Personal Finance 101: What the HELOC Is a Home Equity Line of Credit?

Many homeowners use a home equity line of credit to finance big remodeling projects, like installing a new bathroom — but you’re not required to use the funds on your house. Photo: Cheryl Marland

Need access to a lot of cash at an interest rate much lower than credit cards? Do you still want the flexibility to take only as much as you need, when you need it? A home equity line of credit, or HELOC, can deliver these advantages.

Of course, a HELOC also has disadvantages — we’ll cover those, too. We’ll also discuss other HELOC basics, including where and how to get them, why you’d use them, the differences between HELOCs and traditional home equity loans, rates, and fees.

What Is a Home Equity Line of Credit (HELOC)?

A HELOC functions much like a credit card. You have a set credit limit that you can borrow against — or not — when you want as long as you have credit available, typically via a card or checkbook. So if you need $1,000 for a small home project now, $3,000 in a few months, and $5,000 at the end of the year, a HELOC can give you that flexibility.

HELOCs typically have low interest rates because your home equity is collateral, drastically reducing the bank’s risk. Note that your interest rate will typically be variable, meaning it fluctuates with the market. Interest is tax-deductible up to $100,000 no matter what you use the HELOC for, or $1 million if the money is used exclusively for home improvements.

Why Would I Use a HELOC?

You can use the money from a HELOC for anything, but that doesn’t necessarily mean you should. Projects that will raise your home’s value are the best use for a HELOC. These would absolutely include any necessary improvements — say, a new roof or water heater — and, to a lesser extent, updates that will recoup most of their value, such as a kitchen remodel.

• Related: What Common Home Repairs Cost, and How to Budget for Them

Debt consolidation is another popular use for a HELOC. While paying off debt with a HELOC is understandably appealing, it’s also risky. Though you’ll be left with one monthly payment that is likely much less than the total of all your previous payments (especially if you opt to make interest-only payments, as your HELOC will initially allow), remember that you still owe the same total in the end. You also must be willing to change your old habits. That means not racking up more debt because you suddenly have breathing room in your budget again — especially because with a HELOC, your house is on the line if you don’t pay.

Some people also use a HELOC as an emergency fund. After all, it’s easy to access a large amount if you need it, so why not? Well, if you can afford to pay back the funds relatively quickly and only use the money for a true emergency, it can work. However, saving up your own money for an emergency fund is vastly preferable. You don’t want to pay interest for years just because you needed funds in a pinch, and you certainly don’t want to lose your home because of it.

While tempting, it’s best not to tap a HELOC for big discretionary purchases like a vacation or a shiny new boat. Save up the old-fashioned way so you won’t still be paying for that boat once it’s a rusted-out heap in your backyard, or even worse, lose your home because you can no longer afford it.

How Is the Amount of My HELOC Determined?

Banks determine the limit on your home equity line of credit by using two crucial numbers: the value of your home and the amount of any loans you’ve already made against it.

Let’s look at an example. Say your home is worth $300,000. Lenders will typically take 80% of this value (in this case, $240,000) and then subtract the value of any outstanding home loans. So if you owe $150,000 on your primary mortgage, the bank will subtract that from $240,000. That means you may be offered a HELOC with a credit line of $90,000.

Why don’t lenders use 100% of your home’s value when they’re figuring out how much to lend? That’s because they typically want to keep your loan-to-value ratio, or LTV, at no more than 80%. LTV is simply the loans you have on your house divided by its value. In the example above, you add both loans, $150,000 and $90,000, to get $240,000. Divide by $300,000 and you get 0.8, or 80%.

The higher your LTV, the more at risk you are of defaulting on your home loans. In the event you do default, the lender also wants some equity remaining to help cover the cost of foreclosing on and reselling your home.

How Do I Repay the Money I Use From My HELOC?

HELOCs typically have two payment-related time frames to note. The first, called the draw period, usually lasts for five or 10 years. This is the time when you can borrow whatever you need from your HELOC. During this time, you’ll usually only be required to pay the interest on the money you borrow.

The second period, called the repayment period, typically lasts 10 to 20 years after your draw period. During the repayment period, you can no longer borrow from your HELOC. Instead of making interest-only payments, you’ll have to pay back both the principal and interest on whatever outstanding amount you borrowed.

How Are HELOC Rates Determined?

As I mentioned above, most HELOCs have a variable interest rate that fluctuates based on the market. Your rate will typically be a set margin plus an index such as the prime rate, and when that rate goes up or down, your HELOC rate will, too.

While the amount of equity you have in your home will help determine how much you can borrow; the initial rate you’re offered will depend on other factors. Chief among them are your credit score — the higher the better — and your debt-to-income ratio, or DTI. Lenders typically want to see DTI at 40% or below, which means you spend no more than 40% of your monthly income paying down debt.

Two types of interest-rate caps can protect you when you have a HELOC. The first, called a lifetime cap, is required by law and simply sets a ceiling for your interest rate during the time you have the HELOC. The second, called a periodic cap, limits the amount your interest rate can rise each time it’s adjusted.

What Kind of Fees Can I Expect on a HELOC?

Read the fine print, because a range of fees can come into play. I’ll discuss some of the most common below.

