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A Homeowner's Guide to HELOC Loans

By Rebecca Lake · September 07, 2021 · 6 minute read

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A Homeowner's Guide to HELOC Loans

If you own a home, you may be interested in tapping into your available home equity. A home equity line of credit, different from a home equity loan, can help you finance a major renovation or anything else.

Homeowners sitting on at least 20% equity—the home’s market value minus what is owed—may be able to secure a HELOC.

Like all financing options, a HELOC has advantages and some less attractive features as well.

Home Equity Line vs. Home Equity Loan

A HELOC is a revolving line of credit that lets you borrow money as needed, up to your approved credit limit, pay back all or part of the balance, and then borrow up to the limit again through your draw period, typically 10 years.

The interest rate is usually variable. You pay interest only the amount of credit you actually use.

A home equity loan is a lump sum with a fixed rate on the loan.

Borrowing limits and repayment terms may also differ, but both use your home as collateral.

Hybrid fixed-rate HELOCs are not the norm but have gained attention. They allow a borrower to withdraw money from the credit line and convert it to a fixed rate.

Recommended: What are the Different Types of Home Equity Loans?

How Does a Home Equity Line of Credit Work?

Once you secure a HELOC with a lender, you can draw against your credit line as needed until your draw period ends. You then repay the balance, typically over 20 years, or refinance to a new loan.

The variable rate is frequently tied to the prime rate, a benchmark index that closely follows the economy. Even if your rate starts out low, it could go up. A margin is added to the index to determine the interest you are charged.

HELOCs can be used for anything but are commonly used to cover big home expenses, like a major renovation or addition.

Home equity rose to a new high in 2020. Remodeling expenditures increased in tandem, to $339 billion in late 2020, and were expected to continue to increase in 2021, CoreLogic found.

A HELOC can also be used to consolidate high-interest debt. Whatever homeowners use a home equity line or loan for—investing in a new business, taking a dream vacation, funding a college education—they need to remember that if they can’t keep up with payments, the lender may force the sale of the home to satisfy the debt.

How Much Can You Borrow With a HELOC?

Depending on your creditworthiness and debt-to-income ratio, you may be able to borrow up to 85% of the value of your home, less the amount owed on your first mortgage.

Thought of another way, most lenders require your combined loan-to-value ratio (CLTV) to be 85% or less for a home equity line of credit.

Here’s an example. Say your home is worth $500,000, you owe $300,000 on your mortgage, and you hope to tap $120,000 of home equity.

combined loan balance (420,000) ÷ current appraised value (500,000) = CLTV (0.84)

Convert to a percentage, and you arrive at 84%, just under many lenders’ CLTV threshold for approval.

You’d receive the ability to access the funds in the form of a credit card or a checkbook. In this example, the liens on your home would be a first mortgage with its existing terms at $300,000 and a second mortgage (the HELOC) with its own terms at $120,000.

Qualifying for a HELOC

The main factors a lender will consider include:

•  Your home’s market value

•  How much you still owe on the home

•  Credit score

•  Employment history

•  Income

•  Debt-to-income ratio

Shopping around with different lenders can reveal minimum credit score ranges required for HELOC approval. You can also use that as an opportunity to take a cue from the Federal Trade Commission, which advises shoppers to:

•  Check and compare terms

•  Check the periodic and lifetime rate caps

•  Ask which index is used and how much and how often it can change

•  Check the margin

•  Ask whether you can convert your variable-rate loan to a fixed rate later

•  Ask if the rate you’re offered is “discounted.” If it is, find out how the rate will be determined after the discount period and how much your payments could rise.

If you’re comparing advertised annual percentage rates (APRs) for HELOCs, know that unlike a home equity loan, the APR for a home equity line of credit does not take points and financing charges into consideration. The APR is based on interest alone.

Pros of Taking Out a HELOC

Initial Interest Rate and Acquisition Cost

A HELOC, secured by your home, may have a lower interest rate than unsecured loans and lines of credit. The average HELOC rate in August 2021 was 4.1%, according to Bankrate.

Lenders often offer a low introductory rate, or teaser rate. After that period ends, your rate (and payments) increase to the true market level (the index plus the margin). Lenders normally place periodic and lifetime rate caps on HELOCs.

