With inflation driving up the cost of just about everything, flexible lending products such as home equity lines of credit, or HELOCs, are becoming more popular among homeowners.
A HELOC functions as a revolving line of credit that you can continually access during a draw period -- usually between five and 15 years. This could be a good option if you need access to money but aren’t sure how much you’ll need (or when you’ll need it). But it comes with some risks.
HELOCs may have lower interest rates than other types of home loans or personal loans, but they also tend to be variable.
“In an environment with changing rates, like we are currently experiencing, HELOC loan payments fluctuate,” says Rob Cook, vice president of marketing, digital and analytics for Discover Home Loans.
Borrowing with a HELOC also requires you to put your home up as collateral. If you can no longer afford your monthly payments because of rising interest rates, you could lose your home.
Here’s what you need to know about how HELOCs work, as well as how they compare to other borrowing options.
How does a HELOC work?
A HELOC is a revolving line of credit. During the draw period, you can take out money as many times as you need via check or a debit card, as long as it’s below your total loan amount. You must make minimum monthly payments, typically just for the interest that accrues during the draw period. As you repay your HELOC, this money is returned to your revolving balance (so you can continue to draw funds).
Once the draw period comes to an end, you enter the repayment period, which usually lasts between 10 to 20 years. At this point, you can’t take more money out of your HELOC. During the repayment period, your monthly payments will increase because you must start paying back the principal (the amount you withdrew) in addition to the accrued interest.
Because HELOCs are secured by a collateral -- your home -- they tend to have lower interest rates than unsecured forms of borrowing (like personal loans or credit cards). The downside is that you run the risk of losing your home if you default on payments.
You can typically borrow up to 85% of your home’s value, minus the amount you still owe on your mortgage. To determine how much equity you have in your home, subtract your remaining mortgage balance from the house’s current market value. So if your house is worth $500,000 and you have $300,000 left to pay off on your mortgage, you would have $200,000 in equity. If you borrowed 85% of your home’s equity, your loan amount would be $170,000.
HELOC requirements
Factors such as how much equity you have in your home, how much debt you’re carrying and your credit score all play a role in how likely you are to be approved for a HELOC, as well as determining your interest rate.
For example, most lenders prefer to see a credit score of at least 700, but it’s possible to be approved with a lower score depending on your financial situation. However, a lower credit score is likely to result in a higher interest rate for your HELOC.
Requirements
- At least 15% to 20% equity in your home: Home equity is the amount of home you own. Subtract what you owe on your mortgage and other loans from the current appraised value of your house to get that number.
- Minimum credit score of 620: Lenders use your credit score to determine the likelihood that you’ll repay the loan on time. Having a strong credit score -- at least 700 -- will help you qualify for a lower interest rate and more amenable loan terms.
- A debt-to-income ratio of 43% or less: Divide your total monthly debts by your gross monthly income to get your DTI. Like your credit score, your DTI helps lenders determine your capacity to make consistent payments toward your loan. Some lenders may prefer a DTI of 36% or less.
- Adequate, verifiable income: Proof of income is a standard requirement to qualify for a HELOC. Check your lender’s website to see what forms and paperwork you will need to submit along with your application.
How to pay back a HELOC
A HELOC is divided into two separate payment periods over the length of the loan: the draw period and the repayment period.
- Draw period: The first is the draw period, which is typically 10 years and the time when you can make repeated withdrawals as needed up to your credit limit. One of the benefits of a HELOC is that during the draw period you can make interest-only payments on the funds you withdraw and not the entire amount of the loan, which means you’re able to make minimal monthly payments while borrowing a large amount of money. Similarly, if you end up not needing all of the cash from your HELOC, you aren’t required to use it and can take out only what you need.
- Repayment period: When your draw period ends, you can’t withdraw more money from your HELOC, and you begin your repayment period. The repayment period typically lasts for 20 years. During this period, you’re required to begin paying back your principal loan balance in addition to the interest your loan has been accruing -- which means you’ll have a much larger monthly payment than when you were only paying down your interest. Be prepared for your HELOC payment to spike when the draw period comes to a close.