• Annual fee: Sometimes called a membership fee or maintenance fee, you’ll pay this every year simply to retain access to your home equity line of credit, even if you haven’t used it. Up to $75 is common.
• Application fee: Some lenders will charge you simply to apply for a HELOC. This fee may help defray the cost of a home appraisal, obtaining a credit report, or other loan processing.
• Cancellation fee: Your lender may charge up to $500 if you want to cancel your HELOC because you’ve refinanced or sold your home.
• Closing fees: Substantial closing costs are less common for HELOCs than traditional home equity loans, which often include fees related to title searches, attorney costs, document preparation, and other related costs. Many HELOCs advertise no closing costs; make sure yours is one of them.
• Inactivity fee: Your lender may charge $100 or so if you don’t use your HELOC for a certain period of time, such as once in a year.
• Transaction fee: A fee may apply whenever you take money from your HELOC.

Remember that fees are negotiable and different lenders will charge different fees. If you think a fee is unfair, or better yet, you know a competitor isn’t charging a similar fee, ask for it to be removed. For instance, MyFICO recommends at least asking for the removal of annual fees, inactivity fees, cancellation fees, and any closing costs. If your lender refuses, you can then decide whether it’s worth it to take your business elsewhere.

How Is a HELOC Different From a Traditional Home Equity Loan?

If you’re considering a HELOC, chances are you’ve also looked into traditional home equity loans. Though both products use your home equity as collateral, the similarities mostly end there. Here’s a quick glance at the major differences between a HELOC and a home equity loan:

	HELOC	Home equity loan
Payout	As much as you need up to your credit limit, whenever you need it, during draw period	One lump sum immediately after being approved
Interest rate	Variable (fluctuating rate index plus fixed margin)	Fixed for life of loan
Repayment	Interest only during draw period, principal and interest during repayment period	Fixed payments of principal and interest for life of loan
Closing costs	Usually minimal	Similar to primary mortgage

 

Make sure you fully consider whether a home equity loan might be a better choice for you before committing to a HELOC. For instance, if you just need money to pay for one large project, the lump sum might be a better fit, and you won’t have the temptation of more cash for years after you really need it. And if you’re risk-averse, you may appreciate knowing what you’re getting into with a home equity loan’s fixed rate and payments, which are easier to budget for.

What Are the Advantages and Disadvantages of a HELOC?

Still on the fence about whether a HELOC is a good move for you? We’ve alluded to some of the pros and cons of a home equity line of credit throughout this article, but here are the main points to consider in one spot:

Advantages

• Flexibility: Maybe you’re embarking on a big, long-term home renovation and your costs will be ongoing. A HELOC lets you use the money you need when you need it.
• Low rate: Using your home as collateral means your HELOC will have a lower interest rate than other types of credit or loans. And since you’re accepting some risk in the form of a variable interest rate, your initial rate is going to be lower than that of a fixed-rate home equity loan.
• Interest-only payments: Not only will you have a low rate, but you’ll only need to pay the interest on your HELOC during your draw period, lessening the impact on your budget.
• Tax benefits: Uncle Sam will let you deduct HELOC interest from your taxes. If you use your HELOC only for home improvements, you can deduct up to a whopping $1 million in interest. If you use it for other purposes, you can still deduct up to $100,000.

Disadvantages

• Harder to budget for payments: A HELOC’s variable interest rate means you won’t be paying the same thing month after month.
• Interest rates could rise: In a year or two, your tempting introductory rate will be a distant memory. And depending on what the market does, HELOC rates could continue to climb.
• You need the discipline to plan ahead: While interest-only payments may feel like a pro during the draw period, you need to plan for the repayment period, too. That’s when you must start paying back the principal on your HELOC, too, which means a massive jump in payments. Failing to budget for this substantial change has left many homeowners in serious financial distress.
• Lots of fees: Depending on your lender, using (or not using) your HELOC may come with a lot of fees that you wouldn’t face using some other forms of credit. These can add up, particularly if you only borrow small amounts.
• Your house is on the line: If something happens that threatens your ability to repay — for instance, you lose your job or have an expensive medical emergency — you risk far more than your credit score. You could lose your house if you fall behind on HELOC payments.

Where Do I Look for the Best HELOC Rates?

You can find a HELOC on offer at just about any bank or credit union, but consider using an online search tool such as LendingTree to begin comparing HELOC rates. Answering a few questions about your home’s value, your outstanding home loans, and what you want to borrow will leave you with several personalized offers. You may find a good fit among them, but if not, you still have a valuable starting point for a wider search.

Wherever you search, make sure you keep the following strategies in mind as you decide on a HELOC:

• Shop around. Love your bank? Great. But they may not offer the lowest HELOC rates. If you find a better deal, maybe they’ll beat it to keep you — but maybe not. Don’t forget about credit unions, too, since lower overhead can lead to savings.
• Get your finances in shape first. If you have the luxury of a lot of time to shop for a HELOC, raise your credit score and pay down any unnecessary debt before applying. Even though a HELOC is secured by your house, your current financial situation is still at play.
• Compare fees. They can add up. Remember that you may not be able to negotiate your interest rate, but fees are fair game. You shouldn’t have to pay, for instance, if you don’t want to use your HELOC every year, if you want to pay back the money you’ve used early, or if you need to cancel the line of credit.
• Watch for the teaser. If that low interest rate seems too good to be true, make sure you know whether it’s a teaser — that is, an introductory interest rate that will go up after a year or so.

For more advice on tapping your home equity, see The Simple Dollar’s previous articles on HELOCs and home equity loans:

• Best Home Equity Loan Rates in 2015
• Best Home Improvement Loans
• Need a Home Equity Loan? Answer 3 Questions First
• How to Use a Line of Credit to Your Advantage

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