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What Is a HELOC (Home Equity Line of Credit)?
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A home equity line of credit (HELOC) can be an attractive source of cash. HELOCs are designed to allow borrowers to tap equity whenever they want it — up to a set amount — while making low payments. They generally have lower interest rates than most credit cards and personal loans. However, HELOCs use your home as collateral. In the worst-case scenario, if you don’t repay the loan, the bank could foreclose on your home.
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HELOC basics
A HELOC is a type of second mortgage, meaning you could get one even if you still have your first, or primary, mortgage on the house.
Because a HELOC is a line of credit, it functions differently from a “regular” installment loan. Instead of providing one lump sum of cash that you repay over time with equal payments and a fixed interest rate, like a home equity loan, a HELOC has two phases. You can read about home equity loans versus HELOCs here.
HELOC phases
Phase one: Draw period
Once you’re approved for a HELOC, the draw period starts. In this first phase you can borrow as much cash as you want each month (up to the cap). Many HELOC lenders require a minimum withdrawal — the amount will depend on the lender and how large your credit limit is. Many HELOC loan programs also have fees, including one-time fees for closing costs and ongoing fees like annual maintenance and membership charges.
The minimum payment required can change depending on how much you’ve borrowed and the current interest rate. You can potentially make interest-only payments for this phase, which is typically 10 years.
Phase two: Repayment period
After the draw period, you can no longer borrow from the credit line and you’re required to repay your remaining credit line balance. HELOCs can require repayment all at once or over time. Drawn-out repayment periods typically last 20 years.
Pros and cons of a HELOC
| HELOC pros | HELOC cons |
|---|---|
You can withdraw cash, pay it back and reuse as needed. You could use an interest-only payment option to keep draw period payments lower. You may be able to deduct HELOC interest charges if you use the funds for home improvements. You’ll generally get lower interest rates with a HELOC, versus a personal loan or credit card. You won’t pay mortgage insurance even if you borrow more than 80% of your home’s value with a HELOC. | You could see higher monthly payments in some months, as HELOC rates are usually variable. Your payments may become unaffordable once phase two begins, especially if you've been making interest-only payments. You might have to pay fees for maintenance, membership or prepayment. You could lose your home to foreclosure if you fail to repay the HELOC. |
HELOC eligibility requirements
To qualify for a HELOC, you’ll need to provide financial documentation, such as W-2s and bank statements — these allow the lender to verify your income, assets, employment and credit scores. Expect to meet these requirements:
- 620 credit score. You’ll need a minimum 620 score, but the most competitive rates typically go to borrowers with scores of 740 or higher. You can get your free credit score here.
- 43% debt-to-income (DTI) ratio. This is your total debt (including your housing payments) divided by your gross monthly income. Typically, your total DTI ratio shouldn’t exceed 43% for a HELOC, but some lenders may stretch the limit to 50%. Here’s how to calculate your DTI.
- 85% loan-to-value (LTV) ratio. Your potential lender will order a professional appraisal and compare your home’s value to how much you want to borrow. The LTV ratio is normally capped at 85%, according to the Federal Trade Commission (FTC). For example, if your home is worth $300,000, then the combined total of your current mortgage and the new HELOC amount can’t exceed $255,000.
5 steps to get a HELOC
- Step one: Make sure a HELOC is the right move for you. HELOCs are best when you need large amounts of cash on an ongoing basis, such as covering home improvement projects or medical bills. Be sure you have a solid plan to repay the HELOC.
- Step two: Shop around. Look at what different lenders are offering regarding rates, fees, maximum loan amounts and repayment periods. It doesn’t hurt your credit to apply with multiple lenders for a HELOC anymore than it does to apply to just one, as long as you do the applications within a 45-day window granted by the credit bureaus.
- Step three: Apply to HELOC lenders. You’ll need to provide financial documents and personal details on your applications. At LendingTree, you could get up to five HELOC offers from lenders at once, depending on your creditworthiness.
- Step four: Compare offers. Take a critical look at the offers on your plate. Consider total costs, the length of the phases and any minimums and maximums.
- Step five: Close on your HELOC. If everything looks good and it’s the right move, sign on the dotted line! You may have to bring a check to cover closing costs, which can range from 2% to 5% of the HELOC’s credit line amount.
Backing out or canceling a HELOC
You can cancel a HELOC for any reason within three business days after your closing. You’ll have to do it in writing and the lender must refund any fees you’ve already paid. This three-day time period includes Saturdays, but not Sundays.
If you can prove that the lender didn’t provide all of the required material about the HELOC, you could get up to three years to cancel the line of credit.
If you’ve gone over the time period, your best bet may be to refinance your HELOC. Look at your contract to see if there are any penalties for early payoff and closing. You may be able to pay it off with your savings, another loan or even another, better HELOC.
What to do if you can’t repay a HELOC
If you’re having trouble making mortgage or HELOC payments, contact your lender. Many companies have programs to help borrowers avoid foreclosure. Be prepared to explain why you’re having financial trouble, how extensive your hardship is and how long you expect the trouble to last. The lender may have you do a mortgage assistance application before providing options to you.
You can also contact a housing counselor who’s approved by the U.S. Department of Housing and Urban Development (HUD) (you can find HUD counselors here). They can point you toward other assistance programs, help you choose the best option for your situation and guide you through paperwork.
Alternatives to HELOCs
Not sure if a HELOC is the best option for you? Here are other loans worth considering:
- Home equity loan. As mentioned earlier, a home equity loan is another second mortgage option that allows you to tap your home equity. Instead of a line of credit, though, you’ll receive an upfront lump sum and make fixed payments in equal installments for the life of the loan.
- Cash-out refinance. A cash-out refinance replaces your current mortgage with a larger loan, allowing you to “cash out” the difference between the two amounts. The maximum LTV ratio for most cash-out refinance programs is 80%. The exception is the VA cash-out refinance program, which allows military borrowers to tap up to 90% of their home’s value with a loan backed by the U.S. Department of Veterans Affairs (VA).
- Personal loan. A personal loan isn’t secured by any collateral and is available through private lenders. Personal loan repayment terms are usually shorter, though the interest rates are higher than HELOCs.