Personal Loans » Advice » What Is a Home Equity Line of Credit (HELOC)?
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What Is a Home Equity Line of Credit (HELOC)?

Home equity lines of credit are loans that allow the homeowner to borrow against the equity in their property. Here's our complete guide.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: September 20, 2023
The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: November 1, 2023

The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.

You can trust the integrity of our unbiased, independent editorial staff. We may, however, receive compensation from the issuers of some products mentioned in this article. Transparency is a core value for us, see how we make money.

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With the higher interest rates, HELOC rates remain very reasonable compared to other funding options, making it an attractive option for relevant borrowers.

However, there are some consequences you should understand. In the following complete guide we summarized what is HELOC and how it works, what are the pros and cons, how to shop around to get the best rate – and what are the main alternatives borrowers can consider.

The Recent Trend in HELOC Market

Home equity lines of credit are loans that allow the homeowner to borrow against the equity in their property. This can be an effective way to restructure finance, pay for home improvements or pay for a significant purchase.

As the following chart using FED Survey of Consumer Finances 2019 data, the average by family lines of credit fluctuates over time. In 2001, the average was at a low of $37,000 per family. This peaked in 2010 at $64,000.

Home-Equity Lines of Credit (HELOC)

This year, experts are projecting HELOC’s interest rates starts to increase.  Therefore, it makes sense to shop with the best HELOC lenders online while the rates are still low historically.

How HELOC Rates Work

Unlike many mortgages, HELOCs are a kind of adjustable-rate mortgages.  HELOC rates have two components: a set base rate (“margin”) and a fluctuating rate (“index”).  Each month the HELOC lender will calculate your payment based on your current balance and the combination of these two components to determine your rate.

The lender will use your credit score and the amount of equity you have in your home as the basis of the margin for your HELOC.

As soon as you have your HELOC lender, they will run a single report from all three major credit bureaus, namely:  Equifax, TransUnion and Experian.  Basically, they will merge your credit history that they have extracted from the three sources.  This report will incorporate all your past credit history and your credit scores from each bureau.

Can I Use My HELOC For Any Purpose?

As with a conventional home equity loan, it is possible to use a HELOC for any purpose. However, this type of borrowing is best suited to long term expenses, such as medical bills, home renovations or college tuition. Bear in mind that the interest is only tax deductible for home improvements or renovations.

So, if you simply need to restructure your credit card debt or pay off an auto loan, a HELOC is not the best financial product for your needs.

Why Do HELOC Rates Change?

As with conventional mortgages, HELOC rates are determined by the market rates and your credit. This means that when the base rate increases or drops, it is usually reflected in the HELOC rates. For this reason, many HELOC lenders allow you to convert from a variable rate to a fixed rate. So, if you notice that rates are on an upward trend, you can lock in a lower rate.

The rate on a fixed 15-year fixed-rate mortgage has been below 7% from 2005 to 2021, according to Frediemac. The highest mortgage rate recorded in this period was 6.07% in 2006, and this period was followed by a gradual decline until 2012 when the interest rates fell to 2.93%. The lowest rate on a fixed 15-year mortgage was reported in the first quarter of 2021 at 2.28%.

Chart: Rates on 15-Year Fixed Rate Mortgage in the U.S. 2005-2021

Can I Get a HELOC With a 650 Credit Score?

A 650 credit score is considered “fair”, so you may not have access to the best variety of HELOC plans. Typically, you need a score of 660 or more to qualify for a HELOC, but the lower your score, the higher the interest rate.

Just bear in mind that some lenders may consider other financial factors when making their decision. So, while you may have a 650 score, if you can show that you have low overall debt, a low credit utilization ratio and good debt to income, you may still be able to secure a good deal.

Does a HELOC Require an Appraisal?

Since a HELOC is a line of credit on the equity in your home, lenders do require an appraisal. The lender will need to confirm the value of your property, along with your current mortgage balance to calculate the available equity.

If the appraisal does not confirm the value of your home, you may struggle to obtain your HELOC. The lender requires sufficient equity, so that should you default on your loan, it will be able to recoup the outstanding debt, even after your mortgage has been repaid.

HELOC Pros & Cons

 You only pay interest for the money you spend during the draw period. This is the time frame that you have to withdraw funds. This allows you to choose how much and when to pay it. Keep in mind, however, that the draw period is over, and the loan becomes a repayment plan. Principal and interest payments will be due each month.

HELOCs can be very convenient, similar to borrowing money with a credit card. You have the option to spend as much as you like each month or not at all. It's up to you. UW Credit Union offers the opportunity to lock in the lowest rates for up to five times per term.

HELOC interest is tax-deductible, just like home equity loans. It can be used to buy, build, or substantially renovate a home.

You can use home equity credit for large projects, such as those that require a lot of planning, major expenses, or emergency funds.

As long as the balance is paid off in a minimum of one to three years, these lines are a smart choice. HELOCs can be used for home improvements, consolidating loans, paying medical bills, and paying educational costs.

