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A home equity line of credit (HELOC) is a type of loan that uses your home as collateral. It’s meant for people who want to tap into their home equity for large purchases such as home repairs or medical bills, but who aren’t sure how much they’ll need at any given time. A HELOC works like a credit card where you can borrow up to a maximum amount much like a credit limit. If you’re looking for a flexible loan option, a home equity line of credit may be a suitable option.
- How Does a HELOC Work?
- Risks and Benefits of a HELOC
- What's Required to Qualify for a HELOC?
- What Does the Application Process Look Like?
- Considering Alternatives to a HELOC
How Does a HELOC Work?
Typically, a HELOC is divided into two phases: a draw period followed by a repayment period. When you get approved for a HELOC, your lender will grant you a maximum loan amount and enable you to withdraw money as needed during a set period. This phase is known as the draw period, which typically lasts for 5 to 10 years but can vary from lender to lender. You may borrow up to the maximum amount approved for the HELOC and the minimum payments you make only cover the cost of interest.
Once the draw period is over, you’ll enter into the repayment period. Generally, this period lasts around 20 years, but the timing can vary depending on the amount borrowed and how much the interest rate has fluctuated. You will pay down both interest and principal on the HELOC during this period. By the end of your repayment phase, your HELOC will be paid off.
Risks and Benefits of a HELOC
HELOC loans are popular because their interest rates are lower than many other types of loans. HELOCs offer great flexibility since they let you borrow as much or as little as you want over a period of time. Moreover, most lenders do not charge closing costs for a HELOC, which reduces the upfront expenses of obtaining credit. And finally, the interest payments on a HELOC may be tax deductible in certain circumstances.
These numerous advantages also come with some significant risks. The variable rate of a HELOC means that the interest may fluctuate throughout your loan. The interest you’ll pay is most commonly based on a benchmark rate, usually the federal funds rate. If the benchmark rate increases, so does your monthly payment. The fine print of your loan agreement often includes a maximum possible rate; keep in mind, however, that the size of your payments depends on how much you borrow as well as on the interest rate.
If you borrow too much or if interest rates increase more than you expected, your monthly HELOC payment could grow beyond your ability to pay. As with any loan, falling behind on your HELOC payments can damage your credit. In the worst-case scenario, your lender can foreclose on your home, since you will have put it up as collateral for the HELOC.
Even if your HELOC rate stays the same, you may still face an increase in monthly payments if you choose to make interest-only payments during your initial draw period. Although interest-only payments will minimize your monthly costs at first, making such small payments so early in the loan period may lead to a dramatic increase in your monthly costs once the loan enters the repayment period. At that point, you'll need to start paying back the principal as well as the interest. If you don’t budget for any monthly payment increases, you’re at risk of not being able to afford not only your loan, but your everyday expenses, too.
What's Required to Qualify for a HELOC?
Most lenders will require that you have at least 20% equity in your home. You'll have a hard time getting approval if your equity hasn't reached at least that level. Lenders also look at your credit record, which should show a credit score of at least 620 and a consistent history of on-time payments.
Other requirements by lenders include a debt-to-income ratio of at least 43% and loan to value ratio of 80% or less. These numbers describe the relationship between how much you earn or possess versus how much you owe to other lenders. If you do not fit these requirements, you may need to provide additional proof that you have the ability to keep up with your loans.
What Does the Application Process Look Like?
Before filling out an application, you’ll need to gather all required financial documentation. This includes your personal information, your employer’s contact, evidence of income for the previous two years, proof of homeownership and insurance, a mortgage statement, and any evidence of existing debts and liens on your home.
Once you’ve applied for a loan, the lender will review your financial profile and measure it against their requirements. The lender may ask for additional information and another appraisal on your home. The approval process can take anywhere from two to four weeks. If approved, you’ll sign closing documents and access to the funds will be ready within a few business days.
Considering Alternatives to a HELOC
HELOCs are relatively complex loans, and you may want a simpler solution that reduces your exposure to changing rates. A home equity loan works much like a HELOC, except that the loan is at a fixed interest rate, which means your monthly payments won’t change. Also, a home equity loan gives you a single lump sum instead of repeated withdrawals during the draw period. While this schedule offers less flexibility than a HELOC does, home equity loans are ideal if you already know how much you need to borrow. In addition, the predictable repayment schedule of a home equity loan can save you from the potential instability of HELOC payments.
If HELOC rates are too high for you, refinancing your mortgage for a higher loan amount may be a better alternative. In cash-out refinancing, you replace your current home loan with a new mortgage that borrows more than what you owe currently. Since there's more than enough money to pay off your old loan, you receive the remainder in a lump sum. A cash-out refinance follows a fixed rate structure, which results in lower rates and a stable monthly payment. However, mortgage refinancing does come with higher closing costs and a longer approval process compared to a HELOC. Alternatively, some lenders have begun offering convertible fixed-rate HELOCs which behave like a hybrid between a HELOC and a home equity loan.