US home values are still high despite dipping home prices. At the end of 2022, 94.1% of homeowners paying off mortgages had built up some equity in their homes. As a result, many homeowners may consider tapping into their home’s equity to help finance home improvements, education and medical expenses.
That’s why now might be a good time to consider a home equity line of credit or HELOC. A HELOC lets you open a line of credit and use it over an extended period of time, typically a decade. With a HELOC, you can take money out of your home without disrupting the rate on your primary mortgage.
HELOCs can be a cost-effective way to get a cash infusion. To qualify for a HELOC, it’s important to make sure the fundamentals of your financial life are sound. For starters, you need solid credit and a low debt-to-income ratio.
Read on to learn more about HELOCs and how you can possibly secure the lowest rate and most favorable lender terms.
What you need to know about HELOCs
When you borrow with a HELOC, you use the difference between what your home is worth and what you owe on your mortgage as collateral. That’s why HELOCs can be risky: If you default on payments, you could lose your home.
HELOCs work similarly to credit cards. During the draw period, there’s a limit to how much you can take out at once, but you’ll only pay interest on what’s borrowed. HELOCs typically have variable interest rates, which means when rates go up, so will your monthly payment. In contrast, home equity loans offer you a one-time lump sum of cash that you pay off over time, typically at a fixed rate.
Another benefit is that you can make interest-only payments on the money you withdraw rather than the total amount of the loan, which means you can make minimal monthly payments while having continued access to cash for years.
Lenders typically require you to have at least 15% to 20% equity in your home before approving you for a HELOC.
What factors can affect your rate?
Credit score
The better your credit score, the lower your interest rate is likely to be. To qualify for a HELOC, lenders usually want to see a credit score of 620, but you should expect to pay higher interest rates if your score is that low. Having good to excellent credit (typically 700 or higher) is the best way to secure a low rate.
In general, maintaining a high credit score is part of maintaining your overall financial health.
“Two thirds of your credit score really comes from two factors -- paying your bills on time and showing your ability to keep your debts modest and pay them down over time,” says Greg McBride, chief financial analyst at Bankrate.com, CNET’s sister site. “If you do those two things, that’s two thirds of the battle right there.”
Debt-to-income ratio
To appeal to lenders and banks, it’s critical to pay off high-interest consumer debt such as credit card debt. You can be denied for a HELOC if you have too much debt. Lenders use a formula called your debt-to-income ratio, or DTI, to determine whether they think your current debt load is manageable enough to take on an additional loan payment. Your DTI is determined by adding up all of your monthly bills and debts and dividing them by your gross monthly income.
Usually, lenders want to see a DTI no higher than 36%. If you have a high DTI, be prepared to be approved for a smaller loan or to be turned down outright.
Income and employment
You must show stable employment and income. Have your tax returns, W-2s and pay stubs handy to show that you have a consistent source of monthly income, and enough of it, to comfortably pay the HELOC -- which is essentially a second mortgage -- in addition to your current mortgage.
Tips for making the most of your HELOC
Interview multiple lenders
You don’t need to get your HELOC from the same lender through which you have your mortgage. Shopping around with different lenders can help you secure a lower interest rate. According to research from Freddie Mac, getting just one additional rate quote could save a homeowner an average of $1,500 over the lifetime of their loan. And if you get five additional rate quotes, you can save an average of as much as $3,000, the Freddie Mac survey revealed.
That’s why it’s crucial to take the time and effort to shop around and compare offers. Make sure to ask questions upfront to understand what rates and fees are associated with a HELOC. Look at lenders’ APRs in addition to interest rates to get an idea of the true rate you are paying with fees included. Terms and fees vary between lenders, so what you want is a true apples to apples comparison.
Ask your lender to fix your rate
There are a few other strategies you can employ to increase your chances of securing a lower interest rate and potentially a lower APR as well, which can save you tens of thousands of dollars over the lifetime of your equity loan. For example, in a rising interest rate environment such as the one we’re in now, it’s worth asking your lender if it’s possible to fix the interest rate on your remaining balance or refinance your HELOC into a home equity loan at a fixed rate.
You may prefer the certainty of having a fixed-rate and monthly payment in a turbulent rate market.
Ask your current HELOC lender if they will fix the interest rate on your outstanding balance,” says McBride. “Some lenders offer this, many do not. But it is worth asking the question. Nothing ventured, nothing gained.”
If fixing the interest rate is not an option, you can look into refinancing your HELOC into a fixed-rate home equity loan. “The rate may not be much different from what you’re currently paying on your HELOC, but it does provide certainty on your interest rate, monthly payment and payback period,” McBride says.
Keep in mind, however, that if you refinance a HELOC into a home equity loan, you will receive the money in a lump sum and you won’t be able to withdraw additional funds over time as you would with a HELOC. What’s more, you’ll likely pay additional lender fees to refinance the loan.
Borrow with a purpose
Avoid treating your HELOC like a credit card. It’s important to have a clear purpose -- such as home improvement that will add to your property’s value -- when taking out a HELOC. Other uses, like debt consolidation and education, are OK so long as you can comfortably afford your monthly payments.
Using your line of credit to fund one-time expenses, like a wedding or vacation, is not ideal. Explore other types of financing -- that are not secured by your home -- for such expenses.
The bottom line
A HELOC can be a cost-effective way to access cash by borrowing against the equity you’ve built up in your home. To get the best HELOC rates available, you must have an above-average to excellent credit score, a debt-to-income ratio of less than 36% and proof that you’ve had a steady, consistent source of income, such as from an employer. Being financially healthy by keeping your debt low and your credit score high, as well as interviewing multiple lenders in search of the best rate, will not only help make you an attractive candidate for loan approval by a bank or lender, but will help you secure the best rate and terms on a HELOC.
