A HELOC (home equity line of credit) is a revolving credit line that uses the equity in your home as collateral and works similar to a credit card. How much you can borrow (the credit limit) is replenished when you repay the money you borrow.
HELOCs are offered by banks, credit unions, loan brokers, and online lenders.
Similar to credit cards, HELOCs can be used for nearly any purpose, although they are most commonly used for home remodeling projects or home additions. Some people also use them to consolidate credit card debt.
Borrowing from a HELOC is very easy. Most lenders provide debit cards or checkbooks that let you make quick withdrawals. You can draw from the account as often as you like, as long as you don’t go over the credit limit.
Unlike traditional loans, HELOCs don’t have fixed monthly payments. Instead, you can make interest-only payments for as long as the account is open (the draw period).
If the borrowed money isn’t repaid by the end of the draw period, a balloon payment may be required for the full amount due.
Some lenders may give you the option of converting the balance into a traditional loan with a fixed repayment term and regular monthly payments. The typical HELOC draw period is 10 years, followed by a 20-year repayment period.
HELOCs also have variable interest rates, which means you will need to know the current interest rate every time you borrow money. A home equity line of credit will also have closing costs, which may be 2% to 5% of the credit limit.
How to Get a HELOC
Obtaining a home equity line of credit is simple and can be completed in the following steps.
1. Assess your equity
The amount of equity you will need for a HELOC varies depending on the lender, but is usually a minimum of 15% to 20%. Equity is the current market value of your home less the amount you owe on it.
If the current market value of your home is $300,000, for example, and you still owe $200,000 on your mortgage, you have $100,000 in equity.
2. Research lenders
Before you officially apply for a HELOC, it’s a good idea to research multiple lenders to compare different interest rates, fees, and terms and conditions. This lets you determine which option is the best deal.
3. Apply for a HELOC
After you have selected a lender, fill out the HELOC application to start the loan approval process. Your lender may require an appraisal of your property to determine its current market value and verify your equity.
To ensure you can repay the money you borrow, your lender may seek additional information to verify your employment and financial information.
4. Close on the loan
Similar to mortgages, home equity lines of credit must go through the closing process before you can start borrowing money. At the closing, you will sign the HELOC agreement and other documents. After the account is established, you can start making withdrawals from your new credit line.
How Much Money Can I Borrow With a HELOC?
How much you can borrow with a HELOC is based on the amount of equity you have in your home, your credit score, and your current debts. Lenders will also look at your loan-to-value (LTV) ratio. Depending on the lender, the amount you can borrow with a HELOC may be up to 85% of your equity.
Let’s say your home’s current market value is $350,000, and you owe $250,000 on your mortgage. That means you have $100,000 in home equity ($350,000 – $250,000). A lender may approve you for a HELOC of up to $85,000, which is 85% of your equity.
How to Pay Back a HELOC
Paying back the money you borrow from a HELOC is different from an installment loan. With home equity loans, you receive lump sum payments for the full amount and then repay the money over time with fixed monthly payments, in which you’ll pay interest and the principal.
With a home equity credit line, however, you can borrow money as often as you like, as long as you don’t go over the credit limit. You can then repay the borrowed money periodically to replenish your available credit.
You also have the option with a HELOC of paying interest on the money you borrow and deferring the principal payment until the end of the draw period. Depending on your lender, you may be required to make a balloon payment on the balance, or you may be able to refinance it into a traditional loan.
Using a HELOC to Purchase Real Estate
Using a HELOC to buy real estate is a strategy many real estate investors use to quickly grow their portfolios. If you already own a property, you can use the equity to obtain a HELOC. You then borrow money from it to use as a down payment on another home.
If you have equity of $100,000 in a property, for example, you may be able to obtain a HELOC for up to $85,000. You can then withdraw up to $85,000 to use as a down payment on the purchase of another property.
It’s important to keep in mind that if you do use a HELOC to buy real estate, you will have two loans to repay: the line of credit and the mortgage.
Be sure to carefully evaluate any investment you are considering to make sure you will earn enough from it to repay the money you borrow.
