A HELOC loan, or a home equity line of credit, is a type of revolving credit backed by the equity you currently have in your home. Unlike a home equity loan, (or a second mortgage), which is a loan issued in a lump sum at a fixed rate of interest, a HELOC gives you access to as much credit as you need, whenever you require it, like a credit card.
If you are looking for a lower interest loan to complete home improvements, or you want access to low-interest emergency funds, a HELOC could be useful. Here’s what you need to know about this type of loan.
What is a HELOC Loan?
A HELOC loan is a source of revolving funds that you can access when you choose, with a variable interest rate. Many qualified people are able to access around 80% to 85% of the equity in their home with a HELOC loan.
Many lenders prefer that you borrow no more than 80%.
You often need a credit score of at least 680 to qualify for a HELOC.
Some applicants qualify with a lower credit score, but in this case, you will most often be charged a higher interest rate and other financial factors may be considered for approval. This can include your overall debt.
How Does a HELOC Loan Work?
Once you are approved for a HELOC, you can take out as much money as you need at any time. It’s good to know that:
- HELOCs are often issued as a checkbook or a credit card
- HELOCs involve a draw period as well as a repayment period. You can pay back money borrowed on a HELOC at any time. Payments in the repayment period are much higher. During the draw period, you are only required to make payments on the interest.
- Because a HELOC is a loan secured by the equity in your home, if you cannot make your payments on the loan, you could lose your home to foreclosure.
How to Calculate Interest on HELOC?
Unlike a home equity loan that has a fixed interest rate, HELOCs are often based on a variable interest rate. This means the rate can go up and down over the course of your loan.
HELOC interest rates are based on the lender’s prime rate, and this can vary between institutions.
The prime rate is determined by individual banks and lenders and is often based in part on the rate banks charge each other for short-term loans. This is a rate established by the Federal Open Market Committee in the US.
In order to calculate how much you need to pay in interest on your HELOC in any given month, first calculate your average daily balance during this month. Next, take your current daily interest and divide it by 365. For example, if your interest rate is 6%, divide 0.06 by 365. This equals 0.000164. Finally, multiply your average daily balance by 0.000164.
So, if your average daily balance was $100,000:
0.000164 x 100,000 = $16.40
If there are 30 days in the month:
$16.40 x 30 = $492
You would pay $492 in interest this month on your HELOC.
In order to qualify for a HELOC, you must have equity available in your home. This means the amount of money you owe on your home must be lower than the current value of your home. If your home has a market value of $300,000, you need to owe less than $300,000 on it.
Generally speaking, you must also have a source of income in order to qualify. If a lender doesn’t require this, it could be a red flag. Every lender has their own set of requirements but most ask that you have good credit, a reliable payment history, and a low debt-to-income (DTI) ratio.
Your DTI ratio is a calculation that compares your overall income to the amount of debt you owe. Many lenders prefer you to have a DTI ratio of less than 36%, with no more than 28% of this total going towards a mortgage or rent payments.
The Different Phases of HELOCs
HELOCs have two distinct phases:
- The draw period
- The repayment period
The draw period on a HELOC is often about 10 years, but it can be any fixed amount of time. During this time, you can borrow as much money as you require up to your total available credit. You can repay the money you borrow during this time if you choose. You are only required to pay the interest owed during the draw period.
Once the draw period is over, you cannot borrow any more funds from the loan and you transition to the repayment period.
The repayment period of a HELOC requires you to make payments that include payments made on the principal and interest. These payments are much higher than those required in the draw period.
The repayment period is often a bit longer than the draw period. The amount you need to repay during the repayment period fluctuates as interest rates go up and down.
- For some people, the interest paid on a HELOC can be tax-deductible. This tends to be true if the funds are used to perform improvements on your home.
- Some lenders charge prepayment penalty fees if you repay your HELOC early.
How Much Can You Borrow with a HELOC?
Generally speaking, the amount of credit you can qualify for through a HELOC depends on the equity you have in your home, as well as your debt-to-income (DTI) ratio, and your credit score. Let’s create an example. Imagine you own a home valued at $300,000 and you still have $100,000 left to pay down your mortgage, (you have already paid off $200,000). You also have a good credit score and DTI ratio.
In this case, if your lender is giving you permission to borrow up to 80% of the equity in your home, you can be approved for a HELOC of up to $160,000, ( or 200,000 x 0.80).
Pros & Cons of HELOCs
As with any loan, a HELOC comes with various pros and cons. Whether a HELOC is right for you depends on your personal situation, your finances, and your comfort with risk.
- HELOCs normally have much lower interest rates than credit cards, personal loans, and other types of unsecured debt. This can make them attractive options.
- You can draw as much money as you need from your HELOC, up to your credit limit.
- You can borrow as much, or as little, money as you require.
- A HELOC allows you to draw funds in an emergency.
- If your credit is good, there are no closing costs, unlike with a home equity loan.
- You shouldn’t need to pay a fee to withdraw funds, unlike with a credit card.
- A HELOC can potentially lower your credit score over time.
- HELOCs give you access to funds you can use to complete larger projects like home improvements.
- You can lose your home if you become unable to pay the loan back.
- Some HELOCs charge a fee if you do not draw a certain minimum of funds annually.
- If interest rates rise, you could end up paying a higher interest rate down the road compared with when you started because a HELOC is a variable-rate loan.
- When you reach the repayment phase, your required payments jump considerably. You need to be ready to be able to pay.
Every loan comes with its own pros and cons, disadvantages, and advantages. A HELOC can be very useful in certain situations. Talk to an advisor to see if applying for a HELOC makes sense for you.
The Risks of a HELOC
If your home decreases in value, such as in the crash of 2008, you could end up owing more money on your HELOC and mortgage than your home is now deemed to be worth. With a HELOC, there is also the risk of losing your home. If you don’t make the required payments, you could lose your home to foreclosure.
It’s important to make sure you are using your HELOC in a healthy financial way.
Experts advise that you do not use a HELOC loan to:
- pay for an expensive vacation
- consolidate credit card debt
- buy a car
- pay for college
- invest in real estate
It’s also risky to use a HELOC on your primary residence as a down payment on a second residence.
Some Alternatives to a HELOC
There are several alternatives to a HELOC. If you are looking for access to a loan, you might consider:
- A home equity loan
- A cash-out refinance
- A credit card with a 0% annual promotional interest rate
- A car loan through a local credit union on a car that is paid off
- A loan from your 401(k)
The Bottom Line
A HELOC can be a useful financial tool when used responsibly. One of the top reasons for accessing your home’s equity is to do home improvements or in a time of emergency. If you are considering a HELOC for some other reason, reflect on whether or not this may be a solid financial decision. It’s important to consider the risks when looking at HELOCs as your home is a valuable asset and worth preserving and protecting. A HELOC can be a great way to access low-interest credit and you should weigh the pros and cons when considering applying for one in order to do what is best for you.