If you have a large expense that you must pay for immediately, then a Home Equity Line of Credit (HELOC) may be the ideal solution. These versatile loans can be used to pay for medical or educational expenses, debt consolidation, home renovations or any other expense that you may encounter. They can be issued quickly and usually have very flexible terms. Read on to find out how these loans work and how they can benefit you.
If you need a large sum of cash now, you have a few options available to you. You can apply for a personal loan or a payday loan, borrow from your employer-sponsored retirement plan, or get a loan from a friend or relative.
But if you own a home, you may have an even better alternative. Your home is probably your largest single investment, and a home equity line of credit (HELOC) is an easy way to tap into the equity that you’ve built up in it.
This method is much easier than a cash-out refinance, and the interest that HELOCs charge is tax-deductible if you qualify to itemize your deductions. You may also be able to opt for either a fixed or variable interest rate. You just need to have a minimum credit score of 620 and a total combined mortgage balance of less than 85% of your home equity.
What’s more, the closing costs that mortgage lenders charge for HELOCs are reasonable. You might have to pay for some annual fees and expenses, but this type of loan is generally a bit cheaper than a first mortgage. And the interest rate that is charged will almost certainly be lower (in many cases much lower) than that of a credit card.
A home equity line of credit is a line of credit that uses the equity you have built up in your home as collateral. For example, if you buy a house for $350,000 with a first lien of $300,000 and you have paid off $175,000 of this amount, then you may be eligible to take out a home equity line of credit for $125,000 or more (300,000 – 175,000 = 125,000).
Home equity lines of credit are essentially lines of revolving credit that work in the same manner as a credit card or department store charge card. As you pay down the balance, the lender replenishes the line of credit back up to its maximum dollar limit.
HELOCs stand in contrast to home equity loans, which are not replenished as they are repaid. Home equity loans also usually charge a fixed interest rate, which may be higher than that of a HELOC.
Furthermore, any untapped money that you have in a HELOC doesn’t charge you any interest. If your line of credit is for $100,000 and you take out a loan amount of $30,000, then you will not pay interest on the remaining $70,000. This is true not only for all member FDIC lenders, but all other types of lender as well.
An example of HELOC interest payments
For example, say you have a home equity line of credit for $100,000, and then you use that entire amount to add a new room onto your home. Then, over the next 30 months, you pay $1,000 a month to the loan and thus reduce the balance by $30,000. You will then have an available line of credit for $30,000.
As you pay your outstanding balance, your available amount of credit will continue to grow. You can also put the unused balance of your HELOC in your savings account so that you can earn some interest on it until you need to use it.
HELOCs can be attractive options for homeowners because the rate of interest that this type of loan charges is usually less than for other types of debt that could be incurred instead.
In many cases, HELOCs usually charge a variable rate of interest, but most homeowners will still come out ahead in the long run from using this line of credit than they would from using a credit card or taking out a personal loan. And the interest that you pay may be tax-deductible if you are still able to itemize your deductions.
You can use the money you get from a HELOC for any purpose you choose, from home improvements to debt repayment to buying a new car or paying for educational expenses. You can set up your monthly payments on autopay in most cases.
Just make sure that you’ll be able to make the payments on the loan without any problems going forward. And if your HELOC charges a variable rate of interest, make sure that you’ll be able to make an even higher payment if interest rates rise.
In a nutshell, home equity is the amount of your home that is not mortgaged. For example, if you buy a house with an appraised value of $400,000, and have to take out a primary mortgage for $325,000, then you’ll have $75,000 of equity in your home to begin with.
Equity is the dollar amount of your home value that you have paid off. Every time you make a mortgage payment, you add a little bit to your home equity.
The value of your home in the real estate market can also affect the amount of equity that you have in your home.
Using the same example from above, if you buy your home for $400,000, and then the market value of your home rises to $450,000, you’ll have $125,000 of equity in your home ($75,000 plus the additional $50,000 that your home rose in value as a result of market fluctuation). Your equity is measured by taking the current value of your home and subtracting what you owe to your lender or lenders.
Over time, you will slowly build up the equity in your home. This equity can be an important source of funds when you need to get your hands on a large sum of money quickly. In most cases, you will qualify for this type of loan (HELOC) more quickly and easily than for any other type of loan.
You will also probably qualify for a larger loan balance than you would for an unsecured personal loan, depending upon the amount of equity that is available. So if your car breaks down and your mechanic tells you it’s not worth fixing, then a HELOC could be your ticket to a nicer, newer mode of transportation.
