How Does a Home Equity Line of Credit (HELOC) Work?

A home equity line of credit, or HELOC, is a financial product that allows you to tap into your home equity. You can use the money to fund home repairs, pay for large expenses, or whatever else you like. However, you need to make monthly payments to the lender in order to repay the loan over time.

For homeowners who have a solid credit history and plenty of home equity, a HELOC may be an affordable and convenient way to access a line of credit; however, it’s not the right solution for everyone. Below, we explain how a HELOC works and how to know if it’s right for you.

What is a HELOC?

This type of loan is a revolving line of credit which uses your home as collateral. You get approved for a maximum loan amount and can draw on the line of credit as often as needed for a period of time. That time is known as the “draw period” and usually lasts around 10 years. After the draw period you enter the “repayment period” when you must pay off the amount you have borrowed.

HELOCs typically have variable rates, which means that your interest rate can go up or down over time. This unpredictability can make it difficult to accurately budget and plan ahead. A fixed rate, on the other hand, stays the same throughout the loan. You may get a lower interest rate on a HELOC compared to an unsecured account like a credit card--one reason they are so popular--but, it doesn’t mean the interest can’t add up quickly.

HELOC Pros & Cons

Like any product, a HELOC has pros and cons.

HELOC Pros:

• Flexibility: Instead of obtaining your funds in one lump payment, with a HELOC you have the flexibility to draw on the credit line as needed during the draw period (usually 5-10 years). You would then repay the borrowed amount during the repayment period.
• Low interest rates: As previously mentioned, HELOCs tend to offer lower interest rates than many credit cards and personal loans; this discrepancy is due to the fact that the loan is secured by your home. As a result, a HELOC can be an attractive option for big expenses or debt consolidation.
• Tax benefits: In the U.S., the interest paid on a HELOC is tax deductible, which can reduce the overall cost of borrowing.
• Convenience: A HELOC can be useful to assist with ongoing expenses, such as those involved in a home improvement project, because it is so easy to access the funds whenever you need them.
• Builds equity: When you enter the repayment period and repay the borrowed amount, your available credit increases and you effectively build up equity in your home.

HELOC Cons:

• Risk of foreclosure: While the loan being secured by your home enables the lower interest rates, this security is also a disadvantage. If you fail to repay the loan, you could risk losing your home through foreclosure. This might not be a risk you are willing to take!
• Variable interest rates: As we mentioned, most HELOCS are accompanied by variable interest rates. When your payments fluctuate over time, you could experience difficulties with your budget.
• Potential over-borrowing: It can be a real boon to have funds so easy to access, but it can also be a problem if you over-borrow. You don't want to accidentally accumulate more debt than you can manage. HELOCs can tempt homeowners to use their homes like an ATM, tapping into their equity for non-essential expenses.
• Closing costs and fees: Many HELOCs will have closing costs and other fees, which increases the overall cost of borrowing.
• Changing property values: If the value of your home declines, you may have less equity available. In turn, the lender might reduce your credit line and limit the amount you can borrow.

How to Qualify for a HELOC

Qualifying for a HELOC is fairly similar to obtaining any other loan, but there are some criteria related specifically to the equity in your home. Here are the typical factors considered by lenders when you apply for a HELOC:

• Sufficient home equity: The main requirement for a HELOC is to have enough equity in your home. Remember, equity is the difference between the current market value of your property and the amount you still owe on your mortgage. Specific lenders will have specific guidelines for just how much equity you need, but the typical criteria is to have around 15-20% (or more!).
• Credit score: You'll need a good credit score in order to qualify for a HELOC. Though the minimum varies from lender to lender, the higher your credit score, the higher your chances for approval--and more favorable terms and interest rates.
• Debt-to-income (DTI) ratio: Your DTI ratio compares your monthly debt payments to your gross monthly income. A lower DTI demonstrates your ability to manage additional debt.
• Stable income and employment: In order to ensure that you are able to make the required monthly payments, lenders want to see that you have a stable and reliable source of income. A stable employment history is the strongest evidence.
• Loan-to-value (LTV) ratio: Your LTV is the amount you want to borrow as a percentage of your home's appraised value. In most cases, the combined LTV (including your first mortgage and the HELOC) should be below a certain threshold--often around 80-90%.
• Property assessment: All lenders will require an appraisal of your property to determine its current market value. The appraisal helps establish the maximum credit limit for your HELOC.
• Documentation: You'll need to provide documentation as to your proof of income, employment history, tax returns, etc.
• Payment history: Lenders will evaluate your past credit and loan payment history to determine your creditworthiness.

