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9 min read Jan 30, 2024

Home Equity Line of Credit: Pros, Cons, and Key Considerations

Homeowners find it a challenging task to access the value of their homes. However, you have several loan options that can help you transform your home’s value into cash.

The Home Equity Line of Credit, or HELOC, is one such option. This allows you to borrow against the equity you’ve built up in your home.

But what is equity and how can you borrow against it? This blog will give you an in-depth analysis of HELOC.

Key Takeaways

  • HELOC can be an excellent way to get cash for renovations, large purchases, or debt repayment.
  • As per Bankrate.com, the average fixed rate for 15-year and 10-year home equity loans was 7.87% and 7.93%, respectively.
  • “As long as the Fed is active, HELOC rates are going to continue to march higher.” – Greg McBride, CFA Bankrate.

What is Home Equity

A home equity line of credit uses your home equity as collateral. But what is home equity?

Home equity is the amount of your home that you actually own. It’s the difference between the value of your house and the amount you still owe on your mortgage.

For example, if your home is worth $300,000 and you still owe $200,000 on your mortgage, your home equity is $100,000.

What is a Home Equity Line of Credit?

A HELOC is a type of loan that allows homeowners to borrow against the equity they have in their property. Unlike a traditional mortgage, a HELOC provides a revolving line of credit, similar to a credit card.

To understand HELOC better, you need to know the following terms:

  • Collateral and Lien Position: It uses your home as collateral, allowing the lender to seize it if you default. The lien position determines the creditor payment order in the event of foreclosure.
  • Draw and Repayment Period: HELOCs have two phases: a draw period (5-10 years) for accessing funds and making interest-only payments. It is followed by a repayment period for repaying principal and interest.
  • Variable Interest Rates: HELOCs typically have a variable interest rate that can change over time.

Requirements for Home Equity Line of Credit

Qualification requirements for a home equity line of credit (HELOC) can vary among lenders, but here are some common criteria:

  • Good Credit Score: The credit score for buying a house should be 620 or above. It also demonstrates your creditworthiness and improves your chances of approval.
  • Debt-to-Income Ratio: Your Debt-To-Income(D-T-I) should generally be below 43%. This ratio compares your monthly debt payments to your gross income.
  • Stable Income: Lenders assess your income stability and may require documentation such as pay stubs, tax returns, or bank statements.
  • Sufficient Equity: Your home equity should be around 15% to 20% of its appraised value.

How to Get a Home Equity Line of Credit

Here’s a step-by-step guide on how to get a HELOC:

1. Assess Your Financial Situation

Before applying for a HELOC, evaluate your financial standing. This includes your credit score, income stability, and debt-to-income ratio.

Lenders typically consider these factors when determining your eligibility.

2. Calculate Your Home Equity

The primary requirement for a HELOC is having equity in your home. Equity is the difference between the current market value of your home and the outstanding balance on your mortgage.

Most lenders require a minimum home equity threshold, often around 15% to 20% of the home’s value.

3. Gather Necessary Documentation

Collect all the required documents required for HELOC. This includes your proof of income, bank statements, tax returns, property documents, and a recent appraisal of your home.

Check with your lender for their specific documentation requirements.

4. Submit Your Application

Complete the HELOC application provided by your lender. Provide accurate information about your financial situation, home value, and desired credit limit.

Double-check your application for any errors before submission.

5. Undergo a Credit Check and Evaluation

The lender will review your credit history, income, and other financial factors to assess your creditworthiness.

They may also conduct an appraisal to determine the current market value of your home.

6. Sign the Agreement

Once you are satisfied with the terms, sign the HELOC agreement.

Understand the responsibilities and obligations outlined in the contract, including repayment terms and consequences of default.

7. Access Your funds

After the agreement is signed, you can begin accessing funds from your HELOC.

Depending on the mortgage lender, you may receive a checkbook, or debit card, or have the option to transfer funds online or through mobile banking.

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How Does Home Equity Line of Credit Work?

Here’s how a HELOC typically works:

  • Evaluation of Home Equity: Lenders determine equity by comparing the actual market value of a home to its outstanding mortgage balance.
  • Determine Credit Limit: The lender determines the maximum credit limit based on the home’s equity, creditworthiness, income, and DTI ratio. This limit represents the total amount the homeowner can borrow.
  • Draw Period: Once approved, the homeowner enters the draw period, typically lasting 5 to 10 years. During this period, the homeowner can access funds from the HELOC as needed.
  • Repayment Period: After the draw period ends, the homeowner enters the repayment period, typically lasting 10 to 20 years. During this phase, the homeowner can no longer borrow from the HELOC. They must start repaying the principal amount borrowed, along with interest.

