What are HELOC mortgages?
If you own a home and are looking to borrow cash, consider yourself fortunate. You likely have a number of legitimate ways with which to procure funds for home remodeling projects, necessary repairs or other important needs such as consolidating debts.
For eligible homeowners, one of the most popular options to access cash is by opening up a home equity line of credit (HELOC). This means tapping into existing home equity by using your home as collateral and obtaining a second mortgage on your house. However, while a HELOC loan is considered a great way to get a significant amount of money through available assets at intervals of your choosing, it may not always be the best option for homeowners struggling to make current mortgage payments. That’s why it’s important to educate yourself on the facts.
In this article, we’ll go over what exactly a home equity line of credit is, who’s eligible and the difference between a HELOC and a home equity loan. We’ll even examine cash-out refinance as a way to access cash and discuss how that compares to a HELOC. As is the case in so many borrowing situations, your unique financial portrait, including established equity and an ability to stomach variable interest rates, will play a pivotal role in deciding if a HELOC is right for you.
What exactly is a HELOC?
A home equity line of credit or HELOC is a revolving credit line that relies on tapping into home equity to provide funds to homeowners. If you choose a HELOC loan, you are using your home as collateral and opening up a second mortgage; a second mortgage whose rates are likely variable and therefore may fluctuate significantly over the life of the loan, depending on market-based factors.
Also, with a HELOC, there exists a set period of time—typically up to 10 years—during which you can withdraw approved funds in any increments you see fit. This is called the draw period.
Most lenders provide you with a choice:
- A HELOC with an interest-only draw period; or
- A HELOC that allows you to make payments on both interest and principal. This option enables borrowers who can afford the weightier payments a way to more quickly pay off the line of credit (and re-establish home equity in the process).
Once the draw period is over, the repayment period begins. The repayment period is structured similarly to a typical home loan and can last up to 20 years. And just like a mortgage, borrowers are obliged to pay back the outstanding balance, as well as any interest.
HELOC and credit cards: A useful comparison
Many financial experts liken the HELOC to a credit card account. Major credit card companies, for example, will extend you a line of credit based on your financial profile (credit score, income, history of on-time payments, etc.). They also set a maximum amount—a credit limit—that you cannot exceed.
Most people don't automatically max out their credit card on day one, and the same is true for those who open up a HELOC. It’s not about the lump sum; it’s about an accessible line of credit that you can return to at intervals during the draw period to obtain necessary cash up to a pre-established limit. The flexibility is what’s so attractive. Also: You only pay interest on the money you end up actually borrowing—not on the amount of credit extended to you.
A note on home equity
Home equity is achieved by paying down the principal in the form of monthly payments to your mortgage lender. In addition, remember that down payment that you provided at the time of original purchase? That also builds equity; the more you put down, the less the outstanding balance on your mortgage and the greater the equity.
Appraisals and home equity
There’s also the appraised value of your home to take into consideration. If you purchased a house for $200,000 and it’s now worth $300,000, then you’ll not only receive a nice financial windfall when you decide to sell, but you’ll also be able to tap into an ever-increasing amount of home equity in the interim.
Of course, getting an appraisal comes with its own built-in caveats, namely the fact that you don’t know for sure that the licensed appraiser will necessarily issue an assessment that increases your home value. Appraisals are based on numerous factors and often rely on complex formulas to calculate value. There are no foregone conclusions with appraisals; therefore, you should think carefully before ordering one. The last thing a borrower-in-need wants is for home equity to decrease.
HELOC and interest rates
We’ve established that HELOC loans are made possible through tapping into home equity, but how much will this type of loan cost you and what kind of rates can you expect for the opportunity to borrow money off the value of your home?
While it is possible to find a fixed-rate HELOC (which is more of a hybrid between a HELOC and a home equity loan), these loans are typically obtained with a variable interest rate. Certainly, this could mean your interest rate will decrease in the years ahead when it comes time to paying back the loan; however, it could also mean the opposite: Having to pay back the loan at an interest rate much higher than the prevailing rates available when the loan was agreed upon.
Another option: Home Equity Installment Loans (HEIL); these are loans that afford you a one-time lump sum with an amortizing (P&I) repayment structure and generally a fixed rate.
As savvy homeowners know, to secure the best rates you’ll have to possess a high level of creditworthiness—the same high level that borrowers are typically asked to demonstrate during the initial homebuying process or when choosing to refinance. In other words, credit scores matter, income matters and so does existing debt.
The exact interest rate offered to you is also tied to the Prime Rate, which might be referred to as the prevailing index rate. However, this is rarely the whole story. From here, borrowers can expect a markup from their lender. This is where the above mentioned factors including credit score play a role. The markup is called a margin, and it’s the margin plus the index rate that ultimately determines the specific rate offered to you.
Note: For most HELOCs, the rate offered is merely the introductory period rate. While rate determination ultimately rests in the hands of the lender, ideally you want to obtain the longest and lowest introductory rate possible. Why? Most borrowers wisely want to limit their exposure to potentially high variable interest rates in the years to come.
