A home equity line of credit (HELOC) is a debt product that lets you tap into the equity you’ve built up in your home. It functions like a credit card, and you can borrow and repay funds on an as-needed basis during the draw period.
You’ll generally need good credit, a reasonable debt-to-income ratio and a sizable amount of equity in your home to qualify. Also, keep in mind that your home is used as collateral, which means falling behind on payments puts your home at risk of foreclosure.
How a HELOC works
When you’re approved for a HELOC, you’ll be given a credit limit based on your available home equity — typically you can borrow up to 85 percent of your home’s value, minus outstanding mortgage balances. During the established draw period, you can draw funds from the account using dedicated checks or a draw card. You’ll need to make minimum monthly payments on the amount you borrow, but as you pay back your HELOC, the funds are replenished. This draw period typically lasts 10 years.
After that, you’ll enter a repayment period, during which you’ll no longer be able to access funds and will instead repay the principal. Most HELOC plans let you repay the remaining balance over a period of 10 to 20 years.
How to qualify for a HELOC
Each lender will have its own requirements for getting a HELOC, but there are some general criteria that lenders will consider when deciding whether to approve your application.
- Equity in your home. Most lenders require homeowners to have at least 15 percent to 20 percent equity in their homes.
- Good credit. Homeowners with credit scores in the mid-600s and higher have the best chances of being approved for a HELOC. If you are approved with a lower credit score, you’ll likely get a higher interest rate.
- Debt-to-income ratio. Many lenders will look for a reasonable debt-to-income ratio, generally approving applicants with a ratio of 43 percent or lower. However, some lenders may approve you with a debt-to-income ratio of up to 50 percent. Be sure to calculate your debt-to-income ratio before applying.
- Adequate income. Before you can be approved for a HELOC, a lender will evaluate your annual income to ensure that you can afford your monthly payments.
- Responsible payment history. Timely payments demonstrate to lenders that you can responsibly manage your outstanding debt obligations. If lenders see a history of missed or late payments, they are unlikely to approve your application because your chances of defaulting on a new loan are higher.
Types of interest rates on HELOCs
You’ll almost always encounter variable interest rates with HELOCs, but a few lenders offer exceptions.
Variable interest rates
Like credit cards, HELOCs come with a variable interest rate, which means that your monthly payment will vary depending on the current interest rate and how much you borrow at any given time.
The variable interest rate on your loan is partly determined by publicly shared indexes, like the U.S. prime rate. The prime rate is set by collective financial institutions and is influenced by fluctuations in the federal funds rate (the rate that banks charge other banks for short-term loans).
Because the prime rate is affected by market and economic conditions, it causes your HELOC’s interest rate to increase or decrease over time. As interest rates change and you draw on your HELOC account, the monthly payment that’s due will also change. However, there is a legal cap on how much your rate can increase over the plan’s lifetime.
Fixed interest rates
Some lenders offer the opportunity to lock in a portion of your HELOC balance under a fixed rate, essentially converting part of your HELOC into a home equity loan. Companies that offer fixed-rate HELOC options typically let you repay that portion of the loan over a period of five to 30 years, though the balance must be repaid by the end of your normal HELOC repayment period. Companies may also let you have multiple rate locks in place at any given time.
Choosing to lock in a portion of your HELOC could be a smart financial move, given the current market conditions. With so much uncertainty, more consumers are moving towards fixed interest rates to minimize the cost of borrowing should they continue to rise over the course of your repayment period. If you’re interested in this option, look for companies advertising “hybrid HELOCs” or fixed-rate locks.
Why choose a HELOC over a home equity loan
A HELOC could be more ideal than a home equity loan if you want a flexible line of credit you can access on an as-needed basis. This affords you the ability to only pay interest on the amount you borrow. However, you’ll be responsible for interest on the entire home equity loan balance, even if you don’t use all the funds.
If you’re planning to cover a significant expense in the near future and want to have a pool of cash readily available, a HELOC may also be the better choice. That’s only if you don’t mind a variable interest rate (unless the lender offers otherwise) and a fluctuating monthly payment.