What’s more, the interest on this debt will most likely be lower than you would get with a car loan. But be sure to only spend the equity in your home on essential items such as credit card debt or medical bills. It should not be used for nonessentials like vacations or to buy frivolous items such as clothes. When it’s used correctly, a HELOC can be a lifesaving tool, for example, if you have lost your job and need a quick source of cash until you can find other employment.
How much could my HELOC be based on my current home equity?
Although they can be very flexible in many respects, HELOC lenders will not allow you to borrow the entire remaining amount of equity in your home, even if you sign up for automatic payments.
Most lenders will look at both your credit score and the combined loan-to-value ratio (LTV) of both your current mortgage and the proposed new loan before they will approve you. In most cases, you can only borrow up to 85% of the total market value of your home between your primary mortgage and your HELOC. This rule applies even if you have excellent credit.
For example, if your home is worth $400,000 and you have a first mortgage of $220,000, then the amount that you can get from a HELOC is calculated like this…
- You have to multiply your home’s value by 85%. In this case, $400,000 x 0.85 (85%) which comes to $340,000.
- Next you have to subtract the amount of your first mortgage from this amount, which comes to $120,000 ($340,000 – $220,000).
So the maximum line of credit that you can qualify for is $120,000. Credit approval always boils down to this equation.
Although both HELOCs and home equity loans use the equity in your home as collateral, they are fundamentally different in nature in a few respects.
Lump sum vs. revolving credit
First, with a home equity loan, you get the entire loan balance up front regardless of whether you use all of the money you get or not. You receive it in a lump sum.
If you are only going to need to tap into your home’s equity once, such as to complete a specific project, then a home equity loan may be the better option. You can simply take out a loan for the amount you need, get it up front upon approval, and then start paying it back down.
If you think that you might need to tap into your home equity more than once, then a HELOC may make more sense. Talk with your financial advisor or mortgage broker about this before you proceed with either loan option so that you know which choice is best for you.
If you choose the latter option, then you can probably get your money in as little as a few business days. The credit approval process usually happens very quickly in these cases.
For example, if you buy a vacation home down by the lake in your state, and that home will need a number of major home improvement projects and renovations, you can use a HELOC to fund the ongoing expenses that you incur.
A one-time loan may not be sufficient to cover the costs of the entire project, because additional expenses may arise that you did not foresee, such as the need for treatment for insects or other pests or foundation repair. A HELOC line amount will most likely be a much more convenient source of funds than a home equity loan if you encounter unforeseen obstacles such as these.
Fixed rate vs. variable rate interest
While a home equity loan is a fixed-rate loan that gives you a set amount of money to use for a fixed term, a HELOC is simply a line of credit that has a certain dollar limit based on the amount of equity in your home.
A home loan will charge you interest on the entire loan balance regardless of whether you spend all the money you get immediately or not. A HELOC only charges interest on the actual outstanding loan balance, whatever that may be.
Furthermore, home equity loans almost always charge a fixed rate of interest, while most HELOC rates are variable. When interest rates are really low, you may come out ahead with a HELOC as opposed to a home equity loan, because a fixed rate of interest will almost always be at least slightly higher than a variable rate of interest.
With a home equity loan, each payment that you make is a combination of interest and principal, just like it is with your first mortgage. And most home equity loans will only charge you a fixed rate of interest that will last as long as the loan term. You will be charged interest throughout the life of the loan, right up through your final payment.
Home equity loans don’t have draw and repayment periods like HELOCs. They simply have a repayment period that begins immediately.
But HELOCs often only charge interest-only payments during the draw period and then add in the principal balance during the repayment period. This means that your payments can rise by a substantial margin once the repayment period begins. You can ask your lender what your payments will be once this period begins so that you can make additional room for it in your budget.
With a home equity loan, you are essentially taking out a second mortgage, which requires the same closing fees in most cases as your first mortgage did. Closing costs for a home equity loan are usually much higher than for a HELOC. This means that the fees for a home equity loan can easily run between two and five percent of the loan balance.
With a home equity loan, you may also be assessed a point or two along with the closing costs of the loan, just as you may have been with your primary mortgage. A point equals one percent of the total loan balance including closing costs.
If you pay points of any kind, then you will usually get a slightly lower rate of interest on your loan. You can think of points as a way to buy down the monthly cost of your loan. But points are rarely seen with HELOCs, although there may be broker or origination fees in some cases.
Since a HELOC is a type of revolving credit, you can run up the balance and pay it back down at your leisure (at least during the draw period). If you have a HELOC for $50,000, then you could borrow $25,000, pay off $15,000 of it and then draw out another $30,000 if you so choose. You just can’t go over the prescribed limit of the line of credit.
