One way to do that is through a home equity line of credit, or HELOC. Like a credit card backed by your home equity, a HELOC gives homeowners access to a revolving line of credit they can borrow from as much and as often as they need to. There’s a designated draw period for using the funds and a repayment period when it’s time to pay the money back.
Also known as second mortgages, HELOCs are loans secured by your house which offer competitive interest rates, long repayment periods, and lots of flexibility. They’re a popular option to pay for home repairs and renovations, as the interest on HELOCs is tax-deductible up to a certain amount when used to improve your home.
Let’s have a look at what a HELOC is, how HELOCs work, and the requirements to get a HELOC if you want to make use of the equity in your home.
Here’s Where to Start
- What Is a HELOC?
- How a HELOC Works
- How Much Can You Borrow?
- Qualifying for a HELOC
- How to Get a HELOC
- Home Equity Loan vs. HELOC
- Is Getting a HELOC a Good Idea?
- Alternatives to a HELOC
- Frequently Asked Questions (FAQ)
What Is a HELOC?
A HELOC is a revolving line of credit secured by the equity in your house. Like a home equity loan, a HELOC is a secured loan where your home acts as collateral, meaning the lender can take your house if you default.
“[A] HELOC is like a credit card on your house in the sense that it’s a revolving line of credit and you can borrow and repay with a lot of flexibility, borrowing what you need when you need,” says Greg McBride, chief financial analyst at Bankrate.
Because HELOC interest rates tend to be lower than those of credit cards and personal loans, HELOCs are a popular option for consumers who want to finance large expenses — such as home improvements — or consolidate credit card debt. A HELOC’s flexibility also gives it certain advantages over other methods of tapping against your home equity, such as home equity loans or cash-out refinancing.
How a HELOC Works
HELOCs usually work on a 30-year model, with a 10-year draw period and a 20-year repayment period. During the draw period, you can spend as much as you want, whenever you want, up to your credit limit. Then you’ll have the length of the repayment period to pay off what you spent. Other lengths of draw periods and repayment periods also exist.
You can borrow up to a predefined maximum amount, similar to how a credit card works. The size of your HELOC credit line is determined by a number of factors including how much equity you have in your home, your credit score, and your employment situation.
HELOCs traditionally have a variable interest rate, meaning your interest rate fluctuates in relation to a benchmark prime rate. Your individual rate will be the prime rate plus a margin, set by the lender and determined based on your creditworthiness. Fixed-rate HELOCs or rate-lock options on existing HELOCs do exist, but they might have higher starting rates than traditional variable-rate HELOCs or come with an additional fee.
“Some lenders offer borrowers the option of fixing the interest rate on their outstanding balance for example, so they are not exposed to rising interest rates after they’ve piled up a balance,” McBride says.
In some cases, a HELOC will be an interest-only HELOC. This means that borrowers can make interest-only payments during the draw period. During the repayment period, borrowers begin making both interest payments and payments on the principal. Even on an interest-only HELOC, you can still make payments toward the principal during the draw period. In fact, experts recommend doing so if you can, to reduce your monthly payment when the repayment period arrives and pay less interest in the long run.
How Much Can You Borrow?
Generally speaking, you can borrow up to around 85% of your home’s appraised value — though the exact limit depends on the lender. Most lenders limit your combined loan-to-value ratio (CLTV) to 80% to 85%, meaning that the total amount of outstanding debt attached to your house, including your primary mortgage and any HELOCs or home equity loans, cannot exceed 80% to 85% of your home’s appraised value. In other words, lenders want you to maintain at least 15% to 20% equity in your home.
Equity is the difference between the current market value of your home and your remaining mortgage balance. For instance, if your house is worth $500,000 and you have $300,000 left to pay on your mortgage, you have $200,000 worth of equity in the home. In this case, you would be able to borrow $125,000 with a HELOC if you wanted to maintain a loan-to-value ratio of 85%.
Borrowers who request smaller LTV ratios may find that their rates are more favorable, since they are opting to keep more equity in the home and borrow a smaller amount. The maximum amount you can borrow may also depend on personal factors such as your credit score and income.
Qualifying For a HELOC
When you apply for a HELOC, your lender will look at several factors to determine whether to lend to you and what interest rate to give you:
- Your credit score. Your credit score acts as an indicator of how well you’ve managed your debts in the past. The higher your credit score, the more likely you’ll be approved for a HELOC, and the lower the interest rate you’re likely to get. Different lenders have different minimum credit score requirements, but you’ll generally want a credit score of at least 620.
