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How to shop for home equity lines of credit
Homeowners have multiple ways to turn their home equity into quick cash. If you own a home that’s worth more than your existing mortgage debt, a home equity line of credit (HELOC) can be a good way to get cash when you need it.
Many people confuse a HELOC with a home equity loan. While they both involve the equity in your home, they are not the same thing. Below you will discover the ins and outs of a HELOC so that you can decide whether or not it’s right for you.
What is a HELOC?
HELOC stands for “home equity line of credit.” It’s a revolving credit line backed by the equity you have in your home.
This line of credit is an opportunity to borrow money when you need it. Unlike a loan with a fixed payment, a line of credit works like a credit card. You can borrow as much as you need, up to your credit limit, pay it back, then borrow again (as before, up to your available limit).
A “line of credit” may also be called a “credit line.” The two terms mean the same thing and can be used interchangeably. A home equity line of credit allows homeowners to cash out on the equity of their home without having to sell. It is a popular way to borrow at low rates, particularly in tough financial times or to finance large projects.
Home equity is the difference between the market value of your home and the amount of mortgage debt that you owe.
For example, if your home is worth $500,000 and your mortgage balance is $350,000, you have $150,000 of home equity. If you obtain a second mortgage for, say, $50,000, your equity will drop to $100,000.
Equity rises when you pay off home equity debt or your home appreciates. Equity falls when you borrow against your home or your home depreciates.
Put the line of credit and your home equity together, and you have a HELOC — a line of credit that’s backed, or secured, by the equity you have in your home.
How do home equity lines of credit work?
HELOCs allow you to draw only the cash you need up to your credit limit during what is called a “draw period.” This is the time during which you can withdraw money from the credit line. It typically ranges from five to 10 years. When the draw period ends, you enter the repayment period, usually 10 to 20 years.
Your home is your collateral
An asset that secures a credit line (in this case, your home) is known as the “collateral.”
Using your home equity as collateral for a second mortgage or line of credit means you’ll get a lower rate than you would for unsecured debt, which could save you money.
It also means you could lose your home if you borrow against your equity and don’t make the payments when required.
What determines your credit limit?
The credit limit on a HELOC depends on how much equity you have, your income, your total debt, and your credit history. Most lenders will allow you to borrow against at least 75% of your equity. Many will push that up to 80%, 85%, or even 90%. Around 85% is typical.
The maximum limit on your credit line depends on the amount of equity you have in your home and the lender’s analysis of your ability to repay debt. For example, assume your lender authorizes the typical 85%. If you have $100,000 of equity in your home, you could get a credit line of $85,000.
Costs for a HELOC include interest and, in some cases, fees. The interest rates are usually variable and are composed of a benchmark index (the London Interbank Offered Rate, LIBOR, or the US Prime Rate) plus a margin (additional percentage points). Lenders determine the amount of your margin by analyzing your credit and financial history along with other factors. The better your credit and the lower your risk profile, the lower your margin will be.
The variable rate means your monthly payments fluctuate with the market. Some HELOCs come with an introductory fixed rate, but these usually last only one to six months. (Source)
How do payments on a HELOC work?
When you withdraw funds from a HELOC during the draw period, lenders will require you to make minimum monthly payments. These often go toward the interest only but may go toward the interest and principal with some lenders. Payments may change based on your balance, on interest rate fluctuations, and on whether you make additional principal payments. Making additional principal payments when possible will help you save on interest and reduce your overall debt more rapidly. When the draw period ends, you will either owe the balance in full (balloon payment) or will begin a repayment period.
If you opt for the latter, you’ll gradually pay back your balance over a 10 to 20-year term through monthly payments.
When you enter the repayment period, you monthly payments can increase by as much as 300% (Source). For instance, a HELOC with a $270 payment could jump to $1,080 after the draw period. It’s these drastic fluctuations in payments that get some borrowers in trouble. Some HELOCs reduce this payment shock by giving longer repayment periods or requiring borrowers to repay some of the principal during the draw period.
How do you calculate interest on a HELOC?
A homeowners whose equity line of credit has a variable interest rate may see rates change from month to month, as already noted. To calculate your interest, add together the benchmark rate and your margin to get your adjusted interest rate. Then, multiply your adjusted interest rate by your outstanding HELOC balance to get your total annual interest. If you want to see your monthly interest payment, divide the annual interest amount by 12.
US Prime Rate: 4.25%. Margin: 0.50%. Adjusted Interest Rate: 4.75%. Outstanding HELOC balance: $15,000. Total annual interest (balance times adjusted interest rate): $712.50. Monthly payment to interest (divide by 12): $59.38.
Also, keep in mind that some lenders provide discounts that will lower your adjusted interest rate. Bank of America, for example, offers an interest rate discount for setting up automatic monthly payment deductions from one of its checking or savings accounts.
What are the requirements of a HELOC?