You will have a monthly payment for your HELOC just as with your primary mortgage, so be prepared to make two monthly payments once you’ve taken one out (your HELOC payment plus your primary mortgage payment). It’s also important to know a HELOC will put a second lien on your home. This increases the risk that your home could be foreclosed upon if you can’t make payments.
This is the major downside of a HELOC. If you become unable to make the payments on your loan, the collateral that you have used is your home itself. Defaulting on your HELOC could mean your home could be repossessed by the lender, just as it would if you couldn’t make your primary mortgage payments anymore.
The more you borrow against your home, the more risk you take with it. But if you are able to make your payments faithfully each month, then a HELOC can be a great source of funds to use for big-dollar expenses.
Homeowners can use a HELOC for many different purposes. There are no prescribed limits or prohibitions regarding how the money can be used. That said, there are some popular reasons for taking out a HELOC. Some of the most common include:
- Renovating or improving your home: This is one of the best ways that you can use a HELOC. If the renovations or improvements will add to the value of your home, then your equity will increase and thus raise the sale price of your home if you choose to sell it.
- Paying off debt: A HELOC can be a real lifesaver for those who are burdened with medical bills or high-interest debts such as credit card debt or car loans. You can pay off all of your debts using a HELOC and enjoy a lower rate of interest from then on. Just be sure that you don’t run your credit cards back up again after you pay them off.
- Higher education expenses: Paying for college tuition is often a very expensive proposition. A HELOC can come in handy if you still have expenses left over after student loans or other financial aid. But you should explore all of your other options first, because student loans may be cheaper and more manageable than a HELOC in some cases.
- Large purchases: If you want to take that dream vacation that you’ve always wanted, travel the country in an RV, or just buy a nice new car, then a HELOC can provide the funds you need. Just be sure that you’ll be able to make the payments on time every month so that you don’t end up in financial trouble.
- Avoiding PMI: HELOCs can also be used to avoid having to pay private mortgage insurance (PMI) on your home. This type of insurance is required if the equity in your home equals less than 20% of its value. So many home buyers will take out a primary mortgage for 80% of their home’s value and then do a HELOC or home equity loan for the remaining amount that they can’t cover in cash. They will still have to make two payments each month, but at least both payments are now being used to pay the home off instead of just paying for insurance that they cannot recoup.
Most home equity lines of credit have a life that is divided into two periods. The draw period is the length of time in which you can draw on your line of credit. The repayment period is when you have to pay back what you’ve drawn from your line of credit. Here’s how they both work in more detail.
The draw period
HELOCs come with two separate time periods. The draw period ends after about ten years in most cases, and this is the period of time in which you have the eligibility to draw on your line of equity.
During the 10-year draw period, you can generally draw from your line of credit as often as you need to, and you can also start repaying the amount you’ve taken out as soon as you like.
There are typically no limits on the number of times that you can draw from your HELOC during the draw period. The drawing period allows for free cash flow in both directions. And all of the payments that you make during the draw period may be applied mostly to your principal, provided you make more than the minimum payment. Most HELOCs only charge interest during the draw period, so any payment above and beyond that can go to principal.
In some cases, you can request that this period of time be extended, but this is done at the choice of your lender. Some lenders will extend this period while others will not. If they will not, then you will no longer be able to draw on your line of credit.
This can be an important item to check on when you shop for a HELOC, because a longer draw period may save you much financial inconvenience down the road.
For example, if you buy a second home in the scenario described previously, and at the end of ten years you realize that you’re going to have to replace the roof and redo one of the bathrooms, then an extension will allow you access to additional funds without having to apply for another loan or line of credit.
The repayment period
The repayment period comes after the draw period has elapsed. This period of time often lasts for 20 years, and you cannot draw on your line of credit once the repayment period begins.
It should also be noted that a HELOC which charges interest-only payments during the draw period can have its payments almost double once the repayment period starts. You need to know beforehand what your repayment period payments will be before they come due so that you can be prepared.
This can come as a nasty surprise to borrowers who were previously skating by making interest-only payments each month. Suddenly, their payments can almost double, and if they are not prepared for this, then they can ultimately lose their homes because they cannot afford to make the new higher payments. Then your financial situation will be worse than ever.
For example, if you take out a HELOC for $200,000 and draw out $160,000 to do renovations on your vacation home, then the interest-only payment at a rate of 7% would come to $940 per month during the draw period.
Once this period ends, though, you could see your payment jump to a whopping $1,440 per month at that interest rate. And this payment will increase if interest rates start to rise.
Just know that the amount of your monthly payment during the repayment period will depend largely upon the amount that you borrowed during the draw period. If you have reached the limit of what you can draw out with your HELOC, then your account will usually close automatically regardless of whether the draw period has elapsed or not. If you are below your limit at the end of the draw period, then you will only be charged interest on your current loan balance.
