How To Qualify For A HELOC: A Complete Guide
Need to pay for a major kitchen remodel, second bathroom or master bedroom addition? A home equity line of credit, better known as a HELOC, can help. You can use the funds from this loan product however you want. And you’ll pay far less in interest for a HELOC than you would by putting your repair or renovation bills on your credit card or paying for them with a personal loan.
Here are the facts on how to qualify for a HELOC, how these loans work and how they differ from other home equity loans.
What Is A Home Equity Line Of Credit (HELOC)?
A home equity line of credit (HELOC) acts a bit like a credit card, only your credit limit with a HELOC is based on the equity that you’ve built in your home.
Equity is the difference between what your home is worth and what you owe on your mortgage. If you owe $200,000 on your mortgage and your home is worth $350,000, you have $150,000 in equity. You’ll then be able to apply for a HELOC for a portion of this equity. If you have $150,000 in equity, you might qualify for a HELOC with a credit limit of $130,000.
You can then borrow up to that amount and use the money for whatever you like, from home renovations to paying off high-interest-rate credit card debt or covering a portion of your child’s college tuition.
The best use of the funds from a HELOC is for home improvements or renovations. If you spend your HELOC dollars on improvements that boost the value of your home, you can deduct from your income taxes the interest that you pay on your line of credit. You can also deduct the interest you pay on a HELOC if you use the funds to buy or build a home. If you use your HELOC for any other use, including paying off credit card debt, funding a vacation or covering your child’s college tuition, you can’t deduct the interest.
HELOCs come with two phases, the draw period and the repayment period. During the draw period, which usually lasts from 5 to 10 years, you can borrow against your HELOC’s credit limit. Say you have a HELOC with a credit limit of $100,000. One year, you might borrow $25,000 to build a primary bathroom. Two years later, you might borrow $30,000 to renovate your home’s kitchen.
During the draw period, you are only required to pay interest on what you’ve borrowed. In the above example, you’d pay interest on $55,000, the money you borrowed for your bathroom and kitchen projects. You can also pay back some or all of the money you’ve borrowed during the draw period, which would reduce what you owe when it’s over.
Once your HELOC enters its repayment period, you can no longer borrow against it. Instead, you must repay what you borrowed, with interest. It varies by lender, but you’ll often have 20 years to pay back what you’ve borrowed. If your credit limit was $100,000 and you borrowed $80,000, you’ll only pay back that $80,000 amount, plus interest, during your repayment period.
HELOC Vs. Home Equity Loan
It’s easy to get them confused, but a HELOC is not the same as a home equity loan.
The main difference between a HELOC and a home equity loan is how you get your money. With a home equity loan, you receive your funds in a single lump sum. You then pay this amount back with regular monthly payments with interest.
Say you have $80,000 in equity in your home. You might take out a home equity loan for $60,000. You’ll receive that $60,000 in one payment, and you can spend that money however you’d like. You’d then make regular monthly payments until that sum is paid back, usually over a period ranging from five to 30 years.
As with all mortgage products, you’ll need to meet certain requirements to qualify for a HELOC. Be aware that these requirements will vary by lender:
- Home equity: This varies by lender, but most require that you have at least 20% equity in your home to qualify for a HELOC. Your lender will order an appraisal of your home to determine how much your property is worth. Say your home is worth $400,000 and you owe $200,000 on your mortgage. That leaves you with $200,000 in equity. To turn that figure into a percentage, divide it into your home’s value: $200,000 divided by $400,000 equals 0.50. Multiply that amount by 100, which gives you 50% equity, more than enough to qualify for a HELOC.
- Credit score: Your three-digit FICO® credit score tells lenders how well you’ve paid your bills and managed your credit. FICO® Scores range from 300 to 850, and the higher your score the more likely you are to qualify for a HELOC at the lowest interest rates. Again, lenders vary, but credit bureau Experian® says that you’ll typically need a FICO® Score of at least 680 to qualify for a HELOC.
- Payment history: Lenders will look closely at your record of on-time payments when deciding whether to approve you for a home equity line of credit. If you have several missed or late payments in your past – these remain on your three credit reports for 7 years – you might struggle to convince a lender to approve you for a HELOC.
- Debt-to-income ratio (DTI): Your debt-to-income ratio measures how much of your gross monthly income your monthly debts consume. This varies, but most lenders prefer that your total monthly debts – including your current mortgage payment and your estimated HELOC payment – equal no more than 43% of your gross monthly income. Have a debt-to-income ratio higher than that, and you’ll typically be hit with higher interest rates.