 If you are looking for a different way to spend your day, this option may not be for you. HELOCs usually require minimum withdrawals of $10,000 or more.

 Your HELOC will be available for a limited time. HELOCs typically use a 30-year structure, which has a 10-year draw period followed by a 20 year repayment period. You won't have access to your HELOC after your draw period expires.

HELOCs may be expensive. HELOCs can be expensive. There are annual fees, transaction fees, appraisal fees and application fees. You may not be charged all fees for every HELOC account. However, it is important to know which fees might apply to you.

Your credit rating will be affected if you fail to make your HELOC payment on time. Remember that your HELOC is secured by the value of your home. If you fail to make your payments, the lender may seize your home.

High Credit Score = Lower HELOC Margin

Most lenders usually pick the average of the three scores although the conservative ones might use the lowest of the three scores.  The rule is, the higher your credit score, the lower your HELOC margin will be.  Negative information such as late payments or credit problems can cause you to have a higher margin.  In some cases, applicants lose their eligibility for a HELOC because of the severity of their derogatory credit history.

You can compute your home equity by dividing the total outstanding loans by your home’s value.  Take note that most lenders would want to see that your total loans do not exceed 90% of your home’s value.  The lower this percentage is, the lower your HELOC margin will be – and vice versa.

So, looking at this principle, your margin can practically be as low as zero. But, it can also be as high as a few percentage points if you had credit issues and very low equity.

Here are other things you might want to know about getting the best HELOC rates:

Shop Around For The Best HELOC Rate

If you want to get a good interest rate, repayment plan and low closing costs, you have to do some ‘legwork’ with your hands.  This means you need to compare offers by as many different companies as you can.  You can do this now via the Internet.  Many borrowers automatically choose the company they’ve worked with previously – but they may not always get the best deal.

Most HELOCs use the prime rate as a basis; it’s now easy to compare companies.  In fact, you might not even need to use a mortgage broker.  Do not give in to the temptation of settling for the first few offers because a small detail can make a big difference in the long run.  A tiny increase in the APR, for example, can mean thousands of additional dollars over the life of the HELOC.

Once you’ve short-listed your HELOC lenders, you’ll want to compare their offers on the following:

  • Margin.  Some lenders add higher margins more than others based on your credit profile and home equity.  This is the most significant factor in determining your HELOC rate.
  • Rates on fixed-rate advance options. This is the second most important factor for your HELOC rate and this can be as varied as the number of lenders.
  • Maximum lifetime rate.  HELOCs will have a restriction to ensure that Prime plus Margin cannot go over a certain amount at any time.  This is your protection should Prime were to rise dramatically over the life of the HELOC.
  • Interest only against fully amortized payment.  HELOC payment terms will vary.  Some will allow you to pay just the interest due on the outstanding balance while others will ask for principal plus interest payments.  The lender that follows the latter can sometimes amortize the payment over 10 or 20 years.  This will make the payment materially higher overall.
  • Draw period.  A draw period is the length of time you can draw on your HELOC and it can vary among lenders.  A longer draw period is advantageous if you plan to keep the home and the HELOC for a longer term.  These period runs for about 10 years and don’t differ drastically from lender to lender, but it’s still good to ask.
  • Repayment period.  This sets how long you have to pay back whatever funds you drew from the HELOC.  Similar to draw periods, this is usually standard at 20 years but again, you should check.  You have to get the longest possible time or at least enough time according to your planned time in the home.
  • Annual fees.  HELOCs work in the same way as credit cards in that you can use and pay off the funds anytime.  However, for the lender, this will require more overhead than traditional mortgages so they often charge an annual fee like credit cards.  The fee may be insignificant but do compare because you might choose one that happens to charge the highest among all.
  • Early termination fee.  Many HELOC lenders charge this fee if the borrower close the HELOC within a certain number of years.  Not only will the actual fee matter to you, but find out how many years you need to hold the HELOC before they waive this fee.

Can I Negotiate HELOC Rate?

As with a conventional mortgage, it is possible to negotiate your HELOC rate, but you will need to do your research. There are numerous companies that will compete for your custom, so you may be able to find more beneficial quotes for a new HELOC deal. You can then use these quotes to negotiate the rate with your current HELOC provider.

However, you may need to be prepared to switch over to a new provider. If your current lender is unable to match the rate of your best offer, you will need to think about the costs involved in switching providers before making the change. For example, there is no point in saving $50 a month if you need to pay out $5,000 in early repayment fees and charges.

Solidify Your Finances

While HELOC lenders primarily base their decisions on your home equity level, they also look at your overall financial picture.  These elements are important considerations to them in deciding to approve or disapprove your application.  Your credit score and debt level vis-à-vis your income will affect your rate and even your approval.

Raising your credit scores and lowering your debt by paying some of them off can make a big difference (debt consolidation will probably not make any difference).  Even reducing your overhead can turn to huge savings in the long run.

It’s a good idea to check your credit reports from the three major credit bureaus we mentioned earlier before you apply for your HELOC.  Sometimes, there are erroneous postings or old “zombie” debts on your credit record that may be pulling your scores downward.