For example, if you get a HELOC for $50,000 and draw out that much halfway through the draw period, then your HELOC will automatically close until you start repaying that amount. If you only make the interest payments, then you cannot draw out any more money until you start repaying the principal.
There are even some HELOCs that charge interest-only payments during the draw period and then charge the entire remaining loan balance during the repayment period. Different lenders use different loan structures, so be sure that you understand the terms of repayment for any type of home loan you take out, whether it’s a home equity loan, a HELOC or even a first mortgage. A cash-out refinance can have a term for as long as 30 years in some cases, but some HELOCs require full repayment at the end of the draw period.
By contrast, home equity loans can have terms that range anywhere from five to 30 years. But there is no separate draw and repayment period with them; the very first payment that you make will pay off some interest as well as a bit of your principal, and your payments will remain constant over the life of the loan. Regardless of whether or how you used the money you received, you will have to make these payments each month.
Although they are generally cheaper than home equity loans, most HELOCs charge many of the same closing fees as a primary mortgage, including:
- Origination or broker fees: These are generally equal to one or two percent of the maximum line of credit allowed by the HELOC. They represent compensation to the mortgage broker or lender.
- Application fee:This is usually around $100. You can request that this fee be waived, but this will only happen at the discretion of the lender.
- Title search and appraisal fees: These fees can easily run you another $150 to $300. You will most likely need to have your house appraised again when you take out a HELOC because the lender will need to know the current market value of your home before extending credit. The title search is necessary in order to ensure that no other claims are being made against your property.
- Attorneys’ fees: These are fees that cover the cost of drawing up the loan documents.
- Lender’s fees: Your lender may charge you specific up-front or ongoing fees. For example, there may be a monthly or annual fee on top of the closing costs, or an additional fee for every time you draw on your HELOC. Be sure to read the fine print in your loan document before signing on the dotted line so that you aren’t surprised with these fees later on.
Eligibility for a HELOC is similar to meeting the requirements that you had to meet in order to get your primary mortgage. The specific requirements will of course vary somewhat from one lender to another, but there are certain equal housing lender boilerplate requirements that most borrowers have to meet in order to qualify for a HELOC or home equity loan. They include:
- A FICO credit score of at least 620 or higher
- A home value that exceeds the total amount of all debt taken against it by at least 15% (this is the 85% maximum LTV standard discussed earlier)
- A debt-to-income ratio that is no higher than 40% (and less is better)
- Valid property insurance on your home, and maybe flood insurance in some cases
Here’s a look at each of these requirements in more detail.
While some lenders are more stringent than others, the majority of HELOC and home equity loan lenders like to see their prospective borrowers show a strong credit history. A FICO score of 620 is the standard minimum for most primary mortgages, but those with a score at or near this level may find it more difficult depending upon how much you draw out, and if it will put you above that critical 40% level, then you may be denied the loan.
Furthermore, your credit score will usually dictate what the annual percentage rate is that you will pay on your loan. If you have a credit score of 700 or higher, then you’ll probably qualify for a lower rate on your HELOC. If your credit score is 620 or below, then you’ll probably have to pay a higher rate of interest. If your current financial situation is weak, then you may want to try and clean up your credit report in order to qualify for a HELOC or home equity loan with lower rates.
Amount of debt vs. income
When it comes to primary home loans, some mortgage lenders will allow you to carry a debt-to-income ratio as high as 50%. But most lenders are more stringent with their DTI requirements for a HELOC.
The highest DTI that most lenders will accept for a HELOC is 43%. If your DTI is above this level, then you probably will not qualify for a line of credit. You will need to pay down some of your other debts first before you can do this.
For example, if your income is $5,000 per month and your monthly debt payments total $2,700, then your DTI would be 54% ($2700/$5000). Of course, the whole reason you need the HELOC to begin with may be for debt consolidation, but you’ll have to dig yourself a little further out of the hole you’re in before you can do this.
One of the key factors that HELOC lenders look at during underwriting is the amount of equity you currently have in your home. Most lenders want to see their borrowers have a bare minimum of 15-20% of equity before they will approve the loan. So if you only have five to 10 percent equity in your home, then you’re probably not going to get approved.
It should also be noted that taking out a HELOC can either help or hurt your credit score. You will still have to make all of your payments on time every month, or else your credit report will be dinged with late or missed payments.
But if you can pay off all of your other debts with a HELOC and are able to make that payment every month, then your credit score should improve over time. In fact, it would be a good idea if you can pay more than the minimum payment each month, especially during the draw period. This way you’ll have a lower monthly payment when the repayment period starts.
