How to Qualify for the Best Rate on a HELOC

Having a good credit score and minimal debt can help you secure a low interest rate.

US home values are still at historically high levels despite a slight drop-off in home price growth. Although home price gains slowed slightly in May, prices were still nearly 20% higher than during the same period last year, remaining at record-breaking highs. Many homeowners now have more equity in their properties than ever before, making it possible for them to take money out of their homes to fund big-ticket items like home improvements, college tuition and investing.

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. It can be a cost-effective way to unlock the equity in your home if you need access to cash. 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

A HELOC enables you to borrow against the equity in your home by using your house as collateral to secure the loan. That's why HELOCs can be risky: It's possible to lose your home to the bank or lender if you default on your loan or can't pay it back for any reason. 

To be approved for a HELOC, lenders typically require you to have at least 15% to 20% equity in your home. With enough equity, you can open a line of credit and borrow against it. A HELOC gives you a set time period to withdraw funds – usually 10 years, and then a set repayment period, usually 20 years. During the 10-year draw period, you can withdraw funds as you see fit; you don't receive them in a lump sum the way you would with a home equity loan. That's one benefit of a HELOC -- you can receive your money in installments over time rather than all at once. 

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. 

What factors can impact 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

The more lenders you speak with, the greater your chances are of securing 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. Terms and fees vary between lenders; some lenders may have low rates but high fees, for example. Look at lenders' APRs in addition to interest rates to get an idea of the true rate you are paying with fees included.

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. 

"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.

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.