For example, continuing with the above example, if your home is valued at $250,000 and your lender allows you to borrow up to 80% of your home’s value, multiply 250,000 by 0.80. This will give you $200,000. Subtract the amount you still owe on your mortgage (let’s assume $100,000) and you’ll have the maximum amount you can borrow using a HELOC: $100,000.

Is every homeowner eligible for a HELOC?

Like every loan and line of credit, HELOCs have eligibility requirements. Exact criteria will vary, but most lenders will only approve the line of credit for homeowners who have a debt-to-income ratio of 40% or less, a credit score of 620 or higher and a home with an appraised value that is at minimum 15% more than what is owed on the home.

How does a HELOC work?

A HELOC works similarly to a credit card. Once you’ve been approved, you can borrow as much or as little as needed, and whenever you’d like during a period of time known as the draw period. The draw period generally lasts five to 10 years. Once the draw period ends, the borrower has the choice to begin repaying the loan, or to refinance to a new loan.

How do I repay my HELOC?

The repayment schedule for a HELOC can take one of three forms:
Some lenders allow borrowers to make payments toward the interest of the loan during the draw period. When the draw period ends, the borrower will make monthly payments toward the principal of the loan in addition to the interest payments.

For many borrowers, though, repayment only begins when the draw period ends. At this point, the HELOC generally enters its repayment phase, which can last up to 20 years. During the repayment phase, the homeowner will make monthly payments toward the HELOC’s interest and principal.

In lieu of an extended repayment phase, some lenders require homeowners to repay the entire balance in one lump sum when the draw period ends. This is also known as a balloon payment.

How can I use the funds in my HELOC?

There are no restrictions on how you use the money in your HELOC. However, it’s generally not a good idea to use a HELOC to fund a vacation, pay off credit card debt or to help you make a large purchase. If you default on your repayments, you risk losing your home, so it’s best to use a HELOC to pay for something that has lasting value, such as a home improvement project.

How is a home equity line of credit different from a home equity loan?

A home equity loan is a loan in which the borrower uses the equity of their home as collateral. Like a HELOC, the homeowner risks losing their home if they default on it. Here, too, the exact amount the homeowner can borrow will depend on their LTV ratio, credit score and debt-to-income ratio.

However, there are several important distinctions between the two. Primarily, in a home equity loan, the borrower receives all the funds in one lump sum. A HELOC, on the other hand, offers more freedom and flexibility as the borrower can take out funds, as needed, throughout the draw period. Repayment for home equity loans also works differently; the borrower will make steady monthly payments toward the loan’s interest and principal over the fixed term of the loan.

A home equity loan can be the right choice for borrowers who know exactly how much they need to borrow and would prefer to receive the funds up front. Budgeting for repayments is also simpler and can be easier on the wallet since they are spread over the entire loan term. Some borrowers, however, would rather have the flexibility of a HELOC. They may also anticipate being in a better financial place when the repayment phase begins, so they don’t mind the uneven payments.

If you’re a homeowner in need of some extra cash, consider taking out a HELOC.