A home equity line of credit, also called a HELOC, uses a certain percentage of your home equity to provide you with a revolving line of credit for large expenses. Maybe you need a new roof on your house or want to add an in-law suite. A HELOC can help.
Instead of a set dollar amount, a HELOC lets you borrow up to a certain amount, typically 75%–85% of your home’s value.
You can take a HELOC out on a home that has a mortgage or is fully paid off. A HELOC usually has a lower interest rate than other types of loans, such as home equity loans, and the interest may be tax deductible.
How Does a HELOC Work?
A HELOC works like a credit card, in that you are allowed to borrow up to a certain amount for the life of the loan, carry a balance from one month to the next and make minimum payments.
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.
Other characteristics include a “draw period,” typically 5–10 years. During this time, your monthly payments will be only for the interest on the loan.
After the draw period, many HELOCs have a repayment period of 10–20 years when you’ll make regular payments of principal and interest until the loan is paid off. With other HELOCs, the entire balance becomes due when the draw period ends, and you would need to pay the amount still owed as a lump sum.
And unlike home equity loans, HELOCs have variable interest rates, meaning your rate could fluctuate based on the Fed’s Prime benchmark interest rate. Lenders will typically charge the amount of the index plus a “margin,” say 2 percentage points or “Prime plus 2%.” If the index rises, so will your rate, although most HELOCs set a ceiling (or cap) on how high rates can go in certain time frames or over the life of the loan.
Here’s how your payment could change: If the current Prime rate is 4%, a HELOC with a rate of Prime plus 2% would have a total APR of 6%. So, if you borrowed $10,000 at 6%, you’d be paying $50/month in interest. However, if the Prime rate went up to 10%, your interest rate would rise to 12%, and your interest payments would be $100/month.
How much you can borrow on a HELOC depends on the value of your home, how much you owe, your credit history and other factors. There are online calculators, such as this one from The Motley Fool, to help you estimate how much you may be able to borrow.
Wise (and Unwise) Uses for HELOCs
The federal 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.
While it may be tempting to use the HELOC for a new car or vacation, those purchases won’t help you build wealth and could, in fact, hurt you in the long run. Failure to repay the HELOC according to the loan terms will damage your credit score and could result in you losing your home through foreclosure.
Also, your bank may decide to freeze your HELOC if your home value drops dramatically or the bank reasonably believes you won’t be able to repay the loan. A frozen HELOC doesn’t mean foreclosure, but it does cut off the line of credit.
An even bigger drawback is that if your home value falls, you could end up owing more than your home is worth. This situation, known as being “underwater,” means you won’t be able to refinance your mortgage, and it could be difficult to sell your home.
There are a few alternatives to HELOCs to consider, based on your financial goals.
Home equity loans are similar to HELOCs, but you get a lump sum instead of a line of credit and most of these loans have a fixed interest rate. The interest rate may be slightly higher at the start, but it will not rise, providing payment stability.
A cash-out refinance allows you to take cash out of your primary mortgage while leaving some equity in the home. The exact amount you can take out depends on the type of loan. With a conventional loan, you need to leave 20% equity in your home. FHA loans also allow you to take cash out with 20% equity, but you’ll have to pay mortgage insurance premiums. If you’re 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.
If you need only a small amount or don’t want to tap into your home equity, a personal loan or low-interest credit card, perhaps one with a low-interest introductory period, could be better options.
Would You Qualify for a HELOC?
To qualify for a HELOC, you’ll need to have enough equity in your home, at least 15%–20% of its value, which is determined by an appraisal.
You’ll also need a credit score of 620 or higher, a debt-to-income ratio in the low 40s or less and a strong history of paying your bills on time.
Pros and Cons of HELOCs
There are advantages and drawbacks to getting a HELOC. Here are a few to keep in mind:
- Interest rates tend to be low, and you are charged interest only if you withdraw the money.
- Some HELOCs may not have any closing costs.
- HELOCs are similar to an adjustable rate mortgage, so your rate can go up or down as the market changes (so that low introductory may quickly change).
- Fluctuating monthly payments due to interest rate adjustments can make it difficult to budget and plan.
- Costs can add up. Some HELOCs have interest-only payments or prepayment fees.
- There tends to be a small fee for setting up the account and an annual fee for keeping it open.
- Like with a credit card, you could be tempted to spend beyond your means.
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.