- Your income and employment history. Lenders want to know that you have consistent income to pay back your debts, so you’ll need to provide proof of income when you apply. Be prepared to show pay stubs, bank statements, tax forms, and other documents that show how much you earn and demonstrate you have a steady stream of income. If you have nontraditional employment or an alternative income source — if you’re a freelancer, for example — you may need to provide more documentation or face greater scrutiny in the qualification process.
- Your home equity. How much you can borrow with a HELOC depends on how much equity you have in your house. In most cases, lenders will let you borrow up to 85% of your home’s value in total, including the remaining balance on your mortgage and any other loans secured by your home. If you haven’t built up much home equity, such as if you’ve recently bought your home or had a smaller down payment, you may not be able to get a HELOC at all.
- Your property. Because a HELOC is secured by your house, lenders want to make sure the property is truly worth as much as you say it is. Often, lenders will require a home appraisal as part of the HELOC application process. Depending on the lender, you may have to pay for an appraisal yourself, or your lender may cover the cost for you. The average home appraisal costs around $349, according to the home improvement marketplace HomeAdvisor.
How to Get a HELOC
Here’s our step-by-step guide to getting a HELOC:
- Know your personal finances. Before you decide to take out a HELOC, make sure you know what you’re going to do with the money, and have a plan for paying it back. Consider how a HELOC will fit into your financial goals and budget. Also check your credit score and credit report to get an idea of where your credit stands and how that might affect your approval odds or interest rate.
- Compare HELOC rates from multiple lenders. Check with local and national banks and credit unions as well as online lenders. Some lenders will let you pre-qualify and check your rate online, while others may require you to call or visit an in-person branch. Keep in mind that your exact rate will depend on your credit score, income, LTV ratio, and more. But even with the same financial profile, you may get different rates from different lenders, which is why it’s important to shop around before settling on one. Apart from the interest rate, be sure you’re also comparing fees and terms to find the best lender for you.
- Fill out an application. After you’ve decided on a lender, fill out an official application. On the application, you’ll typically need to provide personal information such as your income and debts, as well as information about the property you’re using as collateral for the HELOC. You may have to provide documentation, such as pay stubs or bank statements, to support the information you provide in the application.
- Schedule an appraisal of your house. Although not always the case, most lenders will require an appraisal of your house to determine the value of your collateral. Check with your specific lender to see whether an appraisal is needed, and if so, how it should be done and who’s responsible for paying for it.
- Submit your application and wait for lender approval. After you submit your application, you may need to wait a few weeks to two months for the lender to review your information and approve your application.
- Start drawing from your HELOC. Once your application is approved, your line of credit is now active and you can start drawing from it. Different lenders may offer different options for accessing your credit line. Some lenders will give you a credit card or debit card to make transactions and withdraw cash, while others will give you a checkbook.
Home Equity Loan vs. HELOC
Homeowners in 2021 gained an average of $48,000 in tappable home equity, but there’s no one-size-fits-all solution as to what is the best way to tap into it. Home equity loans and HELOCs are both popular options, offering longer repayment periods and comparatively low interest rates. However, there are some differences between the two:
|Home Equity Loan||HELOC|
|Installment loan||Revolving credit line with a draw period (often 10 years) and a repayment period (often 20 years)|
|Fixed interest rates||Variable interest rates|
|Receive the full loan amount in a one-time lump sum||Can withdraw money as often and as much as you want during the draw period (up to the credit limit)|
|One-time closing costs and fees||Various fees and interest charges, including possible ongoing fees|
|Typically have 5- to 30-year terms||Typically has a 10- to 15-year draw period and 15- to 20-year repayment period|
|Fixed monthly payments||Variable monthly payments that depend on your current HELOC interest rate|
Is Getting a HELOC a Good Idea?
A HELOC can be useful if you have any big expenses coming up that you need cash for. Right now, HELOC rates are comparatively lower than many other forms of financing, including cash-out refinancing, personal loans, and credit cards, making them an increasingly popular option. But personal finance experts say that whether a HELOC is right for you ultimately depends on your individual financial situation and goals.