The process for getting a HELOC is essentially the same as it was to get your primary mortgage. You’ll have to produce much of the same documentation that you did the first time around. You will also have to get your house reappraised in most cases. Here are the steps that you’ll have to take to get your HELOC issued to you.
1. Determine whether you have sufficient equity
The first step to getting a HELOC is to have your house reappraised. The appraisal that you paid for with your primary mortgage probably will not suffice here, because your home’s value has probably increased since then. As mentioned in the previous section, you’ll have to have at least 15-20% of equity in your home before you will be approved.
2. Shop HELOC lenders
The terms and fees that lenders charge for HELOCs can vary widely in many respects. Some HELOCs charge points and origination fees while others do not. You’ll have to be sure and read the fine print on the application in order to see what you will pay for a given loan.
Before you pick one, look at least half a dozen possible lenders in order to find the loan that’s best for you. You can go to local banks or credit unions, do an online search for HELOC lenders or ask your friends or family who have HELOCs who they used. Some of the most popular HELOC lenders right now include US Bank, PenFed, and Bank of America.
If you do your homework thoroughly, you should be able to find a lender with minimal fees and generous terms based on your credit score and the amount of equity in your home.
You can also enlist the help of a mortgage broker to do some shopping for you if you like. Most mortgage brokers will likely charge an origination or broker fee of around 1% of the credit line. But it may be worth it if your broker can find you a better loan than you have been able to find on your own.
3. Gather the necessary documentation to streamline the process
The first thing you’ll need to apply for a HELOC is documentation of a full appraisal of your home. If your mortgage broker found you the loan that you’re going to use, then he or she will probably be able to furnish you with a qualified appraiser.
You can also find one online if you need to. Then you’ll need to get at least some of the following additional documents:
- At least six months’ worth of bank statements so that your lender can determine your debt-to-income ratio
- Your last two tax returns
- Your most recent retirement plan and investment account statements
- Your two most recent pay stubs
- Your homeowner’s insurance policy
- The deed to your house
- A recent copy of your credit report (if the lender is not going to pull it for you)
- A breakdown of your employment history
- A copy of your monthly primary mortgage statement
Your HELOC lender will tell you which of the above documents it requires, but be prepared to furnish them all if necessary.
4. Once you have selected a lender, apply for the HELOC
If you have chosen a bank as your lender, then you’ll need to talk to their loan specialist. You can also submit an online application in many cases, regardless of what type of lender you use. There are many online lenders that can approve you via online banking.
Once you have submitted your application, it will generally take the lender up to a few days to determine whether you qualify. Once you get approved, then it may be another few days before you can close on the loan, because the lender has to get all of the closing documents ready for you to sign.
Then, once you have closed on the line of credit, it may be a few more business days before you can access your funds. The exact time frame can differ from one lender to another. You may also have to wait a few days for the appraiser to evaluate your home, so be sure to factor that in as well.
5. Read your disclosure documents carefully and make sure the HELOC will suit your needs
Be sure to read all of the fine print in the closing documents before you sign on the dotted line. You need to be certain that your HELOC will do what you need it to and also know what your interest rate will be.
If you have good credit, then you may qualify for a rate somewhere below two percent. You should also find out the answers to these questions:
- Will the loan require you to draw out a substantial amount upfront?
- What exactly do these documents require of you?
- Does it say in the paperwork that the lender can repossess your house if you become unable to make the payments?
- Can you negotiate the rate of interest that the HELOC charges?
- Can you negotiate other terms, such as the compensation for the mortgage broker or the origination fee?
- How long are the draw and repayment periods?
- Do the terms of this loan meet your financial needs?
6. The underwriting process begins
Normally, the underwriting process for HELOCs only takes a few business days, assuming that you have all of your documentation ready to submit. It can take longer if the lender has to wait for you to supply everything they need to look at. During the underwriting process, your lender will evaluate your financial condition by looking at your income and your current debt payments.
Once they have determined your debt-to-income ratio and the amount of equity in your home, they will return to you with a decision to either approve or disapprove the loan. In most cases, an appraisal will be necessary if you haven’t already had your home appraised recently. You can speed up the process by having everything you need at the outset.
7. Sign the paperwork and your line of credit can be accessed
As mentioned previously, be sure to look over the closing paperwork thoroughly to see all of the details that are included in the fine print. If you have any questions about your loan, now is the time to ask them.
Most HELOCs will give you a few days after the closing to back out of the deal if you change your mind unless you are securing the HELOC with an investment property. Once the money becomes available to you, the loan cannot be canceled.
As with any other type of financial product or service, there are both advantages and disadvantages to using a HELOC. You need to know these pros and cons in order to be able to make an informed decision about whether a HELOC is best for you.
