What is a home equity line of credit?
A home equity line of credit, or HELOC, is a second mortgage that gives you access to cash based on the value of your home. You can draw from a home equity line of credit and repay all or some of it monthly, somewhat like a credit card.
With a HELOC, you borrow against your equity, which is the home’s value minus the amount you owe on the primary mortgage. You can also get a HELOC if you own your home outright, in which case the HELOC is the primary mortgage rather than a second one.
Whether a HELOC is a secondary or primary mortgage, you could lose the home to foreclosure if you don’t make the payments.
How does a home equity line of credit work?
Much like a credit card that allows you to borrow against your spending limit as often as needed, a HELOC gives you the flexibility to borrow against your home equity, repay and repeat.
Most HELOCs have adjustable interest rates. This means that as baseline interest rates go up or down, the interest rate on your HELOC will adjust, too.
To set your rate, the lender will start with an index rate, then add a markup depending on your credit profile. Generally the higher your credit score, the lower the markup. That markup is called the margin, and you should ask to see the amount before you sign off on the HELOC.
Variable rates leave you vulnerable to rising interest rates, so be sure to take this into account. Look at the size of the periodic cap — how much the interest rate can change at any one time — and the lifetime cap — the highest interest rate you could be charged over the life of the loan — to get an idea of how high your payments could get.
On the plus side, as with a credit card, you only pay interest on the amount of money you use, not the total amount available to borrow.
» MORE: Compare current HELOC rates
How do you qualify for a home equity line of credit?
Lender requirements will vary, but here’s what you’ll generally need to get a HELOC:
- A debt-to-income ratio that’s 40% or less.
- A credit score of 620 or higher.
- A home value that’s at least 15% more than you owe.
How to get a home equity line of credit
The process of getting a HELOC is similar to that of a purchase or refinance mortgage. You’ll provide some of the same documentation and demonstrate that you’re creditworthy. Here are the steps you’ll follow:
- Determine whether you have sufficient equity, using a HELOC calculator.
- Once you have an idea of what you can borrow, shop HELOC lenders.
- Gather the necessary documentation before you apply so the process will go smoothly.
- Once you have pulled together your documentation and selected a lender, apply for the HELOC.
- You’ll receive disclosure documents. Read them carefully and ask the lender questions. Make sure the HELOC will fit your needs. For example, does it require you to borrow thousands of dollars upfront (often called an initial draw)? Do you have to open a separate bank account to get the best rate on the HELOC?
- The underwriting process can take hours to weeks, and may involve getting an appraisal to confirm the home’s value.
- The final step is the loan closing, when you sign paperwork and the line of credit becomes available.
How much can you borrow with a HELOC?
The maximum amount of your home equity line of credit will vary based on the value of your home, what percentage of that value the lender will allow you to borrow against and how much you still owe on your mortgage. Two quick calculations can give you an idea of what you might be able to borrow with a HELOC.
How do you pay back a home equity line of credit?
A HELOC has two phases: the draw period and the repayment period.
During the draw period, you can borrow from the credit line by check, transfer or a credit card linked to the account. Monthly minimum payments often are interest-only during the draw period, but you can pay principal if you wish. The length of the draw period varies; it’s often 10 years.
During the repayment period, you can no longer borrow against the credit line. Instead, you pay it back in monthly installments that include principal and interest. With the addition of principal, the monthly payments can rise sharply compared with the draw period. The length of the repayment period varies; it’s often 20 years.
At the end of the loan, you could owe a large lump sum — or balloon payment — that covers any principal not paid during the life of the loan. Before you close on a HELOC, consider negotiating a term extension or refinance option so that you’re covered if you can’t afford the lump sum payment.