Pros and Cons of HELOCs
Because they can be used for nearly anything, HELOCs are popular borrowing options. Before you apply for a home equity line of credit, however, consider both their pros and cons to make sure it’s the best loan option for your needs.
If you want to convert your home’s equity into money for a remodeling project or something else, there are several HELOC advantages to consider.
The pros may include:
- Low-cost alternative to credit cards or personal loans
- The money you borrow can be used for nearly anything
- Flexible repayment terms
- Revolving, meaning the money can be reborrowed once repaid
- Tax-deductible under certain circumstances
A home equity line of credit may not be the best borrowing option for every situation.
HELOC disadvantages may include:
- Your home serves as collateral and can be foreclosed on if you default
- Closing costs may be 2% to 5% of the credit limit
- Adjustable interest rates will fluctuate over time
Alternatives to a Home Equity Line of Credit
A homeowner may use a home equity line of credit or a cash-out refinance instead of a HELOC. Personal loans and credit cards are also options to consider. Although they are convenient, you may pay a much higher interest rate with a credit card than with other borrowing options.
HELOC vs. home equity loan
HELOCs and home equity loans both use a property’s equity as collateral and have closing costs. A HELOC, however, is a revolving line of credit, while a home equity loan is an installment loan where you make fixed monthly payments on the money you borrow.
Home equity loans and HELOCs both allow you to tap into the equity in your home, but how you repay the money you borrow is different. A HELOC lets you borrow, repay, and borrow again, while a home equity loan is a lump-sum loan.
In addition, the interest rate charged on HELOC funds is typically variable, while a home equity loan has a fixed interest rate.
HELOC vs. cash-out refinance
The loan option you choose will determine how you pay interest on the money you borrow. With a HELOC, you obtain a line of credit that uses a home’s equity that you can draw from as needed.
With a cash-out refinance, however, you obtain a new mortgage for your home. The new mortgage will be for a higher amount than what you owe on your home. The extra cash you borrow can be used for whatever you like.
A cash-out refinance may be preferable when there are rising interest rates. Because HELOCs have variable interest rates, you can’t predict how much you will pay for the money you borrow. With a cash-out refinance, however, you can lock in the interest rate when the loan is created, which helps with budgeting.
Should You Use a HELOC?
HELOCs are best suited for when you need to periodically borrow money, like when you are rehabbing a home. With a rehab project, you may need to borrow money to buy new flooring, for example. When you are ready for the next phase of the rehab, you can then borrow more.
A HELOC may also be a great borrowing option for real estate investors because it allows you to make interest-only payments during the draw period.
If you are using the fix-and-flip strategy, for example, you can borrow the money you need to rehab a home, make interest-only payments, and then repay the borrowed money after you sell it.
A home equity loan may be a better borrowing option when rising interest rates are a concern. It allows you to lock in the interest rate when the loan is created and make fixed monthly payments over a fixed term.
Home Equity Line of Credit (HELOC) FAQs
Although HELOCs are good borrowing options for many purposes, they may not be ideal for everything. Here are some frequently asked questions to help you decide whether a HELOC is the best loan for your needs.
How much equity do you need for a HELOC?
The amount of equity you will need for a HELOC will vary depending on the lender. Most lenders require that you have at least 15% to 20% equity in a home before they will approve you for a HELOC.
How long does it take to get a HELOC?
How long it takes to get a HELOC is another factor that varies depending on the lender. It may take anywhere from two weeks to two months from the time you submit a HELOC application to the closing. During this time, your financial information will be verified and evaluated, and your home will be appraised.
Is HELOC interest tax deductible?
Thanks to the Tax Cuts and Jobs Act of 2017, interest paid on a HELOC is tax deductible under certain conditions. The money you borrow must be used for home improvements on the property used as collateral. Interest charged on money you borrow for other things, like college tuition, debt consolidation, or a vacation, isn’t tax deductible.
Can you refinance a HELOC?
Some HELOCs require balloon payments at the end of the draw period and don’t automatically convert into repayment periods. If you have a HELOC that requires a balloon payment, you may be able to refinance it into a conventional loan to take advantage of a fixed interest rate and a fixed repayment term.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.