Home Equity Line Of Credit (HELOC): Defined And Explained

A house can be an important asset to have in your financial portfolio. However, because a house isn’t a bank account, its value can be hard to access when you need it the most.

Fortunately, you can capitalize on several options to convert your home’s value into cold, hard cash. One option is a home equity line of credit (HELOC), which allows you to borrow against the equity in your home.

Although Rocket Mortgage^Ⓡ doesn't offer HELOCs, we can explain how they work and compare them to other home equity options to help you decide whether a HELOC is right for you. Let’s go over everything you need to know.

A home equity line of credit is a type of second mortgage that lets homeowners borrow against their home equity as a line of credit. Borrowers can use HELOC funds for a variety of purposes, including home improvement projects, education and high-interest credit card debt consolidation.

Qualifying for a home equity line of credit is a lot like qualifying for a mortgage refinance. You must meet certain requirements to qualify for a HELOC.

HELOC requirements will vary from lender to lender, but you typically need:

• Good credit: A credit score above the mid-600s will likely get you approved for a line of credit. A credit score above 700 is considered ideal.
• Qualifying amount of equity in your home: You should have at least 15% – 20% equity in your home.
• Responsible payment history: Lenders may review your past payment history to check for late payments.
• A low debt-to-income ratio (DTI): The lower your debt-to-income ratio, the better. Ask your lender about their qualifying DTI ratio to learn what you need to qualify.
• Reliable income: Many lenders require proof of income to confirm your ability to make your loan payments.

Overall, HELOC requirements are similar to the requirements to refinance a mortgage. Review the requirements to get the best understanding of the options available to you.

A HELOC has two separate phases. They are known as the draw period and the repayment period. You’ll make payments on the HELOC during both periods.

Phase 1: The Draw Period

The first phase is the draw period. It’s when your line of credit is open and available for use. During this period, you can borrow from your line of credit as needed and make minimum or interest-only payments on the amount you borrow. If you reach your credit limit, you’ll need to repay some of your balance before you can borrow more money.

You may be able to refinance your HELOC to extend your draw period.

Phase 2: The Repayment Period

Once you reach the end of the draw period, you’re in the repayment period. You won’t be able to borrow from your HELOC and must begin making full monthly payments that cover the HELOC’s principal and interest. If you’ve been making interest-only payments to this point, be prepared for your monthly payments to go up – potentially by a lot.

The length of both periods will depend on the loan you get. For example, you may decide a 30-year HELOC with a 10-year draw period and a 20-year repayment period makes the most sense for you.

HELOCs can be beneficial financial tools. But they’re not ideal for every financial situation. Here are the most important disadvantages and advantages to be aware of before applying for a HELOC:

Pros Of A HELOC

• Consolidate debt: You can use a HELOC to consolidate debt at a lower interest rate.
• Flexible use: HELOCs are flexible and can be used for anything that requires cash, including medical bills, college tuition and other expenses.
• Continue to borrow against available credit: As you repay the balance during the draw period, you can continuously withdraw from your line of credit. Withdrawing funds on demand is helpful if you aren’t sure how much money you’ll need to spend on a project or investment upfront.
• Tax-deductible interest: The interest you pay on a HELOC or other home equity loan may be tax-deductible if you use the funds for home improvements.

Cons Of A HELOC

• Upfront costs: Before receiving a HELOC, you may pay an annual fee for the account or an origination fee to cover the cost of setting up the HELOC, a home appraisal, a title search and an attorney. Depending on your lender, the upfront costs may not be worthwhile if you don’t need to borrow a significant amount of money.
• Risk of losing your home: Anytime you take on debt, especially debt tied to your home, there are risks. If you can’t make payments on your HELOC, you may lose your home because it serves as collateral.
• Rates and payments may increase: You must also watch out for potential rate or payment increases based on market fluctuations. Your monthly payments will go up if your rate goes up or when your draw period ends. You must be financially ready for the change in payment.
• Not always a practical option: It’s recommended to only use a HELOC for undertakings that will help you financially, such as boosting the value of your home or paying for higher education. 

Use the following formula to determine your maximum available equity and your HELOC credit. To calculate your estimated line of credit for a HELOC, you will want to use the following calculation:

1. Multiply: (Your home’s value) ✕ (your lender’s loan to value percentage (LTV)) = maximum amount of borrowable equity.
2. Subtract: (Maximum amount of borrowable equity) − (what you currently owe on your mortgage) = your HELOC credit limit.

Home Equity Line Of Credit Example

Going off our earlier example, let’s say you find a lender who’s willing to give you a HELOC with 80% LTV. Your home is worth $250,000 and you currently owe $180,000. To figure out how much your credit limit would be on this HELOC, multiply your home’s value by 80% and subtract your current balance.