Advantages And Disadvantages of HELOC

Here are some advantages and disadvantages of a home equity line of credit:

Pros:

  • Lower Interest Rates: Compared to other credit forms, HELOCs typically have lower interest rates. This will help you to save money on interest charges over time.
  • Flexibility: HELOC offers flexible borrowing within a credit limit and repayment options, including interest-only or principal and interest payments.
  • Large Borrowing Capacity: It allows borrowers to access a large amount of money, up to a certain percentage of their home’s equity. This can be useful for large expenses, such as home renovations or medical bills.
  • Tax Benefits: Sometimes, the interest paid on a HELOC may be tax-deductible. however, this depends on the borrower’s tax situation, so consulting with a tax professional is important.

Cons:

  • Variable Interest Rates: Unlike a fixed-rate loan, HELOCs typically have a variable interest rate that can change over time. This means that the borrower’s monthly payments may fluctuate, making budgeting and planning more difficult.
  • Risk of Foreclosure: Since the borrower’s home secures a HELOC, failure to make payments could result in foreclosure. This risk is higher if you borrow more than you can afford or if there is a drop in home values.
  • Fees: HELOCs often come with fees, including application fees, appraisal fees, and annual fees. These fees can add up and increase the overall cost of borrowing.
  • Requires Home Equity: HELOCs are only available to homeowners who have equity in their homes. If a borrower has little or no equity, they may not be able to qualify for a HELOC.

Alternative to a HELOC

If a Home Equity Line of Credit isn’t the right fit for your financial needs, here are a few alternatives to a HELOC:

  • Credit Cards: Credit cards are a good option for smaller expenses or short-term funding. However, they come with higher interest rates.
  • Cash-Out Refinance: Cash-out refinance allows you to replace your existing mortgage with a new one. The new loan will be for a higher amount, allowing you to pocket the difference.
  • Home Equity Loan: It allows you to borrow a lump sum against your home equity. It provides a fixed interest rate and term, with regular monthly payments.
  • Personal Loan: It is an unsecured loan that you can obtain from a bank, credit union, or online lender. It doesn’t require collateral, but it’s based on your creditworthiness and income.

» Home Equity Line of Credit vs Refinance: Click here to know which one is better.

Difference Between Home Equity Loan and Line of Credit

HELOC and Home Equity Loan are both forms of borrowing against the equity in your home, but they differ in several key aspects:

ParametersHome Equity Line of Credit (HELOC)Home Equity Loan
BorrowingAllows you to borrow funds as needed, up to a predetermined limit.Provides a lump sum upfront, which you repay over time.
RepaymentMinimum monthly payments based on the outstanding balance.Fixed monthly payments over a specified term.
InterestVariable interest rate, typically tied to a benchmark such as the prime rate.Fixed interest rate throughout the loan term.
FlexibilityYou can borrow, repay, and borrow again within the draw period.Once you receive the loan, you cannot borrow more.
RiskInterest rates can fluctuate, potentially affecting your monthly payments.Interest rates are fixed, providing stable repayment amounts.
Closing CostsTypically, lower closing costs, if any, compared to home equity loans.This may involve higher closing costs, such as appraisal and origination fees.

» Home Equity Line of Credit vs Home Equity Loan: Understand the difference between these loans.

Final Word

HELOC might be a good option for you if you need a large sum of money on a revolving basis. It offers flexibility and potentially lower interest rates for homeowners.

However, careful consideration of the risks, such as variable rates and the possibility of home loss, is crucial. Comparing offers and consulting with a financial advisor can help you make an informed decision.

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Frequently Asked Questions

1. How to get a HELOC?

To get a Home Equity Line of Credit (HELOC), contact a lender or a bank offering HELOCs. Prepare the necessary documents and submit your application.

2. How long does it take to get a HELOC?

The time to get a HELOC can range from a few weeks to a couple of months. It depends on factors like documentation preparation, lender's processing time, and property appraisal requirements.

3. What documents are needed for HELOC?

The documentation needed for a HELOC may vary depending on the lender. But typically it includes proof of income, credit score, value of the property, tax returns, bank statements, and proof of insurance.

4. How can I calculate home equity line of credit?

To calculate your HELOC, subtract your outstanding mortgage balance from your home's current market value and multiply the result by the lender's loan-to-value (LTV) ratio.

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