How To Get a HELOC

Applying for a HELOC is actually a lot like applying for a traditional mortgage.

1. Familiarize yourself with your credit; improve it if you can. As we've already mentioned, a strong score (think 700+) will enable you to qualify for the best terms and rates. Be sure to make all of your payments on time, and catch up on any that are overdue. Be sure to review your credit report and correct any errors you may find. It's best to plan ahead so that you can do this several months before you apply.
2. Find your preferred HELOC lender. Like with any big decision or purchase, shop around for your options! Compare the offers. The smallest difference in interest rates could save you thousands of dollars.
3. Apply for the HELOC. You can do this in multiple ways, such as in person or online. But remember, there is quite a bit of documentation that you will need to provide; the more of these materials you have from the outset, the more efficiently this part (and subsequent parts) of the process will go. Think W-2s, tax returns, bank/brokerage statements, and proof of employment. In addition, you will need to both verify your identity and permit the lender to access your credit reports.
4. Wait! Sometimes a lender will get back to you with pre-approval within days, but in other situations, you might find yourself waiting for the entire underwriting process to be completed. The underwriting process tends to take the longest--you may even be asked to provide additional information and documentation. The lender will also do an appraisal of your home, often in-person.
5. Close on the loan. Once the appraisal is complete and you are fully approved, the lender will get in touch regarding a closing date. After the final round of paperwork is signed and complete, there will still be about four days before your funds are available to you.

How Much Can I Borrow?

The amount of credit you can qualify for will depend on several factors, including how much equity you have in your home, your credit score, your income, your debt-to-income ratio, and the lender percentage. Most lenders require that your home equity is equal to or greater than 20% of the home’s value.

For example, let's say that the current market value of your home is $400,000. 20% of your home's value would be 80,000. Therefore, the amount of equity you would need would be at least $80,000.

How To Access HELOC Funds

After signing the loan, you have three business days to change your mind. This period is called the “right of rescission.” After these three days pass, you can access your HELOC funds.

Your lender can arrange to have funds from the HELOC deposited into your bank account once the right of rescission period has passed.

Also, depending on your lender, there may be multiple ways to access funds. You may be able to get money by writing a check, calling the lender, or accessing your account online. Note that some lenders may have minimum or maximum withdrawal requirements.

How to Use a HELOC

Technically, you can use your HELOC however you'd like; there are (typically) no restrictions. A HELOC can be especially apt to fund home renovations since you can borrow merely as needed while you progress through the projects. Because its interest rates tend to be lower than those of credit cards, a HELOC is also a popular vehicle to pay off debt. Other notable uses include: discharging medical expenses, purchasing a car, making a downpayment on a second home or investment property, starting a business, or saving for retirement.

A Unique HELOC Alternative

A HELOC can be an excellent tool to enable you to access the equity in your home. However, it's not the right fit for everyone. If you want to avoid the onslaught of monthly payments, and being beholden to temperamental interest rates, you might need to find an alternative.

Unison pioneered the equity sharing agreement to solve this precise problem. With a Unison Agreement, homeowners can obtain up to 15% of their home's current value in cash in exchange for a percentage of the home's future change in value in either 30 years or at the time of sale. Unison neither requires monthly payments nor collects interest, which means that the homeowner experiences no added debt.

If you are looking for a way to tap into your home equity, but hate the idea of adding an additional monthly payment to your docket, learn more about Unison today.

The Fine Print About HELOCs

Before taking out a HELOC, read the fine print and make sure you understand what it is that you’re getting into. Since this is a variable loan, minimum payments can change from month to month. Borrowers may also need to pay other fees on top of upfront closing costs. These can include an annual membership or a transaction fee, which is charged each time you borrow money.

You should also know that minimum payments during the draw period may be lower than the repayment period. That’s because you may be paying interest only during the draw period while your payments during the repayment period may include the full amount.

Some lenders may also ask you to make an additional payment of the principal loan amount at the end of the loan, also known as a balloon payment. It’s important to understand what your responsibilities are and what the terms of the agreement are, because otherwise you could be at risk of losing your home.

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