If you own a home, you may be interested in tapping into your available home equity. One popular way to do that is with a home equity line of credit. This is different from a home equity loan, and can help you finance a major renovation or many other expenses.
Homeowners sitting on at least 20% equity — the home’s market value minus what is owed — may be able to secure a HELOC.
Here, you’ll take a closer look at this loan product, including:
• What is a HELOC loan?
• How does a HELOC loan work?
• What are the pros and cons of a HELOC?
• What are alternatives to a HELOC?
How Does a HELOC Work?
The purpose of a HELOC is to tap your home equity to get some cash to use on a variety of expenses. Home equity lines of credit offer what’s known as a revolving line of credit, similar to a credit card, and usually have low or no closing costs. The interest rate is likely to be variable (more on that in a minute), and the amount available is typically 75% to 85% of your home’s value.
Once you secure a HELOC with a lender, you can draw against your approved credit line as needed until your draw period ends, which is usually 10 years. You then repay the balance, typically over 20 years, or refinance to a new loan. Worth noting: Payments may be low during the draw period; you might be paying interest only, and then face steeper monthly payments during the repayment phase. Carefully review the details when applying for a HELOC to understand what kind of debt you will be taking on.
Here’s a look at possible HELOC uses:
• HELOCs can be used for anything but are commonly used to cover big home expenses, like a home remodeling costs or building an addition. These expenditures have been rising steeply: The number of home-improvement projects grew 17% to almost 135 million and spending ticked up 20% to $624 billion, according to recent American Housing Survey data.
• Personal spending: If, for example, you are laid off, you could tap your HELOC for cash to pay bills. Or you might dip into the line of credit to pay for a wedding (you only pay interest on the funds you are using, not the approved limit).
• 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 they are using their home as collateral. That means if they can’t keep up with payments, the lender may force the sale of the home to satisfy the debt.
HELOC Options
Most HELOCs offer a variable interest rate, but you may have a choice. Here are the two main options:
• Fixed Rate With fixed-rate home equity lines of credit, the interest rate is set and does not change. That means your monthly payments won’t vary either.
• Variable Rate Most HELOCs have a variable rate, which 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. Or, in these inflationary times, it might go down in the future. A margin is added to the index to determine the interest you are charged. In some cases, you may be able to lock a variable-rate HELOC into a fixed rate.
• 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.
HELOC Requirements
Now that you know what a HELOC is, think about what is involved in getting one. If you do decide to apply for a home equity line of credit, you will likely be evaluated on the basis of these criteria:
• Home equity percentage: Lenders typically look for at least 15% or more commonly 20%.
• A good credit score: Usually, a score of 680 will help you qualify, though many lenders prefer 700+. If you have a credit score between 621 and 679, you may be approved by some lenders.
• Low debt-to-income (DTI) ratio: Here, a lender will see how your total housing costs and other debt (say, student loans) compare to your income. The lower your DTI percentage, the better you look to a lender. Your DTI will be calculated by your total debt divided by your monthly gross income. A lender might look for a figure in which debt accounts for anywhere between 36% to 50% of your total monthly income.
Other angles that lenders may look for is a specific income level that makes them feel comfortable that you can repay the debt, as well as a solid, dependable payment history. These are aspects of the factors mentioned above, but some lenders look more closely at these as independent factors.
Example of a HELOC
Here’s an example of how a HELOC might work. Let’s say your home is worth $300,000 and you currently have a mortgage of $200,000. If you seek a HELOC, the lender might allow you allows you to borrow up to 80% of your home’s value:
$300,000 x 0.8 = $240,000
Next, you would subtract the amount you owe on your mortgage ($200,000) from the qualifying amount noted above ($240,000) to find how big a HELOC you qualify for:
$240,000 – $200,000 = $40,000.
One other aspect to note is a HELOC will be repaid in two distinct phases:
• The first part is the draw period, which typically lasts 10 years. At this time, you can borrow money from your line of credit. Your minimum payment may be interest-only, though you can pay down the principal as well, if you like.
• The next part of the HELOC is known as the repayment period, which is often also 10 years, but may vary. At this point, you will no longer be able to draw funds from the line of credit, and you will likely have monthly payments due that include both principal and interest. For this reason, the amount you pay is likely to rise considerably.
Difference Between a HELOC and a Home Equity Loan
Here’s a comparison of a home equity line of credit and a 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 on the amount of credit you actually use. It can be good for people who want flexibility in terms of how much they borrow and how they use it.
