You’ve lived in your home for a while now, and it could use some renovations. Or maybe your child just got accepted into that fancy Ivy League school they’ve always dreamed of attending. Or perhaps you’ve recently retired, and you’re ready to take that trip around the world that you’ve put off for so long.
No matter which situation best describes you, they all have one thing in common: They’re all going to cost a chunk of money. One way to put your hands on that cash is by tapping your home’s equity, and one way to do that is by applying for a home equity line of credit, or HELOC.
What Is A Home Equity Line Of Credit (HELOC)?
A HELOC is a line of available credit tied to your home’s equity. The expression “your home is a piggy bank” refers to this accumulation of equity. It’s the difference between how much your house is worth and the amount you still owe on your mortgage. Instead of using money advanced to you by a credit card company, you are taking cash from the value you’ve accumulated in your home.
How Does A HELOC Work?
HELOCS are relatively easy to apply for and have greatly reduced closing costs.
The Application Process
When you apply for a HELOC, your lender reviews your credit history and may order a new appraisal of your home, though generally they need only look at data regarding your property’s valuation and/or the real estate market in your area.
To qualify for a HELOC, you’ll need to have more than 20% equity in your home at its current appraisal value. You’ll also need a credit score of 620 or higher, a debt-to-income ratio in the low 40s or less and a good credit history.
If your application is approved, your lender will agree to authorize a line of credit that you can access.
The Draw Period
A HELOC works like a credit card. You can borrow up to 80% of your home’s value, for the life of the loan, carry a balance from one month to the next and make minimum payments during the draw period, which typically lasts 5 – 10 years. During that time, you can use as much or as little of the amount for which you were approved. For any amount borrowed during the draw period, your monthly payments will pay only the interest on the amount you’ve actually used.
The Repayment Period
After the draw period expires, most HELOCs have a repayment period between 10 – 20 years. During that period, you’ll make regular monthly payments of principal and interest until the loan is paid off. These are made in addition to your regular mortgage payment, which is unaffected by the HELOC. There are HELOCs, however, that stipulate that the entire balance becomes due when the draw period ends. That means you would be required to make a lump sum, or balloon, payment. If you’re considering a HELOC, make sure you understand what your repayment terms are before entering into one.
HELOC Vs. Home Equity Loan Vs. Refinance
When you have equity, you have options. Here are two possibilities in addition to HELOCs.
Home Equity Loan
Technically, a HELOC is a type of home equity loan. But when you're talking to lenders, the terms are used for different types of loans. Home equity loans are what we typically think of as a second mortgage. You borrow a lump sum, perhaps for a home addition, and then pay it back in regular monthly payments. With a HELOC, there is no upfront lump sum, and you can use it or not over a longer period of time.
Cash Out Refinance
Another alternative to HELOCs is a cash-out refinance. With this option, you apply for a whole new mortgage to replace the one you currently have. You’ll leave at least 20% (more if you like) of your equity in the new mortgage, and get a check for whatever equity you have in excess of that amount.
After that, you’ll begin making payments on your new mortgage. And you may be pleasantly surprised. Cash-out refinances can be more expensive than HELOCs, because you must pay all of the traditional closing costs upfront or roll them into your mortgage. But particularly if you’re looking to access a large sum of money, those closing costs, as a percentage of the loan amount, go down dramatically, particularly if your first mortgage charged you a higher interest rate than your new mortgage. You can also shorten or lengthen your loan term so that your monthly payments are manageable.
Rocket Mortgage® does not offer HELOCs. However, we do offer cash-out refinances, which can be a good option for those looking to use their home’s equity to their advantage and get the cash they need.
How Are HELOC Interest Rates Calculated?
Unlike home equity loans, HELOCs have variable interest rates, meaning your rate could fluctuate based on the Federal Reserve Board’s prime rate, a common interest benchmark. The prime rate is the very best interest rate available on short-term loans to the very best credit risks, like governments and large corporations. Consumer loans are priced at a premium, or mark-up, to the prime rate.
HELOCs are secured by your home, like your primary mortgage, with one important difference. HELOCs are second in line, after the first mortgage, to recover the proceeds from the sale of your home if you default. However, there aren’t usually sufficient proceeds from the sale of a home to cover both mortgages and pay for foreclosure expenses, so it’s unlikely that the second mortgage holder will recoup much of its losses. Therefore, interest rates on HELOCs are not as low as they are on primary mortgages, though they are still lower than personal loans or credit card debt.
