What is a home equity line of credit (HELOC)?

Quick insights

• A home equity line of credit (HELOC) is a flexible borrowing option that allows homeowners to use the equity in their homes as collateral to access funds as needed.
• HELOCs can offer several advantages, such as lower interest rates compared to credit cards.
• When considering a HELOC, assess your finances and the repayment terms to decide what’s right for you.

Imagine you’ve recently renovated your kitchen and are now thinking about your next project. Your home’s value has increased, and you’ve built equity. You might want to consider a HELOC to fund your project. A HELOC could help you financially manage home improvements, unexpected expenses or even debt consolidation.

How does a HELOC work?

A HELOC functions like a credit card but is secured by the equity in your home. When you open a HELOC, you’re given a credit limit based on the value of your home minus any existing mortgage balance. You can then draw from this line of credit up to your limit as needed.

• Draw period: This is the initial phase, typically lasting 3-10 years, during which you can borrow from your HELOC and make payments. Loan providers may allow or require interest-only payments on the amount you draw. Some loan providers may offer an option to pay down the principal, as well.
• Repayment period: After the draw period ends, the repayment period can last 10-20 years. During this time, you can no longer draw from your HELOC and must start repaying both the principal and interest. Monthly payments are often higher during this phase because of that.

Example: You open a $30,000 HELOC. During the draw period, you use $15,000 for the renovation. You can still borrow up to your $30,000 limit during the draw period. In this example, this would be an additional $15,000 unless you paid down your principal and freed up more of your initial limit.

How much can you borrow with a HELOC?

Many lenders set the maximum borrowing limit for a HELOC at up to 80% of your home’s appraised value minus any outstanding mortgage value. For instance, if your home is worth $300,000, and you own $200,000, you could potentially borrow up to the difference between 80% of home value and the existing loan amount.

Requirements and qualifications for a HELOC

When applying for a HELOC, mortgage providers assess several factors to determine your eligibility. Here’s a closer look at the main requirements:

• Credit score: Terms and requirements vary by lender, but most may require a minimum credit score of 620. A higher credit score can improve your chances of approval and may qualify you for better interest rates.
• Credit history: Lenders will review your credit history to evaluate your ability to manage debt. A history of on-time payments and low credit card balances positively impacts your application.
• Loan-to-value (LTV) ratio: LTV ratio is the ratio of your mortgage balance to the appraised value of your home. For example, if your home is worth $300,000, and you owe $200,000 on your mortgage, your LTV ratio is 67%. Lenders may prefer an LTV ratio of 80% or lower.
• Income: Mortgage companies require proof of stable income, such as recent pay stubs, tax returns and other documentation of income.
• Employment: Steady employment or self-employment with consistent income is critical. Mortgage providers might ask for verification of your employment status and job stability.
• Debt-to-income (DTI) ratio: Your DTI ratio compares your monthly debt obligations to your gross monthly income. A lower DTI ratio may suggest better financial health and could improve your eligibility for a HELOC.

Variable interest rates in HELOCs

HELOCs have variable interest rates that can change over time based on market conditions. A variable rate on a HELOC is usually tied to an index, such as the prime rate, plus a margin set by the mortgage provider. For example, if the prime rate is 4% and your margin is 1%, your interest rate would be 5%.

• Pros: Variable rates often start lower than fixed rates, which could mean lower initial payments. If the market rates drop, your interest rate and payments may decrease.
• Cons: Payments can fluctuate, making it difficult to budget. If interest rates rise, your payments may increase significantly over time.

Is it a good idea to get a HELOC?

A HELOC can be a useful financial tool, but whether it’s a good idea will depend on your specific needs. Here’s a breakdown of key factors to consider and common use cases:

• Home improvements: HELOCs can be used to finance renovations or repairs, which may take some time. Renovations or repairs that have started before financing could potentially impact approval.
• Debt consolidation: Using a HELOC to pay off higher-interest debt could reduce your overall interest payments.
• Emergency expenses: A HELOC can provide a flexible source of funds for unexpected expenses like emergency home repairs.
• Education: Financing education costs can be beneficial, especially if it leads to higher earning potential.
• Down payment: Depending on how you’re able to access a HELOC, some or all of it may be used to fund a down payment on another property.

Advantages of a HELOC

Some of the advantages of getting a HELOC are as follows:

• Flexibility: You can borrow as needed up to your credit limit, which can be useful for ongoing expenses or renovation projects.
• Interest rates: Usually, HELOCs have lower interest rates compared to credit cards and personal loans because they are secured by your home.
• Interest-only payments: During the draw period, you often only pay interest on the amount borrowed, which could keep payments lower.
• Tax benefits: Interest on a HELOC may be tax-deductible if used for home improvements. Please consult with a tax advisor for specifics.

Potential drawbacks

• Potential for over-borrowing: The revolving nature of a HELOC might tempt you to borrow more than necessary, leading to higher debt and financial strain.
• Home as collateral: Failure to repay a HELOC could result in foreclosure. Ensure you’re confident in your ability to manage repayment to help avoid this risk.
• Fees and costs: There may be fees for initial setup, annual maintenance or early repayment. Understanding these costs can help you know the true expense of a HELOC.

What is the difference between a HELOC and a home equity loan?

A HELOC is a revolving line of credit with variable interest rates and flexible borrowing and repayment options. A home equity loan provides a lump sum with fixed interest rates and fixed monthly payments. HELOCs can be ideal for ongoing expenses, while home equity loans suit one-time large expenses. Chase does not offer home equity loans.

How to apply for a HELOC

When applying for a HELOC, you may want to consider a few factors such as your financial stability, equity in your home and long-term goals. Before you begin, make sure you have a stable income and strong credit history. You will also need sufficient home equity to qualify for a HELOC. An LTV ratio of 80% or lower is typically preferred by lenders. Evaluate if taking on additional debt aligns with your financial goals.

Below is a step-by-step guide to help you navigate the process of applying for a HELOC:

• Assess your needs: Determine how much credit you need and how you’ll use the funds. This will help you select the right HELOC terms.
• Check your credit: Review your credit report and score. Try to aim for a score of 620 or higher because this can improve your chances of approval and secure better terms.
• Calculate your home equity: Find out the current value of your home and subtract any existing mortgage balance to estimate your available equity. Existing mortgage balance could also include any open HELOCs or home equity loans. The estimate may give you an idea of your borrowing limit; however, a home lending professional may be able to provide a clearer estimate.
• Research lenders: Compare HELOC offers from different mortgage providers including banks, credit unions and online lenders. Look at interest rates, fees, terms and customer reviews.
• Complete the application: Apply with a loan provider of your choice. This can typically be done online, over the phone or in person.

Common mistakes to avoid when getting a HELOC

• Ignoring fees and costs: Be aware of potential fees such as application fees, annual fees and early repayment penalties.
• Overestimating your borrowing power: Avoid borrowing more than you need or can comfortably repay. Evaluate your needs and financial situation carefully before deciding.
• Neglecting to read the terms carefully: Fully understand the terms of the HELOC, including the interest rate, repayment schedule and other requirements.

In summary

A HELOC can be a powerful financial tool for homeowners seeking a flexible source of credit. HELOCs can be used to fund home improvements, consolidate debt or handle unexpected expenses. If you’re considering one, carefully assess how borrowing and repaying fits into your financial situation. With careful planning, you can effectively leverage your home’s equity to achieve your financial goals.