Is a Home Equity Line of Credit Right For You?
You've made your mortgage payments and kept a well-maintained home. Congrats, all that effort has turned your house into a store of equity ready to be tapped. One potential lever? A home equity line of credit (HELOC). If you'd like a cushion to cover unpredictable expenses, make further home improvements, or even invest in a business, a HELOC could help.
That said, HELOCs are not always suitable for every circumstance — and not everyone qualifies. So, what are the qualifications for HELOCS, and when should you consider one? Learn how HELOCS work and if a home equity line of credit is right for you. And be sure to consider credit union HELOCs along the way. Your local credit union offers the benefit of great rates and service from neighbors who are invested in your financial health.
What Is a HELOC?
A HELOC is a line of credit that functions similarly to a credit card but with the available balance based on the collateral value you provide. In the case of a HELOC, that collateral is your home.
The significant advantage of a HELOC over other ways you might tap into your home's equity is that you only accrue interest on the portion of the loan balance you spend. Also like a credit card, you can pay down the principal at any time to avoid incurring interest. However, unlike a credit card, HELOCs — especially credit union HELOCs — have much more favorable interest rates if you carry a balance.
Keep in mind that a HELOC is not a risk-free loan. Your lender can foreclose on your home if you fail to meet your obligations. A HELOC also often comes with a variable interest rate, meaning you may pay more in the future if interest rates go up. If the value of your home drops, your lender may also reduce your credit limit or demand immediate repayment.
How Does a HELOC Work?
Your HELOC revolves around your home equity, which is the portion of the home you own after deducting any outstanding mortgage balance. The more of your home you own outright, the more you can borrow.
When considering a HELOC, many homeowners will look at valuations online to get an idea of their home's value. However, remember that these are just estimates related to your home's location, size, and basic attributes. You can also have your home appraised but know that your lender will use its own criteria for valuing your home and may have the property appraised independently.
Regardless, the amount you can borrow will not be determined solely by your home's value. No matter how much equity you have in your home, your creditworthiness and outside economic factors can further limit how much you can borrow against.
What Are the Qualifications for HELOCs?
First and foremost, you will need to own the house. From there, a lot goes into a lender's final decision. Most will want you to own at least 20% of your home. Some lenders may have lower home equity requirements, but all will have a percentage qualification independent of the dollar value.
You will also need to be able to show the lender that you have stable employment, are financially responsible, and have been able to manage past debts. Your lender will verify your employment and income and determine how your monthly income stacks up against your expenditures. This is where outstanding debts, such as a student loan or credit card, may disqualify you or limit the amount you can borrow.
Your lender will want a good credit score and a decent debt-to-income (DTI) ratio. Your DTI ratio compares your total monthly debt payments, such as mortgages, credit cards, and other loans, to your gross monthly income. Many lenders will go as high as 50% DTI for a HELOC. Try to pay down debts that could negatively impact your DTI before applying for a HELOC.
As you learn about the qualifications for HELOCs, you will also hear about the loan-to-value ratio (LTV), or the percentage of the home's value that your lender will allow you to borrow against. Regardless of how much of your home you own, you may still be unable to borrow against the entire equity. To limit risk, most lenders will only let you borrow against around 80% of the equity you have in the home, though this can go up or down depending on the lender and your financial situation.
Benefits of a HELOC
While you now know the answer to "What are the qualifications for HELOCs?" you still need to consider why — and why not — a HELOC might be the right choice for you. To start, we'll take a look at the potential upsides.
One of the biggest benefits of a HELOC is flexibility. Unlike a home equity loan or second mortgage, you don't have to know how much you will need before you take out a HELOC. You can take out a HELOC for way more than you end up spending, and you will never pay a penny of interest on any portion you don't withdraw. This can be a major advantage if you are starting a home improvement project or funding other expenses where the total amount you need to borrow could change.
Each lender has specific restrictions on how you can use your HELOC. Still, many homeowners use a HELOC to help with debt consolidation, ongoing expenses related to education or medical care, or anything else where they may need a financial cushion. Also, unlike putting such expenditures on a credit card, you can carry a balance on a HELOC month-to-month without incurring added fees or higher interest payments.