There are HELOCs that are first in line in case of default. These are known as first-lien HELOCs, and are for homeowners who do not have a mortgage and need to borrow.
As with all things in life, there are both good and bad features to consider when evaluating the best way to finance your next major expenditure. Here are some things to think about.
Lower Interest Rates Than Personal Loans or Credit Cards
As we discussed earlier, HELOC interest rates tend to be lower than other forms of consumer credit. HELOCs are also secured by your home, but they are second in line after the primary mortgage. Because of the risk that there won’t be enough money to satisfy your HELOC after your primary mortgage holder sells the house and applies the proceeds to your mortgage balance, HELOCs charge higher interest rates than primary mortgages but less than unsecured consumer debt.
You Only Pay For What You Use
You are charged interest only if you withdraw the money. If your plans are uncertain, this may save you money.
No Closing Costs
HELOCs often have no or low closing costs. This makes them an attractive alternative for smaller loan amounts. closing costs as a percentage of the loan make a cash-out refinance relatively much more expensive.
HELOCs Charge Variable Rates
HELOCs charge variable interest rates, so your rate, and therefore your monthly payment, could go up or down. That can make it difficult to budget and plan.
There Can Be Hidden Charges
Be careful about other costs that a HELOC might charge because they can add up. You can be charged for setting up and maintaining the account. Some HELOCs charge prepayment fees. Make sure you understand all the potential charges you might encounter.
You Could Lose Your Home If You Default
HELOCs are secured with your home. That means that if you default on your HELOC, you could lose your home, even if you have kept up with your first mortgage.
It can be hard to keep all these choices straight, let alone evaluate other issues that can arise. Here are some common questions and answers we've encountered.
How Do Credit Reporting Agencies Treat HELOCs?
Although a HELOC gives you ongoing access to your home’s equity, credit bureaus don’t necessarily treat it the same as your credit card accounts when it comes to your credit score.
Some bureaus treat HELOCs like installment loans rather than revolving lines of credit, so borrowing 100% of your HELOC limit may not have the same detrimental effect as hitting your credit card limit. But like any line of credit, a new HELOC on your report could temporarily reduce your credit score.
Can I Deduct My HELOC Interest Payments From My Taxes?
The 2019 Tax Cuts and Jobs Act eliminates the interest deduction for equity loans unless the money is spent on improvements that raise property value, such as renovating existing rooms or adding usable space. For any non-home improvement-related use, taxes are no longer deductible.
How Does A HELOC Work If You Have An FHA Loan?
HELOCs are available on FHA mortgages, although you may have even better options. If you want the money to make a home improvement, you may want to consider an FHA 203(k) refinance, which will allow you to borrow up to 80% of the value of your home after improvement, based on comparable real estate sales in your area.
One drawback to FHA loans is the cost of mortgage insurance premiums, or MIPs, beyond the 20% equity mark when most lenders allow you to drop private mortgage insurance, or PMI, the private loan sector’s version of MIPs. If you have more than 20% equity in your home, a cash-out refinance with a conventional mortgage might be a better option, because then you could stop paying MIPs.
With a conventional cash-out refinance, you could take advantage of Fannie Mae HomeStyle Loan. A Fannie Mae loan is less restrictive than the FHA 203(k) loan, requires a higher credit score, and also allows you to use the loan to improve vacation homes or investment properties. With a Fannie Mae loan, you can also include luxury improvements to your properties.
Can I Get A HELOC On My VA Loan?
If your loan is through the Veteran’s Administration, and you are an eligible active-duty service member, veteran or surviving spouse, you can take out a loan for up to 100% of the appraised value of your property, and as with FHA 203(k) loans, the appraised value used is the anticipated increased value, after improvements.
Interested In A HELOC?
Quicken Loans does not offer HELOCs. However, a Home Loan Expert can talk to you about your financial goals and help you make a decision that’s right for you.
If the interest-only period of your HELOC is expiring soon, you might want to consider refinancing to get out of your HELOC. You can roll your HELOC into your new mortgage and make one low monthly payment, which could save you from fluctuating amounts or large jumps in your monthly payment.
Everyone’s financial situation is different, so be sure to consider all of the pros and cons and speak to a professional before deciding what’s right for you.