Here’s why you’ll want to consider a home equity line of credit.
- Debt consolidation. If you have a lot of high-interest debt, such as credit cards, personal loans or car loans, then a HELOC can be a real blessing. HELOCs can allow you to consolidate all of your other debt payments into one manageable monthly payment.
- Lower interest rate. The rate of interest charged by a HELOC is virtually always lower (and is usually considerably lower) than the rates of interest charged by other types of debt such as credit cards or other types of unsecured loans such as personal loans. HELOC rates can offer rate discounts because you are securing your loan with the equity in your home. But the key factor here is that you don’t rack up more debt. If you cannot control your spending, then a HELOC will only be a band-aid on your problems. A low-rate loan will not help you move forward.
- Great for increasing the value of your home. A HELOC can be a great solution if you need to make major home improvements, such as new bathrooms or a new kitchen or roof, because the value that you add to your house may be greater than the amount of money that you have to borrow. Just understand that you’ll have to make two house payments every month until your HELOC is paid off, so make room for that in your budget.
- May not hurt your credit score. The use of a HELOC can negatively impact your credit score, but not necessarily. If you use less than the full line of credit that you qualified for, then you should make at least the minimum payment on the loan during both the draw and repayment periods. This can improve your credit score over time. If you can pay more than the minimum payment, then your score may improve even more. A HELOC often has the same impact on your credit score as a credit card, but it will not necessarily result in a blemish on your credit score if you use the entire amount that you were approved for. Some of the major credit bureaus treat HELOCs like any other type of installment loan instead of as a revolving line of credit. The use of a HELOC will most likely reduce your credit score, at least temporarily. But the continued use of a HELOC can improve your score over the long run, because it will show as another debt that you have made timely payments on.
- Lower upfront fees. HELOCs usually charge lower up-front fees than other types of home loan refinancings such as home equity loans or primary mortgages. You may have to pay an appraisal fee and application fee, but you may not have to pay any origination fees or other fees designed to compensate your mortgage broker.
- Minimal closing costs. Along the same vein as the last point, there may be virtually no closing costs compared to a primary mortgage or home equity loan. HELOCs are probably the most affordable way to access the equity in your home.
- Faster approval process. HELOCs are usually approved sooner than other types of home loans. If you need a major line of credit quickly, HELOCs are one of your best options.
Here’s what you should be wary of before taking out a HELOC.
- Repayment terms. The chief disadvantage that comes with taking out a HELOC is that the repayment terms can be unforgiving. In some cases, the lender can either repossess or force you to sell your home if you become unable to keep up with your monthly payments. Since falling behind far enough can mean losing your home, make sure that you’ll be able to make this payment without fail every month. If you used your HELOC to pay off a variety of high-interest debts, then you should be able to make this payment every month without problem. Just be sure that you can continue to make this payment when the draw period is over and the repayment period begins. Otherwise, you may have to deplete your savings account in order to do this.
- Variable rate of interest. Most HELOCs charge a variable rate of interest, which means that your minimum monthly payment can increase if interest rates rise. Even if you are still in the draw period and are making interest-only payments, your payment can increase substantially if interest rates rise by a material percentage.
- May hurt your credit score. If you eventually become unable to make your HELOC payment each month, then your credit score will suffer accordingly. Late and missed payments will accumulate on your credit file, and you may become unable to qualify for any other types of credit. It is vitally important that you run the numbers so that you will know whether you can make this payment reliably every month before you sign on the dotted line.
- Bad for irresponsible spenders. A HELOC is no solution to turn to if you cannot control your spending. In fact, a HELOC will leave you in worse shape than ever if you keep buying new things and run your credit card balances back up. If that happens, then you’ll have to make a HELOC payment on top of your other debt payments. If you are addicted to buying transient items such as expensive restaurant meals, then you will quickly find yourself in a worse position than you were in before.
- May require initial draw. Your HELOC lender may require you to draw out an initial amount of money up front, such as $25,000, even if you don’t need that much money. If this is the case, then use the excess money to make payments so that you owe as little as possible.
- A variety of fees. Your lender may charge you a variety of excess fees that you must pay up front, regardless of the amount of money that you are able to (or have to) draw once the loan has been approved. Read the fine print in your loan documents so that you aren’t caught by surprise when this happens.
If you apply for a HELOC and your application is accepted, then you have certain guaranteed rights that cannot be taken away from you, regardless of the terms of your HELOC. These rights include:
- Under federal law, you have three business days from the date you signed the closing papers to back out of your HELOC if you so choose. This law is commonly known as the Three Day Cancellation Rule. Saturdays are generally considered to be business days. But Sundays and holidays are exempt from this method of calculating the time passage.
