A home equity line of credit (HELOC) allows you to borrow against the equity in your home. It’s a revolving line of credit, similar to how a credit card works.
Know This:
- A home equity line of credit (HELOC) is a revolving line of credit that borrows against the equity in your home.
- HELOCs have variable interest rates that depend on the market.
- The loan amount you qualify depends on your combined loan-to-value ratio, or CLTV.
- A HELOC can get you cash fast, but you may put your home at risk. Tread carefully.
Using a HELOC, which is a type of second mortgage, can work in your favor if you need money fast and can get a good interest rate. But it’s not always the best option, so do your research before committing.
You can use it for anything – home renovations, emergency situations, paying off debt, etc.
What’s the difference between a HELOC and a home equity loan?
Both of these lending methods draw on the equity of your home. A home equity line of credit (HELOC) is a revolving line of credit with a variable interest rate, so the interest you pay depends on the market. This could be good or bad depending on the circumstances.
A home equity loan works more like a personal loan. You get a percentage of your equity in a lump sum. Payment terms are usually between 5 and 30 years. They’re usually used for one-time expenses and they have a fixed interest rate. Additionally, many home equity loans have closing costs. These are rare for HELOCs.
Why would I get a Home Equity Line of Credit (HELOC)?
You need money fast.
You may want to consolidate your credit card debt before the interest charges get too high. Or you may want to do some expensive renovations on your house. Whatever you want to use the HELOC for, you need money in the short term. (You can have a HELOC in 30 to 45 days.)
You can’t qualify for other loans.
If you have a lower credit score, you may not be able to qualify for a personal loan. Or, if you do qualify, your interest rate may be too high to handle.
In normal economic circumstance,s you may still qualify for a HELOC even with a weak credit score because your home is used as collateral to secure the credit line. There might be higher interest rates attached, but at least you would get the loan.
Ask the Expert: Is HELOC a good idea right now? »
How do I qualify?
This depends on your combined loan-to-value ratio, or CLTV. Banks usually have a maximum CLTV that determines how much you can borrow.
For example, let’s say you find a bank that offers a max CLTV ratio of 75%. Your home is worth $250,000, and you still owe $95,000. Here’s how you would calculate how much you can borrow:
(Max CLTV) x (Value of your home) = (CLTV value)
0.75 x $250,000 = $187,500
(CLTV value) – (What you currently owe) = (How much you can borrow)
$187,500 – $95,000 = $92,500
As you can see, in this scenario you could borrow up to $92,500. That’s a large amount of money, and you definitely shouldn’t feel pressured to take it all.
The interest rate you qualify for depends on your credit score, income, and other personal financial factors.
NOTE: Many banks have stopped offering HELOCs during the coronavirus pandemic. Check with your lender to see if it’s still an option for you. For other options, see our section on HELOC alternatives.
Talk to a certified debt professional about the best debt relief solution for your situation.
The two phases of a HELOC
Draw period
The draw period is the first phase of a HELOC. During this time, which is 10 years long, you make interest-only payments with variable interest rates. Your bills will be smaller than in the repayment period.
Repayment period
When this phase comes, payments can nearly double. During the repayment period, you start paying back the principal and interest. You can sometimes establish a fixed interest rate during this time.
Ask the Expert: Can I improve my HELOC loan rates? »
Benefits and drawbacks of a HELOC
Pros
One benefit of a HELOC is that if you itemize deductions, you can write off some of the interest you pay on that line of credit. This tax deductible can make the process easier on your wallet.
HELOCs also aren’t usually as expensive as other types of credit lines or loans. Even though the interest rate is variable, it’s still often lower than what you would get with a credit card or personal loan.
Cons
If you can’t pay back what you owe on the HELOC, you risk losing your home. You could suffer a foreclosure. This is one of the many reasons not to use a HELOC if you can’t afford it.
You could end up taking out too much money. Depending on how much of your mortgage you’ve already paid off and how much your bank allows you to borrow, you could take out tens of thousands of dollars — perhaps even hundreds of thousands.
There is also a risk of going “underwater.” This happens when you have a higher-than-average CLTV ratio and the real estate market drops. You end up owing more than the home is worth.
Alternatives to a home equity line of credit
If you need to pay off debt…
You may be looking into HELOCs because you’ve heard you can use it to pay off your debt. Here are some alternatives that may suit your situation better:
Debt consolidation loan
A debt consolidation loan is a personal loan you use to pay off all of your debts. This consolidates all of your payments into one monthly payment, usually with a lower interest rate. If you have a good enough credit score to qualify for one of these loans, this could be less risky than a HELOC.
Debt management program
A debt management program (DMP) is a repayment plan you can enroll in with the help of a credit counselor. After a free consultation with a certified credit counselor, they will point you toward the right debt solution for you. This could be a DMP.
Basically, a DMP rolls all of your monthly payments into one, while minimizing interest charges to get you out of debt faster. If you can qualify, this is one of the best options for debt relief since it leaves your credit score intact.
Debt settlement
Settling your debt means agreeing to pay less than what you owe. You can negotiate settlement on your own or get professional help. Your credit score will take a hit.
Bankruptcy
If you have too much debt and you don’t think you will ever be able to repay it, bankruptcy could be the right choice for you. It will hurt your credit score, but it allows you to hit a financial reset button without risking your home.
If you need money fast…
You could be looking into a HELOC because you need access to money fast. Here are some other options to get the cash you need:
Home equity loan
Another type of second mortgage, a home equity loan also borrows against your home, but it has a fixed interest rate and you get it in a lump sum. Depending on your situation and how much money you need, this could be a better option.
Personal loan
A personal loan can help you cover big expenses without digging into your home equity. If you have a good credit score, you are more likely to qualify for a low interest rate and a higher borrowing amount. Consider this before jumping straight into a second mortgage.
Cash-out refinance
To use this method, you basically take out a new mortgage for more than you currently owe, pay off your current mortgage, and get the difference in cash. Like a HELOC, a cash-out refinance comes with the risk of going underwater or losing your home. Consider a cash-out refinance carefully.
401(k) loan
It’s not advisable, but you can dig into your retirement funds and borrow from your 401(k). It will get you money fast but it’s risky and comes with extra costs.
Borrowing against a life insurance policy
If you have a life insurance policy, you can borrow from it and repay it with interest. Monthly payments aren’t mandatory and it’s tax-free. However, failing to repay the loan with interest can cause a lapse in your life insurance policy, so it isn’t completely risk-free.
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Watch out for HELOC fraud
Home equity lines of credit are susceptible to fraud. Identity thieves can raid your HELOC account and take advantage of the revolving credit for themselves. Take steps to protect yourself from identity theft and check your credit report often.
Usually, thieves target homeowners who already have a HELOC. But all homeowners with equity could be susceptible.
If you notice suspicious activity on your credit report concerning your HELOC account, you may want to contact a real estate attorney.
