Understanding Home Equity Line of Credit (HELOC)?
What is Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is a second mortgage that provides access to cash based on the value of your home. It can also serve as a primary mortgage if you own your home outright. You borrow against your home equity, which is the home's value minus the amount you owe on the primary mortgage.
Typically, you can borrow up to 85% of your equity, although this varies by lender.
A HELOC allows you to draw funds and repay them monthly, similar to a credit card, but it is not intended for minor expenses.
When looking for a loan, borrowing against your home equity often offers the best rate.
How a Home Equity Line of Credit Works (HELOC)?
A HELOC allows a homeowner to establish a line of credit using their home as collateral.
The application process is similar to that of a home refinance and usually requires the homeowner to pay loan processing, origination, appraisal, and recording fees.
There are two phases of HELOC:
The Draw Period: During this phase, you can borrow money from the account up to your approved limit. You are required to make interest payments, but payments towards the principal are optional. This period typically lasts 10 years.
During the draw period, the borrower is only responsible for paying interest on the amount they borrow.
After the draw period ends and the repayment period begins, the borrower must make monthly payments on both the principal and interest.
The Repayment Period: In this phase, you can no longer withdraw money and must make both principal and interest payments until the borrowed amount is fully repaid. The addition of principal payments can cause monthly payments to rise sharply compared to the draw period.
The repayment period usually lasts 20 years, but the borrower must repay the loan in full upon selling the home.
Common HELOC Uses
HELOCs are flexible lines of credit that can be used to cover a wide range of expenses, including home improvements, medical bills, education costs, or other large purchases.
Homeowners can also utilize HELOCs for debt consolidation or as a stopgap to manage inconsistent cash flow.
HELOC Qualifications
HELOC qualifications vary by lender, but standard requirements typically include:
A debt-to-income ratio of 40% or less
A credit score of at least 620
A history of on-time payments
Demonstrated ability to repay the line of credit
At least 15% equity in your home, as determined by an appraisal
Pros and Cons of HELOC
Pros:
A HELOC is often used for home repairs and renovations, which can increase your home's value.
You might get a better rate with a HELOC than with an unsecured loan.
Additionally, the interest on your HELOC may be tax-deductible if you use the money to buy, build, or substantially improve your home, provided that the combined amount of the HELOC and your mortgage does not exceed the stated loan limits, according to the IRS.
Cons:
A HELOC increases the risk of foreclosure if you can’t pay the loan.
It is not recommended if your income is unstable or if you won’t be able to afford payments if interest rates rise.
Additionally, a HELOC may not be the best choice if you’re planning to move soon.
One of the main benefits of a HELOC is its long borrowing and payment timeline, but you’ll have to pay it off entirely at the time of sale.
A HELOC may also not be the right choice if you aren’t looking to borrow much money, as the associated costs might not be worth it; in such cases, a low-interest credit card might be a better option. Additionally, a HELOC is not ideal for basic needs, small purchases, or expenses that don’t build personal wealth, such as a new car or vacation.
How to calculate your HELOC
Home equity is one of the primary factors a lender evaluates when reviewing a HELOC application.
To calculate how much equity you have in your home, you can start by:
Estimating the market value of your home using an online real estate marketplace like Zillow or Realtor.com.
Keep in mind that these websites only provide rough estimates, and your lender will likely require a formal appraisal when you apply for a HELOC.
Once you determine the market value of your home, add up the balances of any mortgages or loans against the home.
Then, subtract the total mortgage balance from the market value to obtain your home equity.
Home’s Market Value – Total Mortgages = Equity in Home
Finally, you can divide the equity in your home by its appraised value to obtain your equity percentage for purposes of a HELOC. Lenders typically look for equity between 15% and 20% of the home’s value before they’ll approve you for a line of credit.
Equity in Home / Home’s Market Value = Equity Percentage in Home
Understanding your home equity is crucial when applying for a HELOC.
For instance, if a home has a market value of $350,000 and there is $200,000 in outstanding mortgages, the homeowner would have $150,000, which equates to nearly 43%, in equity. This amount of equity makes it likely that the homeowner would be approved for a HELOC. Conversely, if the same homeowner has $315,000 in outstanding mortgages on the same house, they would only have 10% equity in the home, which may be insufficient for many lenders to approve a HELOC.
In the first scenario with a market value of $350,000 and $200,000 in outstanding mortgages, the homeowner has $150,000 in equity, which is approximately 43%. This substantial equity makes approval for a HELOC more likely.
However, in the second scenario with $315,000 in outstanding mortgages on the same $350,000 home, the equity drops to $35,000, which is about 10%. Many lenders require a higher equity percentage for approving a HELOC, so in this case, the homeowner might face challenges in securing a HELOC with such low equity.