1. 250,000 ✕ 80% = 200,000
2. 200,000 − 180,000 = 20,000

In this scenario, you could potentially get a credit limit of up to $20,000.

The interest rate you’re charged on debt typically depends on your financial situation and how the economy is doing. But, in general, HELOC interest rates are slightly higher than mortgage loan rates. However, they are usually lower than personal loan or credit card rates.

Do HELOCs Have Fixed Or Variable Interest Rates?

Most HELOCs have variable rates, so your interest rate will change with fluctuations in the market. It’s possible to get a HELOC with a fixed rate, but it’s important to know that fixed-rate HELOCs typically restrict how many times you can withdraw money and the maximum amount you can withdraw each time.

How Can You Get The Best Rate For A HELOC?

Before applying for a HELOC, shop around and compare lenders to help you get the best deal. If you can’t find a lender that offers an attractive rate, it may be a sign that you need to improve your credit before shopping around.

If you're considering a cash-out refinance instead of a HELOC, familiarize yourself with current refinance rates.

HELOCs are a flexible way to leverage the equity in your home. There are no restrictions on how you use the funds. Let’s get more in-depth about some common ways to use a HELOC.

1. Make Home Improvements Or Repairs

If you need money to improve your home and increase its value, it can make sense to tap into your home’s existing equity using a HELOC.

Some improvements are more valuable than others. A full kitchen remodel will likely give you a dollar-for-dollar return on your investment, but less extensive improvements can add value to a home. Finishing your basement or updating your home’s interior with a fresh coat of paint can also boost your home’s value.

2. Consolidate Debt

If you have a lot of high-interest debt, such as credit card debt, a HELOC can help you consolidate all that debt into a single, lower-interest loan that can potentially save you hundreds of dollars in interest.

When you use a HELOC to consolidate credit card debt, you’re trading unsecured debt for debt secured by your home. You can lose your home if you default on the HELOC.

3. Pay Off Medical Bills

Medical bills can easily cost thousands of dollars for even the most basic procedures and care. With a HELOC, you may be able to pay off your medical bills and make repayments on your line of credit at a lower interest rate, saving you money in the long run.

4. Pay For Higher Education

Some homeowners use home equity to pay for their own or their children's college education. While this can make sense in some situations, you should explore all your options.

If you or your child qualify for federal student loans, you may get a lower interest rate than a HELOC’s rate. And federal student loan protections and flexible payment plans may make federal loans more advantageous.

If you aren’t interested in opening a home equity line of credit, there are other ways to tap into your home’s equity. A cash-out refinance and home equity loan are two available options.

Cash-Out Refinance Vs. HELOC

A cash-out refinance allows you to refinance your current mortgage loan, meaning you replace your existing mortgage. A cash-out refinance replaces your existing mortgage with a new one for a higher amount so you can pocket the difference.

A cash-out refinance may be a better choice than a HELOC if you only want one loan on your property and one mortgage payment to make each month. And cash-out refinances typically have more attractive rates.

Home Equity Loan Vs. HELOC

Home equity loans and HELOCs are similar because they’re both secured by your home equity. With a home equity loan, you borrow a lump sum and pay it back at a fixed interest rate. Like a HELOC, a home equity loan uses your home as collateral. Unlike HELOCs, you can’t add additional funds to a home equity loan, so you must know how much money you need upfront.

We’ve gathered a few commonly asked questions about HELOCs.

How does home equity work?

Home equity is your home’s value minus what you owe your lender. Each time you make a payment on your mortgage, you add to the amount of your home that you own.

Can I pay off a HELOC early?

Yes, you can pay off a HELOC early. HELOCs typically don’t have prepayment penalties.

The best time to pay off the principal is during the draw period when you only pay back interest. Paying extra toward your principal during this time can help you avoid paying more during the repayment period.

How long does the closing process take for a HELOC?

It typically takes less time to close on a HELOC than a traditional mortgage. In most cases, you should expect to close within 45 days of submitting your application.

What’s the difference between a HELOC and a home improvement loan?

The biggest difference between a HELOC and a home improvement loan is that a HELOC borrows against the existing equity in your home, while a home improvement loan doesn’t. Because of this, home improvement loans have lower borrowing limits. And they may have higher interest rates than HELOCs.

If you need a large sum of cash on a revolving basis to fund your home improvements, a HELOC may be a good choice. A home equity loan may be a better option if you know exactly how much money you need for a project and prefer a fixed monthly payment plan.

Talk to a Rocket Mortgage Home Loan Expert to learn more about tapping into your home’s equity. They can help you navigate home equity and refinancing options. Start a refinance application online today to learn more.