- You don’t have to provide a reason to cancel, as long as your HELOC is backed by the equity in your personal residence. You can cancel for any reason at all if this is the case.
- This right does not apply to vacation or rental homes. If you are taking out a HELOC on either of these residences, then you do not have the right to cancel within three days of closing. You must receive at least two copies of the Truth In Lending document that explains your right to cancel.
- A verbal cancellation is not valid. If you wish to back out of your HELOC, you must do it in writing, and the request must be dated within three business days of the closing date.
- A written notice of cancellation must be delivered either by mail or in-person within the prescribed time period in order to be valid. An emailed request within the three-business-day limit is also considered to be valid.
Exceptions to the Three-Day Cancellation Rule
In some cases, the three-day cancellation rule does not apply, or there are other results that will apply instead. Discuss the rule with your broker or HELOC company if…
- If the proceeds of the line of credit will be used to build, buy or substantially improve your primary residence
- If you refinance your current debt with your primary mortgage lender and don’t take on any new debt (so that both of your combined loans equal or are less than the initial amount of your primary mortgage)
- If you are borrowing from a state agency. If you are, then you’ll typically have other rights-of-rescission laws to protect you
Tax treatment of HELOCs
Most HELOC interest is deductible for those who are able to itemize their deductions. Of course, Trump’s new tax laws have drastically shrunk the number of people who qualify to do this, and those laws specifically impact those who pay mortgage interest.
Under the old laws, anyone who could deduct the interest that they paid on their primary mortgage were eligible to deduct the interest that they paid on their second or third home loans as well. But it is still possible to deduct the interest that you pay on your HELOC, as long as the following conditions apply:
- The dollar amount of the HELOC is $750,000 or less.
- Your HELOC equaled $1 million or less when the new law was passed.
- Your HELOC interest is used to pay for loans used to pay for buying, building, or improving your primary residence.
- HELOC interest that is used to pay for medical bills or debt consolidations paying off high interest debt is no longer deductible.
- These rules apply to all HELOCs that were taken out before December 15 of 2017. No grandfathering clause of any kind applies to this.
Despite the volume of information that has been presented here, you may still have a list of FAQs regarding HELOCs. If you are still wondering whether a HELOC is the right choice for you, here we will cover the reasons why a HELOC may or may not be the right choice. This answer partly depends upon your own spending and saving habits, among other factors.
You may want to take out a HELOC if…
- You need extended access to a large line of credit at low rates. This way you can pay off large balances of unsecured debt, tax liens, or other debts that are charging you a high rate of interest, such as credit cards, student loans, higher education fees, home improvement projects or personal loans.
- You can’t afford the initial costs of another first or second mortgage or home equity loan (HELOC closing costs are usually far less than either of these types of loans).
- Your credit is in good shape (i.e. if your credit score is above 700 or more).
- You have a good debt-to-income ratio (below 30%).
You may want to avoid a HELOC if…
- You lack a stable source of income. If you become unable to make the payments on your HELOC, then you can end up in bad financial shape. You can consolidate your debt with a HELOC and then run your credit card balances back up again. If you become unable to make your HELOC payments, then your credit report will be dinged with even more late and/or missed payments. And you could even lose your home.
- You can’t afford the upfront costs, such as the closing costs or origination fees. These costs are usually higher for home equity loans, but HELOCs have their own closing costs as well.
- You don’t need to borrow a large loan amount. For example, if you only need to borrow $5,000 to replace your roof, then an unsecured personal loan may be sufficient. There may be better loan options than a HELOC. A HELOC in this case could bring your total LTV beyond the maximum amount that you could handle.
- You can’t afford to make payments on your loan if interest rates rise. The vast majority of HELOCs charge variable interest rates, so the payment that you make now may be much lower than the payment that you have to make three years from now. You will need to do some math in order to anticipate what your future payment could be if rates rise. The loan paperwork will tell you the highest rate that the loan can go to. If you can’t afford the loan payment at that rate, then you should think twice about taking out this type of loan. Your lien amount could become more than you can handle.
If you decide that a HELOC isn’t the right choice for you, you may want to consider one of these alternatives:
Home equity loan
This type of home loan can protect you from interest rate increases, because unlike a HELOC, which charges a variable rate of interest, the loan rate will be fixed at the outset. On the other hand, the rate of interest that the loan charges will most likely be higher than that of a HELOC. And home equity loans usually have higher closing costs than HELOCs (stemming from points and origination fees), so the latter option is usually the cheapest route.
This could be a preferable alternative if your new, higher monthly mortgage payment is less than the combined amount that you would pay if you took out a second mortgage of any type. You can still get the cash you need while hopefully lowering the rate of interest that you pay on your primary loan.
