What Is a HELOC Loan, and What Can You Use It For?

While planning your debt consolidation or covering some emergency expenses, you might have stumbled on something called a HELOC loan. But what financial benefits does it provide?

HELOC stands for “Home Equity Line of Credit,” and like a mortgage, the amount is based on your home equity. Both HELOC and home equity loans are types of second mortgages you can take on your home.

Mortgages generally have lower interest rates than other loans, and the most common uses for a HELOC are home repairs, renovations, emergencies, and instant financial flexibility, depending on the situation. Compared to variable-rate credit cards, they can have up to 3 times lower APR.

How Does a HELOC Work?

A HELOC is a type of second mortgage and a revolving credit line, so the amount you can draw depends on the equity you possess and the credit limit set by the lender. Each bank decides on the loan amount depending on your property value, equity, and credit score as a combined loan-to-value ratio or CLTV.

Therefore the size of the second mortgage is directly proportional to how much of the primary mortgage has been paid off.

The way a HELOC works is comparable to the way a credit card does. It’s not a lump sum you have to pay off with interest; rather, you can use only part of your loan, and you’ll be paying interest only on the amount you actually spent.

HELOC funds can be accessed in several ways, depending on the lender. The most common avenues are via check, online transfer, or a credit card connected to the account.

The draw period for a HELOC is usually 10 years, but not always. During that time, the minimum monthly payments are interest-only. You do have the option to cover the principal, and if you completely pay off your balance while still in the drawing period, the bank will offer to close the line of credit.

After the draw comes the repayment. While it lasts, you cannot get any more funds, and your monthly payment will comprise both principal and interest. Thankfully, the standard repayment length is 20 years.

HELOC Requirements

Getting approval for a HELOC will depend on your bank and several other factors:

• Sufficient home equity
• A credit score in the mid 600s
• Reliable payment history
• Low debt-to-income ratio

Owning Equity

To be eligible for a HELOC, you need equity as collateral. The amount of equity you have is a direct result of the current market value of your home and your remaining mortgage debt. Most banks will give you a loan based on 80%-90% of the value of your home.

HELOC With a Bad Credit vs. a Good Credit Score

As always, homeowners with a higher credit score enjoy better interest rates: The difference between someone with a 620 and 750 credit score could be more than 5% in monthly interest rates. If a loan is large enough, this could amount to thousands of dollars per year.

Reliable Payment History

While your payment reliability is reflected in your credit score, most lenders check this parameter separately. The reasoning is simple: A regular debt repayment history means that person is more likely to pay off a second mortgage.

The assessment is so strict because a  HELOC lender is the second party to receive funds in case of a foreclosure. In other words, they’re in a riskier position than the original mortgage lender.

The Importance of Debt-to-Income (DTI) Ratio

Keeping your debt-to-income ratio low is crucial when applying. It directly informs the lender of the amount of income you have available to cover your monthly payments.

You can calculate your DTI by dividing all monthly debt payments by your gross monthly income. If your DTI is below 43%, you’re eligible for a Qualified Mortgage - a loan with fewer risky features.

HELOC Interest Rates

Variable interest rates are par for the course with a home equity line of credit and are a direct sum of the index rate and the margin. The index rate is a market-dependent baseline used by banks to set rates on loans, including HELOCs. The margin depends on your credit score.

A high credit score means a lower margin and, by extension, a lower interest rate. Some banks offer a fixed interest rate for several years, switching to a variable one after that period expires, while some offer a fixed interest rate on the outstanding balance.

Variable interest rates could expose you to paying higher interest on the money you spent. Using your HELOC funds while interest rates are lower and being frugal while the index is high would be a wise financial move.

Calculating Your HELOC Value - Explained

Knowing what factors influence HELOC value makes calculating its financial impact easy. One is the loan-to-value ratio, which is limited at 85% according to the Federal Trade Commission (FTC).

With a home valued at $200,000 and a mortgage of $90,000, home equity totals $110,000. For example, if a bank limits the borrowing amount to 80% of the property value and there are no other liens tied to it, the formula for your HELOC is as follows:

80% of the home’s market value: $200,000 x 0.8 = $160,000

Potential line of credit: $160,000 - $90,000 = $70,000

Additional Fees

While HELOC loans have obvious benefits, they do come with additional expenses for borrowers before the line of credit is set up. These differ by bank and state but include:

• Application fees
• Home appraisal fees
• Annual fees
• Attorney and documentation prep fees
• Recording fee
• Inactivity fee
• Upfront costs
• Early closure fee

Make sure to check with your lender beforehand what extra charges your HELOC setup will bring. The best course of action is to get quotes from multiple banks and find the one that suits you the most in terms of both principal, payment terms, and fees.

Some HELOC lenders might even be open to negotiating these terms.

HELOC vs. Home Equity Loan

HELOCs and home equity loans differ by several key points, each with its advantages. HELOCs and home equity loans can come with similar closing costs, including origination fees, loan recording fees, and underwriting fees.

HELOCs have a variable interest rate or a fixed starting rate that becomes variable. Home equity loans are always fixed-rate. The HELOC APR is slightly lower compared to home equity loans, also. But the main difference between the two is the loan type.

A home equity loan is a lump sum to be paid back with 10 to 30 years of fixed payments. A HELOC is more flexible: During the draw period, you are only expected to make interest payments and then start paying off the principal too when the repayment period starts.

HELOC for Home Improvements

The most common reason for taking out a second mortgage is to finance home improvements.

After all, renovations and remodeling projects increase home value, and using equity to create a more enjoyable living environment is one of the best ways to take advantage of a second mortgage.

Depending on the scale of home renovation you are planning on, either a HELOC or a home equity loan could be appropriate.

Keep in mind that using HELOC for home improvements might make your interest tax-deductible. According to the IRS, for this to happen, the funds must be used to buy, build, or substantially improve the taxpayer’s residence.

Other HELOC Common Use Cases

Home equity line of credit rates can quite favorable if you need to cover any of the following:

• Debt consolidation. Credit cards have less favorable interest rates than HELOC mortgages, so it might be smart to use a HELOC to consolidate credit card debt.
• Medical bills can be covered with HELOC loans and personal loans alike.
• Education costs covered with a HELOC can be a better option than taking on a student loan, especially for borrowers with good credit scores.
• Large purchases, but make sure you have a dependable strategy to pay off the debt during the draw or repayment period.

Pros and Cons

There are two sides to everything, including opening a HELOC account:

Pros:

• Low interest rates with home equity as collateral. Compared to credit cards and personal loans, HELOC rates can be significantly lower
• Waived fees for higher credit scores, usually closing or application fees
• No fees for drawing funds
• Flexible repayment during both the draw and repayment periods
• Make sure that there are no fees for closing the account early
• Tax-deductible interest for a HELOC used for home improvement of qualified residence loans
• Adjustable spending and interest according to your needs

Cons:

• Depending on your HELOC terms, your lender might set minimum draws.
• Just paying off interest during the draw period leaves you with a larger balance to cover during the repayment.
• Variable interest rates mean that any upward adjustment in the index or margin results in rising interest rates.
• Using HELOC funds for anything that’s not an important investment is not a good idea.
• Hidden fees tend to add up.
• Home value can drop due to deterioration and reduce your equity: This is the main reason not to loan against more than 80% of your house value, which leaves you with 20% to compensate for any decrease in value when reselling the house or refinancing to cover the loan.