If you’re planning to make a major home improvement or looking for a smart way to cover a large expense or purchase, you have several options for borrowing money, such as a personal loan or a home equity line of credit (HELOC). Personal loans have grown in popularity because of their simplicity and ability to get an unsecured loan with fixed monthly payments in as little as a few days. But borrowers who own their homes may have another option – a HELOC, or a Home Equity Line of Credit – which could potentially get them a lower rate.
As home values rise, more and more people are looking at the HELOC as a potential option for accessing credit. An estimated 10 million consumers will take out HELOCs between 2018 and 2022, more than double the rate seen in the previous five-year period.
Before you consider taking out a HELOC, it’s a good idea to familiarize yourself with the basics of how they work to see if it might be the right option for you.
What is a HELOC?
A HELOC is a form of revolving credit, where the lender establishes your credit limit and you can then borrow up to your credit limit. During what is often called the “draw period”, you can continue borrowing as long as you’re within your limit, which is outlined in the terms of your HELOC. If you have a credit card, you’re already familiar with the general concept: Credit cards are a widely used form of revolving debt; however, unlike a HELOC, your ability to borrower does not terminate after a certain time period.
With a HELOC, it’s critical to understand that in exchange for the lower rate, your home acts as collateral for the loan. If you are unable to pay back the principal and interest on the HELOC, the lender has the right to pursue foreclosure proceedings—which means you could lose your home.
Once your loan has closed, the lender will typically give you special checks or a specific debit or credit card. Many lenders have withdrawal requirements, such as a minimum withdrawal amount or an initial withdrawal maximum.
How much can you borrow?
One of the ways your credit limit is typically established is by taking a percentage of your home’s appraised value then subtracting the balance owed on an existing mortgage. Lenders also consider your ability to repay the loan by looking at your credit history, income, and other debts and financial obligations, which typically means you need a debt-to-income ratio of 50% or better and a FICO score above 660.
For example, let’s say your home is worth $300,000 and you have a balance of $100,000 on your current mortgage. A lender typically allows you to access a maximum of 80% of the home’s value, less your current mortgage balance. Using that model, here’s an example of how much you could potentially borrow with a HELOC based on these values:
|Appraised value of home||$300,000|
|80% of home value||$240,000|
|Minus balance owed on mortgage||$100,000|
|Maximum HELOC amount||$140,000|
Paying Back Your HELOC
As mentioned above, HELOCs have what’s typically called a “draw period”, which is a specific amount of time during which you can withdraw money up to your credit limit. The draw period is usually between five and ten years. Depending on the terms of the HELOC, there are usually two repayment options during the draw period:
Pay only interest on the balance that you have borrowed. You can borrow funds up to the established limit.
Pay back the amount you borrowed (principal) as well as interest owed. As you pay off the principal, you can access more credit, just like with a credit card. Returning to our example above with a $140,000 credit limit: If you withdraw $10,000, your available credit is now $130,000. If you pay $5,000 toward the principal during the draw period, you would now have $135,000 in available credit. Note that you would be responsible for monthly payments of the accrued interest on the $10,000 that you withdrew according to the terms of the HELOC.
After the draw period ends, you can no longer withdraw money and you enter the repayment period, which is typically 10-20 years. During the repayment period, you begin paying back both the amount you borrowed and interest. If you were making interest-only payments during the draw period, your monthly payment during the repayment phase is likely to be significantly larger. Some HELOCs may offer the ability to have a fixed monthly payment during the repayment period. Under these programs, you may be required to make a sizable “balloon” payment at the end of the repayment period if the fixed monthly payment is not sufficient to repay the entire outstanding principal and interest.
What are typical uses for a HELOC?
Home renovations are the #1 reason homeowners take out HELOCs. You can use the funds to build your dream kitchen, remodel a bathroom or make outdoor renovations. Personal loans are also a popular option for home improvement, but with a HELOC, you typically get a lower interest rate because the loan is secured by a valuable asset: your home.
While home improvements are a top reason for taking out a HELOC, you can actually use the funds for anything you want, such as paying down other debts, making a large purchase like a car or appliance, or reinvesting the money yourself.
However, borrowers should be aware of a relatively new law that states that the interest you pay on a HELOC is only tax deductible if you use the funds to pay for a home improvement expense. Please consult a tax advisor if you have any questions about the potential tax deductibility of your HELOC.
How much does a HELOC cost?
As with nearly all loans, you’ll pay interest on any amount you borrow. Because your home is “securing” the loan, interest rates for HELOCs are often lower than for unsecured loans. HELOCs generally have variable interest rates, which means they can go up or down over time according to a benchmark rate. Some loans also come with an interest rate cap (maximum) and floor (minimum), or a “hybrid” option which allows you to lock in a fixed interest rate for a certain period of time.
You’ll also likely have to pay other fees to take out a HELOC, so be sure to check with your lender. The Consumer Financial Protection Bureau has a helpful worksheet that can help you examine and compare the costs of a HELOC.
Depending on your financial situation, a HELOC could be a great option to meet your needs. As with all financial products, be sure that you understand all terms and conditions before taking out a HELOC.