Still have questions about HELOCS? Here are some of the most commonly asked:
Did the COVID-19 pandemic affect HELOC laws?
The COVID-19 pandemic that ravaged America in 2020 (and is gaining steam again with its latest variant) caused the U.S. government to issue a moratorium on HELOC payments. Those who were behind in their HELOC payments were given additional time to get caught up.
Some borrowers were granted extensions that lasted until June 30, 2021. The government has since granted additional extensions that have recently expired. Time will tell what happens with this, so be sure to closely monitor this issue going forward. Ask questions about relief to all those involved with securing your HELOC.
What safeguards are built into a HELOC?
The Truth-In-Lending Act provides borrowers with certain rights that apply to all types of home loans. Lenders must disclose all of their fees up front and cannot try to force the borrower to accept a different set of terms at the closing table.
Borrowers are automatically afforded a three-business-day cancellation rule during which they can cancel the loan if they so choose. They can still do this even if they are granted low rates of interest on the entire second mortgage balance.
Are closing costs really negotiable?
When it comes to HELOCs, the closing fees are often negotiable. For example, they may be willing to waive the origination fee at your request. They may also be able to offer you a fixed rate of interest for a period of time in some cases.
If they do, they can probably offer you a range of rates for a range of time periods, with higher rates for longer periods of time. As is the case with any type of loan that you take out, it’s always a good idea to check your credit report before closing to make sure that there aren’t any errors on it.
Are you required to have a primary mortgage to take out a HELOC?
The lender for your HELOC may not be the same lender you used to obtain your primary mortgage. HELOCs can also be taken out if you have paid your home completely off. There is no requirement to have a primary mortgage on your home in order to qualify for a HELOC.
Do all lenders generally offer the same rates?
The rates and fees for HELOCs can differ substantially from one lender to another, so it pays to shop around. HELOCs usually don’t charge many fees at closing, but there can still be a material difference between what one lender charges and another.
You can talk to banks, credit unions, home loan companies, savings and loan institutions and other types of lenders to see who can get you the best deal. The interest rates that you are offered will also usually differ, but the general rate you are quoted will depend to some extent on the current Federal Funds Rate or Prime Rate. If you secure a HELOC via online banking, there may also be an additional discount for that. But you can’t get the best rates without a high credit score.
In most cases, if you are looking for a credit limit of $100,000 or less, a small community bank or credit union can get you a better deal than most other lenders. You can also enlist the help of a mortgage broker, who will usually be very knowledgeable about these things and can point you in the right direction.
Does my type of residence matter when applying for a HELOC?
HELOCs can be taken against any type of home that you owe, whether it is a standard single-family residence, half of a duplex or a condominium. As long as you own the property and are not just renting it, then you are eligible for this type of loan.
How will I access my HELOC funds?
Most banks and other HELOC lenders will give you more than one way to access the equity in your home. Some lenders will give you a book of checks or a checking account deposit, while others may give you a debit or credit card. And many lenders are able to do all three of these things. Be sure to find out what methods you will have available to access your equity when you apply for it.
What should I watch out for when shopping for a HELOC?
There are a number of other safeguards that have been established to protect borrowers from scammers. Still, you should keep an eye out for these common schemes:
- False loan closings: Where the lender provides false information on the loan application to qualify the borrower for funds that they would otherwise not receive.
- Insurance packing: Where the lender “packs” an insurance policy into the HELOC.
- Equity stripping: Where a predatory lender buys a property from a homeowner who is facing foreclosure and allows them to continue living there in return for a very high rate of interest plus exorbitant fees on the loan
- Non-traditional loan products: These products charge high fees and interest and may run aground of conventional mortgage regulations.
Each of these practices is specifically prohibited by the Truth In Lending Act, and lenders that engage in these practices can face disciplinary action from federal regulators.
What happens if I can’t pay back my loan?
A HELOC can be a lifesaver if you have a large amount of unsecured debt that you need to pay off, but what happens if you can’t make this payment every month either?
In most cases, the lender will reserve the right to foreclose on your home if you can’t pay off your HELOC or home equity loan. In order to avoid this scenario, you may need to ensure that you can make this payment reliably using your Social Security and/or pension income.
What happens if I sell my home while I have a HELOC?
The total amount of outstanding debt that you owe on your home must be paid off if you sell your home. If your house is worth more than your primary mortgage and HELOC, then you can sell your home with no problem.
However, if you are upside down on your home (meaning that your total debt is more than your home is worth) then you’ll need to either come up with the balance out of your pocket or else negotiate a short sale with your lender.