What Is A HELOC And How Does It Work?

Did you know that you can use the equity you’ve built up in your home as a kind of credit card? A home equity line of credit (HELOC) allows you to borrow against your home equity to fund an expensive renovation, pay off or consolidate other debts or even pay for college tuition. Let’s see how this type of financing works and how it differs from other types of loans.

What Is A HELOC?

First, we should understand what home equity is. Home equity is the amount of your home that you actually own. Specifically, equity is the difference between what your home is worth and what you owe your lender. As you make payments on your mortgage, you reduce your principal – the balance of your loan – and you build equity. At the same time, if the value of your home rises due to market forces, your home equity also grows.

Once you have enough equity built up, you can access it by taking out a home equity loan, undergoing a cash-out refinance or establishing a home equity line of credit (HELOC).

Of these, a HELOC is different in that it’s not a lump sum loan, but instead acts as a revolving line of credit. You can borrow as little or as much as you need, up to your approved credit line, and you pay interest only on the amount that you borrow.

How A HELOC Works

To establish a home equity line of credit, you’ll first shop a few lenders that do this type of financing to find the best deal (currently, Rocket Mortgage® does not offer a HELOC).

After looking at your current mortgage and other personal financial information, banks will determine if you’re eligible, how much credit they can extend, for how long, and current interest rate. A HELOC has two phases: the draw period and the repayment period.

Draw period: Though it varies by lender, this is typically a stage of about 10 years when you can draw funds from the HELOC. You can withdraw as little as nothing or as much as all of the funds – or any amount in between. During the draw period, you make interest-only payments on what you’ve borrowed, but you can also reduce your principal by paying more than the minimum payment. Just be sure that the lender does not charge a prepayment penalty.

You withdraw funds during the draw period much like you would from a checking account. Most lenders allow you to withdraw cash in multiple ways: by online bank transfer, with written checks and/or with a debit card you use to withdraw cash like an ATM. Once the draw period ends, your HELOC closes and you enter the repayment period as set up at the beginning.

Repayment period: Once you reach the end of the draw period, you’re in the repayment period, which typically extends for 20 years. You won’t be able to borrow any more money from your HELOC and must begin making full monthly payments that cover the HELOC’s principal and interest. These payments will certainly be much larger than those you’ve previously made.

The amount of your payments will also be subject to changes if your HELOC has a variable interest rate, as many do. HELOC interest rates are tied to publicly available indexes, such as the prime rate, and rise and fall along with the index. There are limits to how much the rate can change, as most variable-rate HELOCs set caps on how much your interest rate can increase from one adjustment to the next, as well as how much it can increase over the life of the loan.

How Much Can You Borrow With A HELOC?

Typically, lenders will determine how much you can borrow with a HELOC based on your loan-to-value ratio. Lenders apply the LTV test to lots of different types of proposed loans as it relates to the size of a loan against the cost of any purchase, such as a home, auto, RV or other large purchase.

In the case of a HELOC, however, your LTV is a ratio that measures the difference between the amount of equity you have in your home and how much you want to borrow. Say your home is worth $400,000 and you owe $250,000 on your mortgage. Your home equity is $150,000. Assuming your credit score is strong, a typical HELOC lender will allow you to access 80% of the amount of equity you have in your home (some lenders might go up to 90%, though usually at a higher interest rate). But let’s say it’s 80%:

$150,000 x .8 = $120,000

At any point in the draw period of your home equity line of credit, then, you can borrow as much or as little of the $120,000 loan as you wish.

When To Use A HELOC

There really are no limits on what you can use HELOC funds for. A HELOC works very much like a credit card. However, since it uses perhaps your most valuable and important possession – your home – as collateral, you should limit HELOC use primarily on things that can be considered investments.