To qualify for a HELOC, you need to have equity available in your home. So, the amount you still owe must be less than your home’s value. As already noted, you’ll typically be able to borrow 85% of that value, minus however much you still owe on the property. The more equity you have available, the greater your range of options will be.
In addition to available equity, you’ll typically need to meet the same sorts of criteria you had to meet when you first got your home loan. This means you’ll need a good credit score, good credit history, stable employment history, sufficiently high monthly income, and sufficiently low monthly debt payments.
Here a quick summary of common HELOC requirements:
- US citizen or permanent resident.
- A good credit score (at least 680 in most cases, though some lenders may approve a small percentage of people with scores below 680).
- Sufficient equity in a home (you can borrow 80% to 90% of your total equity from most lenders).
- A qualifying combined loan-to-value ratio (compares the value of your property to the total of the remaining balance on your mortgage, the home equity loan amount, and other liens on the property).
- A qualifying debt-to-income ratio (typically less than 43%).
- Other factors: Good performance in prior mortgages, owner-occupied property, sufficient income, an acceptable length of employment, and a lack of significant expenses.
Getting a HELOC with bad credit
If your credit history isn’t perfect or your credit score is on the low side, a HELOC can be both your best and worst option to borrow money.
If you have equity in your home, it’s relatively easy to get approved for a HELOC, even if your credit is mediocre. And your rate for a HELOC should be lower than a personal loan or credit card rate. That’s what can make a HELOC your best option.
What can make a HELOC your worst option, as you might have guessed, is that you could lose your home if you don’t make payments as required. If you’ve struggled with credit in the past, that might not be a smart risk for you to take.
Good and bad ways to use a HELOC
There are many ways to use a HELOC. Some are good. Some are bad. Unfortunately, financial experts don’t agree on which are which.
The truth is, how you choose to use your HELOC might be good for you and bad for someone else. It all depends on your financial goals, ability to manage debt, and personal lifestyle.
Examples of how a HELOC can be used include:
- Making home improvements.
- Adding square footage to your home.
- Paying off credit-card debt or a car loan.
- Consolidating other debts.
- Taking care of emergency expenses.
- Buying a second home as a vacation or rental property.
- Investing in stocks, bonds, or other types of assets.
- Buying a car or boat.
- Paying college tuition for yourself or your children or grandchildren.
5 things to remember about HELOCs
To drive home some key points, here are some facts about HELOC you should be sure to commit to memory.
A typical HELOC has a 5-year or 10-year draw period. During the draw period you can use and reuse the credit line as often as you want.
At the end of the draw period, you’ll enter a repayment period. During this time, your lender will expect you to make payments to pay off your HELOC balance.
A 10-year or 20-year repayment period is typical.
Most HELOCs have a variable rate. That means the interest you’ll be charged if you use your HELOC will probably change over time as market rates fluctuate. Your rate could go up or down, and it could change before or after you borrow money.
Some HELOCs offer a rate discount if you set up automatic monthly payments or make an initial withdrawal when you open your account.
Income tax deductibility
The 2017 Tax Cuts and Jobs Act suspended the federal income tax deduction for interest paid for HELOCs and home equity loans from 2018 until 2026.
But there is an important exception: if the funds are used to buy, build, or substantially improve the home used to secure the loan, the interest is still deductible.
Some restrictions apply. For example, the loan must be secured by your primary home or a second qualified residence. The new law also lowered the loan limit eligible for a tax deduction. Since 2018, taxpayers have only been allowed to deduct interest on $750,000 of qualified residence loans. The limit is $375,000 for a married taxpayer filing a separate return (Source). These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return.
You should ask your tax preparer for details.
HELOC-to-equity loan conversion
Some HELOCs allow you to convert all or a portion of your HELOC into a home equity loan during the draw period. Unlike a HELOC, a home equity loan (or second mortgage) has a fixed term and may have a fixed rate and payment.
The option to convert debt from a HELOC to a home equity loan can be nice to have, especially if your HELOC rate goes up and you want to lock in a fixed rate to protect yourself from further increases. Look for this feature or ask about it when you apply.
Should you get a HELOC or a home equity loan?
HELOCs and home equity loans have certain important characteristics in common.
- Allow you to borrow against your home equity.
- Use your home as collateral.
- Put your home at risk if you don’t make payments when required.
Beyond that, though, HELOCs and home equity loans are very different.
Compare the features of HELOCs and Home Equity Loans to make a better decision.
- The loan is secured by your house.
- Low but variable interest rates.
- Reusable line of credit.
- Draw and repayment periods.
HOME EQUITY LOANS
- The loan is secured by your house.
- Fixed or variable rate.
- Fixed loan amount.
- A fixed-term with a monthly payment.
A home equity loan and HELOC comparison calculator can help you figure out which option you prefer.
HELOCs can turn upside down
One last point should be made about HELOCs and home equity loans. If the market value of your home drops after you borrow against your home equity, you could get flipped upside down on your home loans.
