How does a HELOC work?

When you have big expenses, it’s good to know your financial options. Many people don’t know that a home equity line of credit is a way to get the cash you need when you need it. So, what is a home equity line of credit and how could it help you? We share the ins and outs of this financial option.

What is a home equity line of credit?

A home equity line of credit, or HELOC, is an “on-demand” loan that leverages the equity in your home. Your home equity is the difference between your home’s market value and the remaining balance on your mortgage. If you put a good amount down on your home and you’ve been making payments for a few years, you probably have a lot of equity in your home to borrow against. 

(HELOCs are different from home equity loans that allow you to borrow against the equity in your home by taking a lump sum.)

When could you use a HELOC?

A HELOC is helpful when large expenses come your way, whether they’re planned or unexpected. It’s common to use a HELOC to pay for home repairs and remodels. However, most people don’t realize that a HELOC can also be used for debt consolidation, medical bills, or any other big-ticket items. With a HELOC, you could get a low interest rate and flexible low monthly payments, which is why it’s ideal for big expenses.

Instead of cashing in valuable investments or dipping into your savings, a HELOC could be a good alternative. It’s important to take a look at the possible interest rate on your HELOC and compare it to your investment returns to help you make the right decision.

How do HELOCs work?

A HELOC allows you to borrow from your home as a line of credit, similar to a credit card. Once you open a HELOC, you can borrow what you need, when you need it, until you reach your credit limit. You control how much you borrow, and unlike a loan, you only pay on what you spend. So, like a credit card, you have a line of credit that’s there as you need it. If you don’t use it, it’s still there, just in case.

HELOCs have a draw period and a repayment period. Here is a summary of how those two time periods work when you open an Alliant HELOC:

• Draw period. You can spend against your line of credit for the first 10 years, known as the initial draw period. During that time, your payments will be interest-only and are based on only what you’ve borrowed (you don’t pay on your entire credit limit). Also, although the loan is set up so you only have to pay interest during the draw period, you can choose to also pay off any amount of your principal if you choose during this time, because we won't penalize our members for making the smart money move of paying off their loan early. Such interest-only HELOCs can be a good option if you anticipate needing funds and want lower, interest-only payments initially. As you pay down your balance, the amount you’ve paid off become available for use again. 
• Repayment period. After that 10-year draw period is the repayment period, which is typically 20 years. During the repayment period, you’ll pay both principal and interest, so your payments may be higher than during the draw phase.

Fixed rate vs. variable rate HELOCs

The majority of home equity lines of credit have variable interest rates.  A lender will adjust the rate based on the prime rate. The amount of times an interest rate will change depends on the lender. Some lenders only adjust their interest rates once a year while others adjust their interest rates monthly. If you want a greater sense of security with a variable rate, look at the fine print to see if how often the rate changes.

It is very uncommon to see a HELOC with a fixed interest rate. With a fixed rate, your monthly interest rate payments will stay the same whether the prime rate moves up or down.

Do you pay closing costs on a home equity line of credit?

Not every HELOC is the same, and you don’t have to get a HELOC from the same bank where you have your mortgage. The closing costs for a home equity line of credit could average up to 5 percent of your overall loan. However, there are many lenders who don’t have closing costs on a HELOC. Although closing costs of 2 to 5 percent are lower than a mortgage, these costs could make a significant impact on your wallet.

When shopping around, look for a HELOC with no closing costs, application fees or appraisal fees in addition to hunting for the best interest rate.

How to qualify for a home equity line of credit

Typically, you’ll need to meet the following requirements to qualify for a home equity line of credit:

Equity in your home

The more equity in your home, the higher line of credit you could potentially have.

If you’re wondering, "how much equity do I have?", you can either take your home’s market value minus your remaining balance, or add up the payments to your principal and your down payment. For example, your home has been appraised for $850,000 and you still owe $600,000 on your mortgage. The equity in your home is $250,000.

Why is equity important? The equity in your home determines your loan-to-value ratio (LTV), which lenders use to help determine your line of credit. Each lender has a different LTV they’ll provide. Some will go up to 90 percent. To determine the maximum amount of credit you could get on your HELOC, you could do some simple math:

LTV = (Home equity line of credit + mortgage balance) / home’s market value.

In the example above, the highest line of credit you could get is $165,000 with an LTV of 90 percent. However, it’s important to remember that there are other requirements that will determine how big your line of credit is.

Low debt-to-income ratio

A quick way to calculate your debt-to-income ratio, or DTI, is to divide your monthly debt payments by your monthly gross income. You will usually see your debt-to-income ratio as a percentage. A good debt-to-income percentage is anything below 15 percent. As a rule of thumb, you shouldn’t let your DTI go above 36 percent.

Good credit score and a history of making payments on time

On the FICO scale, a score of 670 or higher is categorized as a “good” rating. Scores above 740 are considered “Very Good” or “Exceptional.” If your score is lower than these ratings, then take a look at how a credit score is calculated to help you move that number even higher. Scoring an even higher credit score can help you to qualify for a great home equity line of credit.

Property insurance

Many lenders require property insurance as well as flood insurance in some cases. When you apply for a HELOC, you may need to provide documentation that you have property insurance on your home.

A home equity line of credit is a great option to have, whether you want to have it open as a safety net or you have a specific expense in mind.

Katie Levene is a marketer fascinated with finance. Whether the topic is about the psychology of money, investment strategies or simply how to spend better, Katie enjoys diving in and sharing all the details with family, friends and Money Mentor readers. Money management needs to be simplified and Katie hopes she accomplishes that for our readers. The saying goes, "Knowledge is Power", and she hopes you feel empowered after reading Money Mentor.