• Home improvements or repairs: Investing back into your house can add value to the property and might ultimately come back in profit when you sell.
• Debt consolidation: If you have multiple debts, consider paying them all off with your HELOC funds. This simplifies your finances, and in the case of many types of debt – especially high interest credit card debt – the interest rate on your HELOC will be much lower than your other debts. You’ll still have debt, but your monthly payments will be more manageable.
• Education expenses: Whether it’s a 4-year degree program, community college or a trade school, the cost of higher education is considered an investment in yourself or a loved one, and one that will continue to pay dividends with career growth.
• Medical emergencies or help with an aging parent: Injuries or illnesses often come out of nowhere and can put you and your family in a large financial hole quickly. Likewise, the cost of care for an aging parent can easily rise into the thousands of dollars per month in some cases. Having HELOC funds available can help, at least in the short term, until the sick person recovers or the financing of long-term care for a parent can be organized.

Is A HELOC A Good Idea? Pros And Cons

HELOC Requirements

Whether you’ll qualify for a HELOC, and for how much credit, will vary by lender but mostly depends on your property and your financial situation.

Credit limits. Most importantly, you’ll need to actually have equity in your home in order to tap into it for a second mortgage. Lenders determine how much you can borrow by establishing a loan-to-value (LTV) ratio. This is typically set in a range of 80% - 90% of the amount of equity you have in your home. So, if your house has a current market value of $200,000 and you still owe $50,000 on your mortgage, your total home equity is $150,000. If the lender sets an LTV at 90%, your line of credit would be $130,000.

Credit requirements. Just as they did for your original mortgage, lenders will want to review your credit score, debt-to-income (DTI) ratio and credit history in assessing your loan application. They typically set pretty stiff credit requirements for a HELOC than for many other kinds of financing. Most require that you have a credit score of at least 680 to qualify. The higher your score, the better your chances of getting their lowest rate.

How To Apply For A HELOC

Applying for a HELOC is very similar to the process of getting any loan, with a few key differences:

1. Choose a lender: Not all banks or mortgage lenders offer a home equity line of credit, but many do. Each will have its own rates, terms and qualifications, so it’s good to shop around. Rocket Mortgage does not offer a HELOC.
2. Review qualifications and collect documents: Talk with potential lenders about all their qualification requirements (your credit score, LTV ratio, income, etc.). If you’re in possession of most of this information from the start, you can save time by weeding out non-starters. Once you’ve found potential fits, you can then begin collecting the documents they require to move forward.
3. Get a home appraisal: Since establishing a loan-to-value ratio is crucial to the amount of credit you’re eligible for, your lender will order a professional appraisal of your home. Your HELOC is based on the difference between the appraised market value of the house and how much you owe on your mortgage.
4. Close on the new line of credit: Closing on a HELOC is very similar to closing on a mortgage. Typically it will take place in person at the financial institution, but in some cases it can be done online. There will be a transfer of title, since the HELOC places a lien on your home in case you default. You’ll need identification documents, proof of homeowners insurance, and possibly appraisal and/or inspection documents. You’ll also need to pay closing costs, typically 3% – 6% of the loan amount.

Alternatives To Getting A HELOC

A HELOC is just one type of loan available to qualified borrowers. Each works differently and has its own pros and cons. Here are a few alternatives:

• Home equity loan: This loan works very much like a HELOC in that it uses the equity you have in your home as collateral to secure a new loan, sometimes called a “second mortgage.” The key difference from a HELOC is that it’s a lump sum loan with a fixed interest rate, as opposed to the revolving line of credit and adjustable rate in a HELOC.
• Cash-out refinance: This type of loan replaces your existing mortgage with a new one for a larger amount than what you owe so you can pocket the difference to achieve your goals. Unlike a HELOC, which adds a second monthly payment, the cash-out refinance provides you with cash you can use for just about anything, but with just one monthly payment.
• Personal loan: This is a common type of loan that lenders provide if you meet qualifications such as credit score, income, etc. You’re required to pay it back in monthly payments over a fixed time period, usually at a fixed rate of interest. It differs from a HELOC in that it does not use your home as collateral in case you default. In fact, you don’t even need to own a home to qualify for a personal loan.

The Bottom Line

A HELOC is a great way to convert the equity you’ve built in your home into instant cash to pay for home renovations, consolidate debt, or just to have on hand for emergencies. Since you only pay interest on what you owe, it allows you to control your monthly payments. To learn about the ways Rocket Mortgage can help you access your home equity, start on an application today.