This situation occurs when you owe more than your home is worth.
If that happens, it could be difficult for you to sell your home for enough money to pay off your home loans and pay your closing costs, leaving you with no equity or in a loss position.
If you have no plans to sell, that might not matter to you. Over time, you could pay off your loans and your home might regain or surpass its former value as housing markets tend to be cyclical.
Still, it’s important to weigh all the risks and rewards when you think about HELOCs and home equity loans.
How do you apply for a HELOC?
Many lenders allow homeowners to apply for a HELOC online. The initial application process can take as little as 15 minutes. Keep in mind that some lenders charge fees and closing costs for a HELOC.
Examples of fees you might be charged:
- Application fee.
- Annual fee.
- Conversion fee (for converting from a HELOC to a home loan).
- Cancellation fee.
- Early account closure fee.
You should shop around and compare your options before you decide to get a HELOC.
How do you compare HELOC lenders?
Lenders can vary greatly in their terms and conditions. Here are the main things you will want to weigh when making your decision on which HELOC is best for you.
What are the interest rates?
The interest rate a lender offers you will determine how much the HELOC will cost you. However, shopping for rates isn’t as easy as heading to a company’s website and looking at the interest rate advertised. Here’s why: The interest rate you get will depend on several factors, including the amount of your credit line, the lien position the HELOC will be in, the combined loan-to-value ratio, the property type, your creditworthiness, the discounts available, and more. The rate advertised is the result of the lender making assumptions for all of these factors. So it is unlikely you will end up with this exact rate. What can you do, then? Aside from actually applying, here are a few things to check:
- The benchmark a lender uses (LIBOR, US Prime Rate)
- If the margin changes after a certain amount of time or stays the same
- Interest rate types: variable or fixed
- Introductory rate offers and the rate after the introductory rate
- Annual Percentage Rate (APR) maximum and minimum limits
- Interest rate discounts
- Customer reviews
- Average credit score of borrowers for the company
Make a short list of the best HELOC lenders and then apply with each of them to find the best rate available to you.
What are the draw and repayment periods?
The draw period varies from one lender to the next. Be sure to check this detail. Additionally, check the repayment period, as you want to ensure you will have enough time to pay off your balance.
What fees do they charge?
Look out for fees or closing costs. Some lenders charge you to apply or to close the account early. Others charge closing costs to all customers, or to customers with high credit lines ($1,000,000 or more). Also, plan for the future by looking at fees for conversion options. For example, Bank of America offers a conversion of variable rate HELOC balances into fixed-rate loans at no cost. Down the road, you’ll thank yourself for choosing a lender who doesn’t charge you for deciding you want a different repayment option.
How will you be able to access your HELOC funds?
Check to see how you will be able to access the funds from your HELOC. Here’s a summary of common access options:
- Visiting a financial center
- Transferring funds online
- Visa access card
- HELOC checks
For convenience, most financial institutions provide checks that can be used to pay directly from a HELOC for services used (for example, a contractor) and purchases made (materials, appliances, etc.). On the other hand, homeowners can use secure online banking to transfer funds from a HELOC to their checking account to pay for home improvements.
What do you need to qualify?
Companies use their own criteria to approve applicants. Just because you don’t get approved by one doesn’t mean you won’t get approved by another. Here are a few requirements that can vary between lenders:
- Credit and income minimums
- Employment requirements
- Owner-occupation of the home
- Debt-to-income ratio maximums
- Combined loan-to-value ratio maximums
- Property types (some won’t lend on mobile homes, properties listed for sale, commercial property, or property with more than four units)
Be sure to read the fine print to find the lenders that best fit your needs.
How much can you borrow with a credit line?
While the maximum amount you can get for a HELOC will depend on your equity, lenders do have limits. If you are looking at taking out a large credit line, be sure to check where lenders top out. Some also have minimum credit line requirements that may be a factor in your decision.
What do their customer reviews say about them?
We all want to be treated well when giving a lender our business, so customer service matters. Check reviews on HELOC lending companies to find out how well they treat their customers and what contact options they offer. If an issue comes up, you will want it to be taken care of quickly and easily.
What is the application process like?
Lastly, what is the process like to apply and get the credit line? Many lenders have online application processes that take about 15 minutes, but not all. Also, find out what steps are involved in appraising your property, finalizing the credit line, and gaining access to the money. By weighing these factors, you will be able to narrow down the many lenders available to find the right one for you.
How do I get a HELOC?
To get a HELOC, the first thing you need to do is find out if you qualify. Check your credit score, find out how much home equity you have, and calculate your debt-to-income ratio. Once you have your ducks in a row, you can start your research. Your visit to this HELOCs review page will help you expedite the process. Here you can compare all the top lenders side-by-side. Now that you’re here, use the factors above as a guide when vetting lenders. After you’ve short-listed the best options, the next step is to apply, compare the offers, and choose the best fit.