While a HELOC functions similarly to a personal line of credit, it typically has a much lower interest rate. Using the equity in your home as collateral lowers the lender's risk, which enables them to offer you more favorable interest rates. HELOC rates, while variable, are generally closer to those found with mortgages or home equity loans. You may be able to lower rates even further with a credit union HELOC, as your local credit union's not-for-profit status often enables it to offer lower interest rates than other lenders.
HELOCs may also offer tax advantages compared to other credit products. Suppose your HELOC is taken out against your primary residence and you use it for improvements or renovations that add value to that same home. In that case, the interest on your HELOC may be tax-deductible, similar to mortgage interest.
Drawbacks of a HELOC
One of the biggest risks associated with HELOCs is the potential to overborrow. Overborrowing on a HELOC can deplete your home's equity, limiting your ability to access funds in the future. It could also negatively impact your refinancing and selling options or even lead to a foreclosure.
Each time you consider a draw against your HELOC balance, do a fresh assessment of your financial situation as if you were taking out a new loan. Calculate how much taking a draw will add to your monthly expenses and know when and how you will pay it back.
The more you borrow on a HELOC, the more interest you pay. If you're not careful, you could be paying a significant chunk of cash toward the interest on the loan rather than paying down the principal. Going too long without paying down your HELOC balance can also snowball, placing you in a cycle you cannot escape.
Most HELOCs have a variable interest rate. Depending on the terms of your HELOC, that could mean a rate that changes monthly, quarterly, or annually. How your rate changes will be based on a predetermined benchmark, such as your lender's prime rate. Know your HELOC's terms and determine how often the lender will recalculate the interest rate before signing.
Home as collateral
Also, remember that your HELOC will have a draw period extending many years, followed by a longer repayment period where you cannot make any draws. Like a mortgage, any remaining balance and interest come due when your HELOC's repayment term ends. If you cannot repay your HELOC at the end of the term or otherwise default on your contractual obligations, your lender can foreclose on your home to repay the debt.
How to Choose the Right HELOC for You
When choosing a HELOC, there is much to consider. You'll want to look at the following:
- Credit and borrowing limits
- Draw and repayment periods
- Interest rates
- Origination fees
- Ongoing fees, such as draw fees
There is a lot of fine print to go over, so it is vital to work with a lender with your best interests in mind.
While your lender will set a maximum credit limit based on your appraisal, home equity, and creditworthiness, that doesn't mean you have immediate access to the total amount. Each lender sets specific limitations and requirements. They may cap how much you can take out at a time or how often you can take a draw.
You will also want to know how to access the money, such as whether you will get a debit card or checks or can make direct account transfers to checking or savings.
You should also look at terms that can affect you further down the line, such as if you cannot keep up with payments. A lender may permit you to convert a portion or all of the balance of a variable-rate HELOC into a new, fixed-rate loan. Credit union HELOCs have a particularly good reputation for making such adjustments to help members.
The fixed-rate option may have a slightly higher initial interest rate, but it can provide more predictable payments if you cannot pay down your HELOC in the near term.
Finally, ask about rate adjustment caps. Limiting how much the interest rate can increase or decrease provides added predictability. However, be mindful that there are both periodic and lifetime caps, with the first limiting how much the rate can move each time it is adjusted and the latter governing how much it can change over the life of the loan.
Further Resources on HELOCs
Before making any financial decision, you must protect yourself with as much information as possible. These additional HELOC resources can help you approach lenders well-educated.
- Know what lenders will see in your credit history. You can access your credit report for free online once a year without additional obligations.
- Be prepared for how debt is going to impact your borrowing limit. You can calculate your debt-to-income ratio with an online DTI calculator.
- Educate yourself about scams and predatory practices. There are plenty of government resources that track the latest scams and fraudulent practices.
Make Your Home Work for You
Your home's equity is a valuable asset waiting to be harnessed wisely. Now that you're better equipped to make informed choices about whether a HELOC is the right fit, use our Credit Union Locator Tool to explore the low rates and excellent service that come with credit union HELOCs.