What is a Home Equity Line of Credit (HELOC)?     

A home equity line of credit (HELOC) is a revolving line of credit secured against the borrower’s home equity. HELOCs are the most popular home equity product in the United States. According to TransUnion, more than 1.2 million HELOCs were originated in the US in 2017, compared to 800,000 home equity loan (HEL) originations and 600,000 cash-out refinance originations.

Home equity is the difference between a home’s fair market value and the outstanding balance of all liens (such as mortgage balance). Let’s say hypothetically that a person’s home is worth $300,000 and they owe their mortgage lender $100,000. In this instance, the home equity would be $200,000. A HELOC loan would allow them to borrow against a portion of that equity. 

HELOCs and Home Equity Loans (HELs) are both types of home equity borrowing, with one major difference between them. A HELOC is a revolving (or open-end) line of credit where the borrower can keep withdrawing money up to a pre-agreed credit limit. A HEL is a term loan where the lender pays the borrower a lump sum and the borrower must pay it back over a fixed term.

How Does a HELOC Loan Work? 

A HELOC loan consists of a term (also known as a draw period) followed by a repayment period. The draw period typically lasts 5 or 10 years. During this period the borrower can draw as much as they like, so long as they don’t exceed the credit limit. Usually, the borrower is required to make minimum, interest-only payments during the draw period. The borrower may also make payments toward the principal if they wish.

Once the draw period ends, the repayment period begins. The repayment period typically runs for 10 to 20 years, although some lenders offer the option of paying everything back in a lump sum (balloon payment). The payment period on a HELOC works much like the payment period on a regular loan. During the payment period, the borrower pays back the money borrowed (principal) plus interest in equal monthly instalments.

How to Apply for a HELOC

A HELOC loan application is similar to a regular mortgage application, with one important exception: when applying for a HELOC, the borrower must meet loan-to-value requirements.

Here are the main criteria for qualifying for a HELOC:

• Credit score: Like any other loan application, the lender will run a hard credit query. The minimum credit score is usually around 620, although it varies from lender to lender.
• Income: Just like a mortgage, the lender will want to check your income and employment history in order to verify your creditworthiness. The lender will use this information to calculate the maximum possible credit limit. Most lenders allow a maximum debt-to-income ratio of up to 43%-50%, with DTI representing the percentage of your gross monthly income that goes to payments.
• CLTV: When it comes to applying for a HELOC, the most important factor is CLTV, or combined loan-to-value ratio. Most lenders allow a maximum CLTV of 80% or 90%, meaning you can borrow up to 80% or 90% of your home’s value. The catch is that the lender factors in any existing liens. Let’s say your home is worth $200,000 and your mortgage balance is $100,000. In this scenario, your existing LTV is 50%. In this case, you may borrow up to $60,000 to $80,000 against your home equity, bringing your CLTV to 80% or 90%.

Fixed vs Variable Rate HELOCs

HELOCs typically come with an adjustable (or variable) rate, as opposed to HELs which come with a fixed rate. In recent years, an increasing number of lenders have begun offering fixed-rate HELOCs and hybrid HELOCs with an adjustable-rate portion and fixed-rate portion. However, adjustable-rate HELOCs are still the norm.

There is no right or wrong answer to the question of “variable rate vs fixed rate HELOCs.” The best option depends on the borrower. If you value convenience or a lower introductory rate, a variable rate may be best for you. If you guarantee certainty and stability, a fixed rate may be best for you.

When federal interest rates go up or down, lenders adapt by increasing or decreasing their own rates. With a fixed-rate HELOC loan or HEL, the lender cannot change the borrower’s rate because they have already committed to maintaining the same rate for the entire term of the loan. When rates go up, the lender—not the borrower—absorbs the difference. 

With a variable rate the lender may change the borrower’s rate at a pre-agreed interval of, say, 1 or 3 years. Therefore, when federal interest rates go up, the lender can push the cost on to the borrower by lifting the borrower’s rate. When a borrower agrees to take a variable-rate HELOC, what they are really agreeing is to take a portion of the risk away from the lender. In return for agreeing to a variable rate, the lender offers the borrower a lower interest rate than they would for a fixed-rate HELOC.

When to Take a HELOC

Technically, a HELOC loan can be used for any purpose. Because a HELOC involves putting up your home as collateral, it is best used for large, unavoidable expenses or for doing something that improves your financial position, such as consolidating debt or making home improvements.

According to TransUnion, HELOC borrowers can be broken down into 5 groups based on how they use the funds: debt consolidation (30% of HELOC borrowers); financing a large expense such as a home renovation project (29%); refinancing an old HELOC (25%), making a down payment on a new mortgage (9%); and standby funds for a rainy day (7%).

Many homeowners prefer taking a HELOC over a HEL because HELOCs offer greater flexibility. With a HELOC, the borrower only draws as much as they want and only pays interest on what they draw. What’s more, the borrower can draw at any time during the draw period, so they can always dip into the funds in the case of an emergency.