• A home equity loan is a lump sum with a fixed rate on the loan. This can be a good option when you have a clear use for the funds in mind and you want to lock into a fixed rate that won’t vary.
Borrowing limits and repayment terms may also differ, but both use your home as collateral. That means if you were unable to make payments, you could lose your home.
Recommended: What are the Different Types of Home Equity Loans?
What Is the Process of Applying for a HELOC?
If you’re ready to apply for a home equity line of credit, follow these steps:
• First, it’s wise to shop around with different lenders to reveal minimum credit score ranges required for HELOC approval. You can also check and compare terms, such as periodic and lifetime rate caps. You might also look into which index is used to determine rates and how much and how often it can change.
• Then, you can get specific offers from a few lenders to see the best option for you. Banks (online and traditional) as well as credit unions often offer HELOCs.
• When you’ve selected the offer you want to go with, you can submit your application. This usually is similar to a mortgage application. It will involve gathering documentation that reflects your home’s value, your income, your assets, and your credit score. You may or may not need a home appraisal.
• Lastly, you’ll hopefully hear that you are approved from your lender. After that, it can take approximately 30 to 60 days for the funds to become available. Usually, the money will be accessible via a credit card or a checkbook.
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 (or, in some cases, even more), 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 (mortgage plus HELOC, $420,000) ÷ current appraised value (500,000) = CLTV (0.84)
Convert this to a percentage, and you arrive at 84%, just under many lenders’ CLTV threshold for approval.
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.
Turn your home equity into cash with a HELOC brokered by SoFi.
Access up to 95% or $500k of your home’s equity to finance almost anything.
How Do Payments On a HELOC Work?
During the first stage of your HELOC loan (what is called the draw period), you may be required to make minimum payments toward your HELOC. These are often 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.
Pros of Taking Out a HELOC
Here are some of the benefits of 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. What is the interest rate on a HELOC? The average HELOC loan rate as of December 15, 2022, was 7.31%.
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 those of a home equity loan. 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
Now, here are some downsides of HELOCs to consider:
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.
Variable-rate HELOCs come with annual and lifetime rate caps, so check the details to know just how high your interest rate might go.
Potential Cost
Taking out a HELOC is placing a second mortgage lien on your home. You may have to deal with closing costs on 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 home mortgage loan, a car loan, or other debts in the near future.
What Are Some Alternatives to HELOCs
If you’re looking to access cash, 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. So if your current mortgage is $150,000 on a $250,000 value home, you might aim for a cash-out refinance that is $175,000 and use the $25,000 additional funds as needed.
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.
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
If you are looking to tap the equity of your home, a HELOC can give you 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. It can be an affordable way to get cash to use on anything from a home renovation to college costs.
If a home equity line of credit sounds right for you, see what SoFi offers. We have HELOC options that allow you to access up to 95% or $500,000 of your home’s value at competitively low rates. Plus, the application process is quick and convenient.
Unlock your home’s value with a home equity line of credit brokered by SoFi.
FAQ
What can you use a HELOC for?
It’s up to you what you want to use the cash from a HELOC for. You could use it for a home renovation or addition, or for other expenses, such as college costs or a wedding.
How can you find out how much you can borrow?
Lenders typically require 20% equity in your home and then offer up to 85% or even more of your home’s value, minus the amount owed on your mortgage. There are online tools you can use to determine the exact amount, or contact your bank or credit union.
How long do you have to pay back a HELOC?
Typically, home equity lines of credit have 20-year terms. The first 10 years are considered the draw period and the second 10 years are the repayment phase.
How much does a HELOC cost?
When evaluating HELOC offers, check interest rates, the interest-rate cap, closing costs (which may or may not be billed), and other fees to see just how much you would be paying.
Can you sell your house if you have a HELOC?
Yes, you can sell a house if you have a HELOC. The home equity line of credit balance will typically be repaid from the proceeds of the sales when you close, along with your mortgage.
Does a HELOC hurt your credit?
A HELOC can hurt your credit for a short period of time. Applying for a home equity line can temporarily lower your credit score because a hard credit pull is part of the process when you seek funding. This typically takes your score down a bit.
How do you apply for a HELOC?
First, you’ll shop around and collect a few offers. Once you select the one that suits you best, applying for a HELOC involves sharing much of the same information as you did when you applied for a mortgage. You need to pull together information on your income and assets. You will also need documentation of your home’s value and possibly an appraisal.
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