How To Get A Home Equity Line Of Credit
To qualify for a HELOC, you’ll need a low debt-to-income ratio (DTI) as well as enough equity in your home. The loan amount you’ll be able to borrow with a HELOC depends on your home equity – specifically, how much you have. You’ll also need to provide your lender with other documentation, such as your credit score and proof of income.
Here are the steps to take if you are ready to apply for a HELOC.
1. Compare Lenders
Lenders do charge fees for originating HELOCs. It’s important then to reach out to several before choosing one to originate your loan. Ask lenders what fees they charge and what their average interest rates are on HELOCs. By shopping around, you can reduce the fees you pay and the interest rate you’ll pay. You might also conduct an online search to see if the lenders you are considering have any complaints filed about them. When you interview lenders, ask for referrals from past clients. Contact those clients and ask about the lenders’ customer service, whether they followed through on promises and whether they quickly answered their clients’ questions.
2. Provide Documentation
Your lender will verify your income to make sure that you can afford your new HELOC. This means that you’ll have to provide your lender with copies of such documents as your last two paycheck stubs, last 2 months of bank account statements, last 2 years of income-tax returns and last 2 years of W2 forms.
3. Get A Home Appraisal
To make sure that you’ve built enough equity in your home, your lender will order a home appraisal. During an appraisal, an appraiser will visit your home, touring both its outside and inside. The appraiser will also study recent sales of comparable homes in your neighborhood to help determine your home’s current market value. Your lender needs this figure to determine how much equity you have in your home.
4. Prepare For Closing
During the closing process, your lender will officially originate your loan. You’ll sign several papers during this process, including ones that outline your monthly payment and repayment schedule and stating your promise to repay your loan on time. If your lender is charging closing costs on your HELOC – such as an origination fee, document preparation fee and appraisal fee – you’ll pay them during closing. These costs will vary, but Experian® says that borrowers pay an average of 2% to 5% of their loan amount. For a HELOC of $80,000, that comes out to $1,600 to $4,000. Some lenders don’t charge closing costs, but you’ll often pay a higher interest rate for such loans.
5. Access HELOC Funds
Once your HELOC closes, you can start borrowing money from it at any time. Your lender might give you an account card that looks like a credit card that you can use to access your money. Ohers might give you checks that you write against the HELOC. You might also be able to log into your HELOC account online to withdraw funds electronically.
Questions about HELOCs? Here are answers to some of the most common.
Why should I get a HELOC?
A HELOC is a good choice if you want easy access to a source of funds that you can use to fund a variety of projects over time. Unlike other loan products, you won’t receive your funds in a single lump sum. This means that you only pay back, with interest, what you borrow. HELOCs, then, provide more flexibility than do other loan types.
Are HELOCs hard to qualify for?
HELOCs are no more difficult to qualify for than are other home loans. You’ll need a solid credit score – it varies by lender, but you’ll probably need a score of at least 680 – and an income high enough to convince lenders that you can pay back what you borrow. You’ll also need equity in your home. Again, this varies by lender, but most will require that you have at least 20% equity.
What are the alternatives to a HELOC?
With a personal loan, you’ll receive a single payment that you can spend on whatever you like. Personal loans differ from HELOCs and other loans because there is no collateral. If you don’t pay your home equity loan on time, your lender can initiate foreclosure proceedings against your home, the loan’s collateral. With a personal loan, lenders can’t take anything away if you don’t make your payments on time. Because personal loans are riskier, lenders generally charge higher interest rates for them.
In a cash-out refinance, you refinance your existing mortgage loan for more than what you owe on it. You then keep the extra cash, which you can use for whatever you’d like. You might owe $200,000 on your mortgage. If you take out a cash-out refinance for $250,000, you’d receive that extra $50,000 as a lump-sum payment.
A home equity loan is also based on your home’s equity. But you receive your funds in a single payment that you then pay back each month, with interest.
How does repayment work for a HELOC?
HELOCs come in two phases, the draw and repayment phases. During the draw phase, you only have to make payments on the interest on the money you’ve borrowed, as mentioned above. This phase usually lasts 5 to 10 years. During the repayment phase, you can no longer borrow against your HELOC. Instead, you pay back what you’ve borrowed, with interest, with regular monthly payments. If you’ve paid back some of your principal during the draw period, your amount due during the repayment period will be reduced.
The Bottom Line
A HELOC is an affordable way to borrow against the equity you’ve built in your home. These lines of credit are attractive because they come with lower interest rates than you’ll find with credit cards or personal loans. This makes borrowing money for home renovation projects or other uses less expensive. If you are ready to apply for a HELOC, get started today and explore your options for tapping into your home’s equity.