A home equity line of credit (HELOC) is a way for qualified homeowners to borrow money against their home’s equity.
Because HELOCs are secured by your home, there’s less risk involved for the lender. As a result, you may be able to qualify for a lower interest rate with a HELOC loan than you can on other types of financing.
Yet despite their benefits, HELOCs aren’t the right fit for every borrower.
So, how does an equity line of credit work? Here's what you need to know about the risks of HELOCs and how they work, before you apply for this type of financing. Here’s what you need to know about the risks of HELOCs and how they work, before you apply for this type of financing.
Home equity lines of credit, sometimes called second mortgages, are similar to credit cards in several ways:
When the draw period on a HELOC loan ends, the repayment period begins. During the repayment period you can’t borrow more money against the credit line.
With 30-year HELOCs, it’s common to have a 10-year draw period and a 20-year repayment period.
Adjustable interest rates are another similarity between credit cards and HELOCs. With this type of financing, part of your annual percentage rate (APR) is based on an index like the prime rate.
Next, the bank adds a markup, or margin, that depends on your creditworthiness. If the prime rate goes up or down, the variable APR on your HELOC may follow suit.
If you want to secure a fixed interest rate on a second mortgage, a home equity loan might be a better option for you.
Some banks do offer fixed rate HELOCs as well, but you'll generally pay a higher interest rate as a trade-off.
Before you can take out a second mortgage, you’ll need to satisfy a lender’s qualification criteria. Most lenders consider the following factors when you apply for a HELOC:
Let’s take a closer look at each of these.
A home equity line of credit is a type of secured financing. Specifically, you secure the loan with the equity in your home. To qualify for a HELOC, you will need to have sufficient equity in your home to satisfy a lender.
The term “equity” describes the portion of your home that you own outright. It’s the difference between your home’s current market value and the amount you owe on your mortgage. So, if your home is worth $250,000 and you owe $150,000, you have $100,000 in equity.
Most lenders will only loan you up to 85% of your home equity.
In the previous example, you might be able to borrow as much as $85,000 if you can meet a lender’s other qualification criteria. However, other factors like your credit score and debt-to-income ratio may also influence the amount of credit a lender is willing to extend to you.
Most banks want to see a credit score of 620 or higher to approve you for a home equity line of credit and determine your HELOC rates. If you fall below this threshold, you may need to work on improving your credit scores before you apply for this type of financing.
For a lender to approve your HELOC application, it has to believe that loaning money to you is a good investment. A lender will want to be sure that your credit risk isn’t too high, otherwise there’s a higher chance you won’t pay back the money you borrow as promised.
Credit scores help lenders predict how likely applicants are to pay their bills on time.
A FICO Score in particular predicts the likelihood that you'll fall 90 days or more behind on any credit obligation within the next 24 months. A higher credit score means less risk for the lender and, often, better rates and loan term requirements for you as a borrower.
Learn more about different types of credit scores.
Another way lenders assess the risk of doing business with you is by comparing your current debts to the amount of income you earn. This calculation is known as your debt-to-income ratio or DTI.
It helps lenders determine how much money you can comfortably afford to borrow and repay.
If you earn $50,000 per year, that breaks down to $4,166.67 per month.
Now, imagine you owe $1,500 per month in existing debt payments. Your DTI in this scenario would be 36% (1,500/4,166.67 = 0.359).
Most banks want you to have a DTI of 40% or lower to qualify for a HELOC. However, in some cases lenders may be willing to go above this threshold.
Also important to note? Your DTI doesn’t typically include other living expenses such as utilities, transportation, food or medical bills. Be sure to factor those costs into your budget when deciding how much you can afford to pay back.
You should always weigh the benefits and drawbacks before you apply for new credit of any kind.
Here are some of the pros and cons of taking out a home equity line of credit.
|You may be able to borrow a large amount of money using your home equity as collateral.||The lender could foreclose on your home if you can’t keep up with your payments.|
|Interest rates may be lower than you can secure with other types of financing.||HELOCs often come with upfront costs.|
|You can withdraw only the money you need with the option to come back for more later.||Variable interest rates can change and make budgeting a challenge.|
|Your interest might be tax deductible.||A second mortgage could make it harder to refinance or sell your home quickly.|
A HELOC has the potential to help or hurt your credit score. Yet like any type of financing, the impact a HELOC has on your credit report and score comes down to how you manage the account.
The majority of your credit score (35% of your FICO Score to be exact) is based on your payment history. So, if you open a HELOC and always pay on time, the account may help you build better credit over time. Late payments on a HELOC, of course, could have the opposite effect.
When you initially apply for and open a new HELOC, it might have a bit of a negative credit impact. Hard credit inquiries, after all, sometimes damage credit scores slightly.
A new HELOC can also lower the average age of accounts on your credit report. (Length of credit history is worth 15% of your FICO Score.)
Additionally, if you owe more than $0 to your HELOC lenders, it will increase the number of accounts on your credit report with balances - a factor that credit scoring models consider. So, a HELOC with an outstanding balance might hurt your score to a small degree.
It’s worth pointing out that, even though a HELOC is a revolving account, it doesn’t count toward your credit utilization ratio. Credit utilization is calculated by comparing your balances to your credit limits on another type of revolving account — credit cards.
High credit card utilization may lower your credit score. But using a large portion of the credit limit on a HELOC doesn’t have the same potentially negative impact.
If you use a HELOC to consolidate your existing credit card debt, it might even give your credit score a boost.
Because of the flexibility they offer, people use home equity lines of credit for a variety of borrowing needs. But even though you can use the funds from a HELOC in many ways, you should exercise caution due to the risk.
Remember, you’re literally putting your house on the line when you use this type of financing.
The smartest way to use a HELOC is arguably for home improvements and repairs. If you make wise choices when working with HELOC lenders, investing in your home could further increase its value and help you build wealth.
Best of all, the IRS may let you write off the interest on your HELOC if you use the money you borrow to “build or substantially improve” the home that secures the loan.
Of course, there are also times when using your home equity to secure a line of credit is a bad idea.
It’s risky to pledge your home as collateral for unnecessary expenses like:
Some people also use home equity lines of credit to consolidate credit card debt.
Yet there are other debt consolidation methods - like a personal loan or a credit card - that don't require you to pledge your home as collateral to secure financing.
Keep in mind that good credit may increase your approval odds or help you to secure a better deal with these HELOC alternatives.
You usually need decent credit to qualify for a home equity line of credit. So, it’s wise to review your three credit reports before you apply for new financing. If you find errors on your credit reports, you can (and should) dispute them with the appropriate credit reporting agencies.
Checking your credit scores can also be helpful to give you an idea of where you stand.
Just remember, there are hundreds of credit scores. So, the credit scores you check online likely won’t be the same scores a lender uses when you apply for a line of credit.
In general, good credit habits will help you earn better credit scores no matter which scoring model a lender uses. Paying on time and managing your credit card debt wisely can both be steps in the right direction. Budgeting is also important since having a solid plan for your money can make it easier to reach your credit-related goals.
Michelle L. Black is a leading credit expert with over 17 years of experience in the credit industry. She’s an expert on credit reporting, credit scoring, identity theft, budgeting and debt eradication. See Michelle on Linkedin and Twitter.
Lauren Bringle is an Accredited Financial Counselor® and Content Marketing Manager with Self Financial – a financial technology company with a mission to help people build credit and savings. See Lauren on Linkedin and Twitter.