HELOC definition: HELOC stands for "home equity line of credit," and it's a revolving credit line backed by the equity you have in your home. 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 and how does it work?
HELOCs come with a "draw period," which is the amount of time 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, which usually ranges from 10 to 20 years. Since the home is collateral for the credit line, if you default on your payments, you may be forced to sell or go through foreclosure to pay off your outstanding balance. 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. Typically, you can get access to around 85% of your equity. For example, 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 (i.e., the London Interbank Offered Rate LIBOR or 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 lower risk your profile is, the lower the margin will be. A few advantages of a HELOC are that interest rates are usually lower than those for other types of loans and your interest payments may be tax-deductible.
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. Dave Gorman, Divisional Sales Executive at Bank of America, says, "Payments may change based on your balance, interest rate fluctuations, or if you make additional principal payments. Making additional principal payments when possible will help owners save on the interest they’re charged and help reduce their overall debt more quickly." 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, lenders restructure the outstanding amount into a traditional loan that you gradually pay back over a 10 to 20-year term through monthly payments.
How do you calculate interest on a HELOC?
"When homeowners have a variable interest rate on their home equity line of credit, the rate can change from month to month," says Gorman. 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.
Here's an example of how it works:
US Prime Rate (10/12/2017): 4.25% Margin: 0.50% Adjusted Interest Rate: 4.75% Outstanding HELOC balance: $15,000 Total annual interest (balance * adjusted interest rate): $712 Monthly payment to interest (divide by 12): $59.38 Also, keep in mind, some lenders provide discounts which will lower your adjusted interest rate. For example, Gorman explains, "Bank of America offers an interest rate discount for setting up automatic monthly payment deductions from a Bank of America checking or savings account before account opening, and for making an initial withdrawal at account opening."
"To qualify for a HELOC, homeowners need to have equity available in their home, meaning that the amount they owe on their home must be less than the value of the home. Owners can typically borrow up to 85% of the value of their home, minus the amount they owe," says Gorman. He adds, "Also, a lender generally looks at a borrower’s credit score and history, employment history, monthly income, and monthly debts, just as when they first got their mortgage. The more equity homeowners have, the more options will be available to them."
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 of 680 and below)
- 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 (looks at the remaining balance on your mortgage, home equity line amount, and other liens on the property in relation to your property's value)
- A qualifying debt-to-income ratio (typically less than 43%)
- Other factors: Good performance in prior mortgages, owner-occupant property, sufficient income, an acceptable length of employment, and a lack of significant expenses
Be sure to check the specific requirements of the lenders you are seriously considering.
How to compare HELOC companies
It's always a good idea to shop around before making a purchase. 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.
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 of 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. Being so, it is unlikely you will end up with the same one. So, what can you do? 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 shortlist of the best HELOC products and then apply with each of them to find the best rate available to you.
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.
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 (i.e., for credit lines of $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 for deciding you want a different repayment option. Gorman says, "Homeowners should talk with a loan professional to get more specifics as well as to compare fees and other costs associated with getting a line of credit. Some lenders charge these and others don’t."
Access to 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
Gorman says, "For convenience, most financial institutions give checks that can be used to pay directly from a HELOC for services used (for example, a contractor) and purchases made (for 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." Depending on your preferences, one lender may better suit your needs.
Companies use their own criteria to approve applicants. Just because you don't get approved with one, doesn't necessarily mean you won't get approved for 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 (i.e., 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.
Credit line amount
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. Also, some also have minimum credit line requirements that may be a factor in your decision.
We all want to be treated well when giving a lender our business, so customer service matters. Check reviews on 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.
Application and Loan Initiation Processes
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 then start your research. To help efficiently expedite the process, start by visiting our HELOCs review page to compare all the top lenders side-by-side. Once you're there, use the factors above as a guide when vetting lenders. After you've shortlisted the best options, the next step is to apply, compare the offers, and choose the best fit.