The closing costs may be lower than a home equity loan’s. Some lenders waive HELOC closing costs entirely if you meet a minimum credit line and keep the line open for a few years.

Taking Out Money as You Need It

Instead of receiving a lump sum loan, a HELOC gives you the option to draw on the money over time as needed. That way you don’t borrow more than you actually use, and you don’t have to go back to the lender to apply for more loans if you end up requiring additional money.

Only Paying Interest on the Amount You’ve Withdrawn

Paying interest only on the amount plucked from the credit line is beneficial when you are not sure how much will be needed for a project or if you need to pay in intervals.

Also, you can pay the line off and let it sit open at a zero balance during the draw period in case you need to pull from it again later.

Cons of Taking Out a HELOC

Variable Interest Rate

Even though your initial interest rate may be low, if it’s variable and tied to the prime rate, it will likely go up and down with the federal funds rate. This means that over time, your monthly payment may fluctuate and become less (or more!) affordable.

Although variable-rate HELOCs come with annual and lifetime rate caps, the lifetime cap is 18% in most states, according to debt.org.

Potential Cost

Taking out a HELOC is placing a second mortgage lien on your home. You may have to deal with closing costs of about 2% of the loan amount, though some HELOCs come with low or zero fees. Sometimes loans with no or low fees have an early closure fee.

Your Home Is on the Line

If you aren’t able to make payments and go into loan default, the lender could foreclose on your home. And if the HELOC is in second lien position, the lender could work with the first lienholder on your property to recover the borrowed money.

Adjustable-rate loans like HELOCs can be riskier than others because fluctuating rates can change your expected repayment amount.

It Could Affect Your Ability to Take On Other Debt

Just like other liabilities, adding on to your debt with a HELOC could affect your ability to take out other loans in the future. That’s because lenders consider your existing debt load before agreeing to offer you more.

Lenders will qualify borrowers based on the full line of credit draw even if the line has a zero balance. This may be something to consider if you expect to take on another mortgage, a car loan, or other debts in the near future.

How Do You Pay Back a Home Equity Line of Credit?

During the draw period, you may be required to make minimum payments toward your HELOC. They might be interest-only payments.

Once the draw period ends, your regular HELOC repayment period begins, when payments must be made toward both the interest and the principal.

Remember that if you have a variable-rate HELOC, your monthly payment could fluctuate over time. And it’s important to check the terms so you know whether you’ll be expected to make one final balloon payment at the end of the repayment period.

What Are Some Alternatives to HELOCs?

Motivated by spiking home values and low interest rates, homeowners cashed out nearly $50 billion in home equity in the first quarter of 2021, according to Freddie Mac.

Here are HELOC options.

Cash-Out Refi

With a cash-out refinance, you replace your existing mortgage with a new mortgage given your home’s current value, with a goal of a lower interest rate, and cash out some of the equity that you have in the home.

Lenders typically require you to maintain at least 20% equity in your home (although there are exceptions). Be prepared to pay closing costs.

Generally, cash-out refinance guidelines may require more equity in the home vs. a HELOC.

Recommended: Cash Out Refi vs. Home Equity Line of Credit: Key Differences to Know

Home Equity Loan

What is a home equity loan again? It’s a lump sum loan secured by your home. These loans almost always come with a fixed interest rate, which allows for consistent monthly payments.

Some lenders will reduce or waive the closing costs if you don’t pay off the loan within a particular period—usually three years.

Personal Loan

If you’re looking to finance a big-but-not-that-big project for personal reasons and you have a good estimate of how much money you’ll need, a low rate personal loan that is not secured by your home could be a better fit.

With possibly few to zero upfront costs and minimal paperwork, a fixed-rate personal loan could be a quick way to access the money you need. Just know that an unsecured loan usually has a higher interest rate than a secured loan.

A personal loan might also be a better alternative to a HELOC if you bought your home recently and don’t have much equity built up yet.

The Takeaway

How does a HELOC work? For equity-rich homeowners, a home equity line of credit can give them money as needed, up to their approved limit, during a typical 10-year draw period. The rate is usually variable. Sometimes closing costs are waived.

A cash-out refinance may hold more appeal for some homeowners, and an unsecured personal loan may suit others. SoFi offers both kinds of fixed-rate loans.

Check your rate options within minutes.


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