Pros and cons of a HELOC
Pros
Lower interest rates: HELOCs may have lower interest rates than other home equity loans, personal loans or credit cards.
Long draw and repayment periods: Most HELOCs let you withdraw money for as long as 10 years and then offer an even longer repayment period (usually up to 20 years).
You can take the money in installments: You don’t have to use all of the money available at once, and you only have to pay interest on the funds you withdraw.
Cons
You have to use your own home as collateral: If you default on a HELOC or can’t make your payments, you could lose your home. When you put a house up as collateral and cannot repay your loan, the bank or lender can foreclose on your home, which means they can take ownership of your house in order to make up for the money they lost.
They have variable interest rates: Your initial interest rate may be low, but HELOC rates are variable and not fixed. This means they can fluctuate depending on what’s happening with the economy and the benchmark interest rate. This means your monthly payments are not predictable and can fluctuate over the course of the loan. While there are fixed-rate HELOCs, they are less common and are considered a hybrid between a HELOC and a home equity loan.
There may be minimum withdrawal amounts: Some HELOCs have minimal initial withdrawal amounts, which could lead you to taking out more money than planned (and having to pay back more than planned).
HELOCs vs. home equity loans
HELOCs and home equity loans both allow you to borrow against the equity you’ve built up in a home. With both, you take out a second home loan in addition to your mortgage. Your home is also used as collateral to secure either type of loan. A home equity loan, however, offers a lump sum of cash that you pay back in fixed monthly installments. A HELOC, on the other hand, approves you for a set loan amount and then allows you to withdraw only what you need, when you need it.
A HELOC has a variable interest rate, whereas home equity loans are fixed-rate loans. This means, you’ll have a more predictable monthly payment with a home equity loan. HELOCs are much more flexible, but your monthly payments can be more unpredictable since your interest rate can fluctuate. With a HELOC, you need to make sure you can afford your monthly interest payments if your rate shoots up.
A HELOC is better if
- You need access to credit for an extended period of time (usually 10 years)
- You need more time to repay the loan amount
- You want the flexibility to withdraw your money in installments and not all at once
A home equity loan is better if
- You want a fixed interest rate
- You want a predictable monthly repayment schedule
- You want one lump sum of cash and know exactly how much money you need
HELOCs vs. cash-out refinances
A cash-out refinance is a different type of loan than a HELOC: You are quite literally cashing out the equity you’ve built in your home over the years. It replaces your current mortgage with a new mortgage equal to your home’s value and allows you to cash out the amount you’ve built in equity. If your home is valued at $300,000 and you still owe $100,000 on a mortgage, the difference of $200,000 is your home equity. Lenders often let you cash out 80% of your equity ($140,000 in this case).
With a HELOC, you’re also cashing out your equity, but you are taking out an additional loan alongside your current mortgage. So, you will have to make your monthly mortgage payments in addition to repaying your HELOC each month. With a cash-out refinance, you are only responsible for your mortgage payment every month. However, your mortgage payment will be more expensive because you added more money onto your mortgage when you cashed out your equity.
A cash-out refinance offers you this equity in a lump sum, whereas a HELOC lets you draw on your equity in installments via a line of credit.
A HELOC is better if
- You need access to credit for an extended period of time
- You need a longer loan repayment period
- You want to the flexibility to withdraw your money in installments
A cash-out refinance is better if
- You want to refinance your mortgage to a lower interest rate or a shorter term
- You want one lump sum of cash and you know the amount
- You want one fixed monthly mortgage payment
The bottom line
A HELOC allows you to access your home’s equity through a revolving line of credit. HELOCs are secured loans, meaning you use your home equity, or the difference between what your home is worth and what you owe on your mortgage, as collateral. There’s a limit to how much you can take out at once, but you will only pay interest on the money you’ve actually used. However, HELOCs typically have variable interest rates. This means your monthly payment is subject to change as rates move.