“People should always be mindful when accessing the home equity they have built in their home regardless of the market,” says Tom Parrish, head of retail lending product management at BMO Harris Bank. “They should think about prudent ways that they can utilize their home equity to help them make real financial progress.”
The funds from a HELOC can be used for almost anything, from college tuition to medical expenses. But two of the most common reasons to get a HELOC are to finance home improvements and to consolidate debt. The flexible nature of a HELOC really shines in situations where you don’t know exactly how much your expenses will be or if you have ongoing expenses, because you’ll only have to pay for what you actually spend (plus interest).
“People that are doing huge home improvement projects where they’re going to be incurring the costs in stages really look to the HELOC because they’re going to borrow the money only when they need it,” McBride says.
Using a HELOC for home improvements also has another benefit: tax advantages. You can deduct interest paid on your HELOC if you use the funds to improve your home. To qualify for this benefit, the total debt related to the house must not exceed $750,000.
The other common use, debt consolidation, involves using the HELOC funds to pay off high-interest debt like credit card debt. HELOC rates are around 5% right now, while the average credit card APR on accounts assessed interest is 16%, according to the Federal Reserve. The lower interest rate will save you money in the long run, and having all your debts consolidated into a single loan instead of juggling multiple monthly payments can streamline your finances and reduce the risk of missing a payment.
But “don’t get [a HELOC] just for the sake of getting it, or get it just because you can,” says Sidney Divine, a financial planner at Divine Wealth Strategies in Atlanta. “Over the long run, it may not be right for you.”
For example, “using your property as collateral reduces the equity you have in your home,” says Michelle McLellan, senior vice president at Bank of America. This might be problematic if you decide to move sooner than anticipated — you’ll have to pay off the HELOC if you sell the property it’s tied to, and it could be more difficult to sell without as much equity.
Alternatives to a HELOC
Home equity loans
Unlike a HELOC, a home equity loan is not a revolving line of credit, but a fixed interest rate installment loan. You can borrow money in a lump sum up front and then pay it off in fixed monthly installments over the loan term. There is one key similarity though: both home equity loans and HELOCs are secured loans that use your house as collateral.
A cash-out refinance is when you sign up for a home loan for more than what you owe on a current mortgage, and then get cash for the difference.
“[When] people are in the position where they can profitably refinance their mortgage, [a cash-out refinance] becomes the avenue through which they can access their home equity,” McBride says.
That was the case in 2020 and 2021, where record-low mortgage rates spurred a huge wave of cash-out refinancing. Now, though, with mortgage rates above 5% and projected to keep rising, cash-out refinancing is a less viable option for many homeowners.
For those who recently refinanced and don’t want to lose the low rate on their current mortgage, a HELOC could be the better option to tap into their home equity without altering their primary mortgage.
A personal loan can get you quick cash without needing to put your house up as collateral. They’re fixed-rate installment loans where you receive a lump sum of cash upfront and pay it back over the agreed-upon term, commonly ranging from two to seven years.
Because personal loans are unsecured debt, they tend to have higher interest rates than HELOCs or home equity loans. Still, they’re a cheaper form of borrowing than most credit cards. The application process is also faster than with a HELOC or home equity loan; some personal loan lenders even offer same-day funding.
Most personal loans require good credit for approval, but bad-credit personal loan lenders do exist. If you have poor or fair credit, though, be prepared to pay a higher interest rate.
Frequently Asked Questions (FAQ)
Is interest on a HELOC tax-deductible?
The interest you pay on your HELOC is tax-deductible for expenses used to substantially improve a qualified residence so long as the total debt related to the house must not exceed $750,000.
What are the fees and upfront costs on a HELOC?
HELOC fees include origination fees, notary fees, title fees, recording fees to the local government, and appraisal fees. There may also be ongoing annual fees to keep the HELOC account open.
Can you close a HELOC early?
You don’t have to keep your HELOC for the full 20- or 30-year period. As long as you pay off the entire balance, you can contact your lender to close the line of credit. However, there may be a penalty for paying off your loan early. Many HELOC lenders don’t charge prepayment penalties, but some do.
If your HELOC lender waived certain fees when you opened the HELOC, it’s possible they may try to claw back those fees if you close your HELOC before a specified amount of time has passed. You’ll be able to find out whether your HELOC lender charges early payment fees in your loan agreement and term disclosure documents.