Be careful: Don't get a new credit card or take on new debt before applying for a HELOC.  They would lower your credit scores and cause your rates to go even higher.

HELOC Tips and Tricks

HELOC deals can be a great way to access the equity in your home, but since your home is collateral, it is important to choose the right product. Some of the HELOC tips and tricks include:

  • Research your options: Just because you’ve worked with a lender before, it doesn’t mean that they offer the best terms and rates. HELOC rates are often based on prime rates, so it makes it quite easy to compare the various options. However, it is important to consider the lender margins. If a rate seems significantly lower than the other deals, it may be an introductory rate not connected to the lender’s margin. This means that after a short time, you could get an unpleasant surprise. So, double check what your final rate will be before making a decision.
  • Consider conversion clauses: Some lenders allow you to convert from a variable rate to a fixed rate during your draw period. So, if you see a rise in interest rates, it is nice to have the ability to lock in a lower rate.
  • Be careful of balloon payments: Some HELOC products have a requirement for a balloon payment when the draw period ends. So, when the draw period ends, you need to pay your outstanding balance in full. While you may have an idea of how you’ll pay this balloon payment, if you have unforeseen circumstances, you’ll face financial difficulties. So, only opt for a balloon payment if you have sufficient cash reserves.
  • Create a payback plan: Finally, ensure you have a payback plan in place. Don’t use HELOC funds to cover monthly payments or you could end up getting yourself into a terrible financial position.

Build up Enough Equity

Your equity in your home has a direct impact on your HELOC.  The higher your equity, the bigger the home equity line and also influences the rate they will give you. The more equity you build up, the more it will appear that you have less debt against your home.  This will make you look better in the eyes of your lenders.

If you do not have an idea of how much equity you have, try a simple method.  Find an online estimate of the worth of your home and then subtract the balance you owe on your mortgage.

Most HELOC lenders won’t want the home equity line and your outstanding mortgage debt to go past 80% of your home’s value.

Consider a Conversion Clause

Some HELOCs will allow borrowers to convert from a variable interest rate to a fixed one during the draw period.  This will work to your advantage during periods of rising interest rates because you can convert and lock into a lower one.  Conversely, some lenders will also allow you to revert back to a variable rate if the interest rates fall again.

Generally, your APR on the fixed-rate portion of your credit line will be higher than the variable APR on the non-fixed portion.  The payments on the fixed part will be higher because you will pay for both the interest and principal – just as you would on a fixed-rate loan.

HELOC vs. Personal Loan

If you are looking for a way to borrow large amounts of money, or if you have a project that will require many draws, a HELOC might be the best option. HELOCs can be affordable due to their low-interest rates. There are risks in using your home to secure your loan, and your rate could rise.

A personal loan could be best for a one-time expense, particularly if you qualify for a low-rate loan and won't benefit from tax deductions from a home improvement loan. A personal loan is easier to obtain and may cost less in the long term.

 HELOC Vs Second Mortgage

Whether a HELOC or second mortgage is the best option for you will depend on your needs and circumstances. While a HELOC offers a line of credit that allows you to draw down funds as and when you need them, a second mortgage provides a lump sum. However, it is important to consider that you will begin paying interest as soon as you receive the funds. So, if you opt for a second mortgage, you will begin paying interest immediately, while you will only pay interest on your HELOC when you draw funds.

This means that you need to consider what you need the funds for and when you will need them. If you’re planning renovations and are likely to pay out in multiple lump sums, a HELOC means that you will pay less interest, as you can call down the funds as you need them.

However, if you want the funds for existing medical bills, it may be better to get a second mortgage and pay them off in full, fixing your monthly repayments now.

FAQs

HELOC rates are based on prime rates and as the overall mortgage rates are predicted to rise throughout 2022, it is a good forecast that HELOC rates will also go up.

Some experts are anticipating that the average rate on a 30 year home loan will increase to 3.8% by December 2022, it is easy to see that the rates are likely to increase significantly this year.

Home equity loans typically have a term of 5 to 30 years, while HELOCs generally allow a 10 year draw period and up to 20 years repayment period.

However, the specific term for your loan will depend on your circumstances and requirements. While it may be tempting to opt for the longest possible term, bear in mind that the longer the repayment period, the more interest you will pay.

So, although a longer repayment period will reduce your monthly repayments, it will cost you far more in the long term. So, think carefully about whether you want to commit to a 30 year home equity loan or if a shorter term would be more appropriate.

As with a conventional home equity loan, it is possible to use a HELOC for any purpose. However, this type of borrowing is best suited to long term expenses, such as medical bills, home renovations or college tuition. Bear in mind that the interest is only tax deductible for home improvements or renovations.

So, if you simply need to restructure your credit card debt or pay off an auto loan, a HELOC is not the best financial product for your needs.

A HELOC allows you access to a line of credit based on the equity in your home. However, you are under no obligation to call down these funds. If you never use the line of credit, your lender may give you the option to close your account or keep the account open for future borrowing.

Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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