Qualifying for a HELOC Loan
Just because you own a home and have begun making payments doesn’t mean you automatically qualify for a HELOC. Let’s take a look at some key factors that are evaluated when determining HELOC eligibility:
- Credit score
- Debt-to-income ratio (DTI)
- Available home equity
Banks, mortgage companies and other lenders can never say enough about the importance of credit scores when it comes to loan approval and obtaining preferred interest rates. For HELOCs, most lenders require a minimum score of 620, although to lock in the best rates, many lenders look for a score over 740. There are no last-minute fixes for credit scores so it’s always wise to check your score regularly and be sure to fix any errors you see.
Debt-to-income ratio (DTI)
Lenders determine your debt-to-income ratio by dividing pretax income by monthly recurring debts. Generally speaking, most lenders prefer to see DTI reflected as a percentage that’s 43% or less, although some lenders are fine with DTI approaching 50%. DTI is important because it helps lenders understand which applicants possess the financial wherewithal to take on regular monthly payments.
In the context of a HELOC, this number is incredibly valuable because a home equity line of credit is a second mortgage. As such, the lender of the HELOC knows that in the event of foreclosure, they will be paid back after the lender of the original mortgage, reducing their chances of full repayment.
Available home equity
Having equity in your home is the most important factor; without available equity, the very idea of a HELOC is a nonstarter. To qualify for a HELOC, the amount you owe on your home must be less than the value of your home.
In the absence of a true HELOC calculator, let’s take a look at a common industry formula for determining home equity:
- Value of home x Percentage of value lender allows you to borrow = Maximum amount of equity that can be borrowed
- Maximum amount of equity that can be borrowed x Remaining mortgage balance = Total amount you are eligible to borrow
Let’s look at an example. If you own a $300,000 home and between the down payment and monthly payments have paid back $100,000 so far, you will be left with a balance of $200,000 on your initial mortgage.
Most lenders will allow you to access up to 85% of your primary home’s value. Following the formula, if you multiply the home value ($300,000) by the percentage the lender will allow you to borrow (.85), you are refunded a maximum amount of $255,000 in equity that is potentially available for borrowing. But we still haven't taken into account your balance.
From here, you would subtract the outstanding balance ($200,000), which gives you $55,000. This is the amount you could be allowed to borrow through a HELOC.*
HELOC vs. home equity loans
Although both HELOCs and home equity loans rely on leveraging equity to borrow money, they are very different types of loans with different interest rates and different payment terms.
First of all, a HELOC is a revolving loan, which means payments on the principal can replenish the amount of money eligible to borrow. A home equity loan works more like a conventional mortgage with consistent monthly payment terms. Let’s take a closer look at some of the contrasts:
- Variable but lower interest rates (mostly)
- Monthly payments that vary
- Access cash on an as-needed basis
- Interest-only payment during draw period; pay back principal + interest during repayment period
Home equity loans
- Fixed but higher interest rate
- Consistent monthly payments
- Money provided as a lump sum
- Repayment starts as soon as loan is disbursed
HELOC vs. cash-out refinance
A cash-out refinance is another way to access funds and it also relies on leveraging home equity. However, as a type of refinance, there is more documentation required, greater closing costs and an understanding that you will be measurably extending the timeframe for paying off your mortgage. Most lenders require your LTV (loan to value) ratio to be no higher than 80%; anything above this translates to a level of risk many banks and mortgage companies are unwilling to take.
While always dependent on market conditions, a cash-out refi tends to have lower interest rates than a HELOC. Unlike a HELOC, however, a cash-out refinance usually only allows you to access up to 80% of your home equity. The money is always disbursed as a lump sum and can be used for whatever purpose you deem necessary.
An interesting note on tax deductions: As a type of mortgage, your cash-out refinance may enable you to deduct tax on the mortgage interest you pay if the loan is used for a capital improvement on the property.** For a HELOC, the interest may be tax deductible if the money is going towards home renovations. Always check with your lender for the exact details on specific financing matters.
For homeowners with established equity, obtaining a home equity line of credit or HELOC can be a convenient and resourceful way to access significant cash on an as-needed basis. Certainly, there are other methods to obtain funds for home renovation projects such as a 203(k) loan; however, a HELOC provides borrowers with both the flexibility to use their line of credit as they see fit and the flexibility to use as little or as much of the approved line of credit at a time of their choosing.
When it comes to financing and borrowing money, there are many competing products available for today’s homeowner. While it can be advantageous for some borrowers to leverage home equity to obtain cash, not everyone is comfortable doing that. Sometimes a personal loan makes more sense for small projects and debt consolidation. As a prudent borrower, it’s always best to have a frank conversation with your lender and chart a course that makes sense for you.
*Sample scenario provided for illustration purposes only and is not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. Guaranteed Rate, Inc. cannot predict where rates will be in the future.
**Guaranteed Rate does not provide tax advice. Consult your tax advisor with all tax-related questions.