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How a HELOC Works

How a HELOC Works

  • Home Equity Line of Credit Overview
  • A home equity line of credit, also known as a HELOC, is similar to a home equity loan except that instead of borrowing a set amount of money when you put the loan in place the borrower is able to borrow money from, or draw down, the line of credit as needed.  For example, a borrower may obtain a $50,000 HELOC but initially only draw down $10,000, which gives the borrower $40,000 in remaining borrowing capacity.  Additionally, the borrower can pay off and draw down the line of credit up to the maximum line amount, an unlimited number of times.  The borrower can draw $50,000 from the HELOC in the second year, pay back $15,000 in year three and then draw $15,000 from the line in the fourth year.

  • Great Mortgage IdeaThe monthly payment on a HELOC is typically lower than the payment on a home equity loan, especially if you are only paying interest on the line of credit
  • Just like a home equity loan, a HELOC is a second mortgage taken out on a property that uses the existing equity in the property as collateral for the loan.  Borrowers can use the proceeds from a HELOC for numerous purposes including home remodeling or renovation, paying off high interest rate credit card debt or buying a second home or investment property.  Borrowers use home equity lines of credit because it enables them to access the cash in their properties without refinancing their first mortgages which can be  significantly more expensive and take a lot of time.  Additionally, HELOCs enable you to borrow and pay interest on only the amount of money you need at any given time, which can make it less expensive, more flexible and more attractive financially than a home equity loan.

    The home equity line of credit is subordinate, or junior, to the first mortgage on the property.  In the event of a default or foreclosure, the holder of the first mortgage is paid off first before the holder of the HELOC.  You typically do not need to get approval from your first mortgage lender to put in place a home equity line of credit but you should review your mortgage note to make sure that there is no acceleration clause that makes the first mortgage payable in full if the you put a second mortgage, such as a HELOC in place.

  • Types of HELOC
  • There are two primary types of home equity lines of credit: adjustable rate and interest only. We explain how each type works below.

  • Adjustable (or Variable) Rate
    • With an adjustable rate (also known as a variable rate) home equity line of credit the interest rate is subject to change, and potentially increase, on a monthly, semi-annual or annual basis and fluctuates based on changes in an underlying index rate such as LIBOR or the prime interest rate.  Some lenders offer a 5/5 home equity line of credit with the interest rate subject to change only every five years.  5/5 home equity lines typically require lower CLTV ratios.
    • Monthly payments for an adjustable rate home equity line are based on the outstanding loan amount and are comprised of both interest and principal, which means you pay down the loan balance a little with every payment.  Some adjustable rate home equity lines allow borrowers to convert all or part of their loan balance into a fixed rate loan, also called a fixed rate advance, which eliminates the risk that the interest rate and monthly payment will increase in the future.
    Interest Only
    • An interest only home equity line of credit is similar to the adjustable rate line of credit because the interest rate is subject to change on a monthly, semi-annual or annual basis and fluctuates with changes in an underlying index rate.  With an interest only line of credit, however, the monthly payment is comprised of only interest and no principal during the draw period which means your monthly payment does not reduce your loan balance.  The interest only option may only be available on owner-occupied properties.
  • How a HELOC Works
  • A home equity line of credit is are typically broken into a draw period and a repayment period although some interest only lines require a balloon payment at the end of the loan.  We explain each component of a HELOC below.  Most lines are structured as 20 or 30 year loans with a 10 year draw period.  In the case of a 30 year HELOC with a 10 year draw period, after 10 years and one month the borrower can no longer draw down the line and is required to pay off the outstanding loan balance over the 20 year repayment period.  So after 10 years the HELOC essentially becomes a 20 year amortizing loan.  At the end of year 30, the loan balance is paid in full.

  • Draw Period
    • The draw period is a set period of time during which the borrower can withdraw funds from the home equity line of credit.  The draw period is typically ten years plus one month.  The interest rate for the draw period is typically adjustable.
    Repayment Period
    • During the repayment period the borrower can no longer access funds with the line of credit and is required to pay down the outstanding loan balance.  The repayment period is typically 10 - 20 years.  The monthly payment during this time period is based on the interest rate and outstanding loan balance at the end of year 10.  Depending on what type of line of credit you have, the interest rate for the repayment period may be adjustable (same as during the draw period) or fixed.  If you have an interest only line of credit, your monthly payment may increase at this time because you are required to pay both interest and principal.
    Balloon Payment
    • Some interest only lines of credit do not have a repayment period and instead have a balloon payment at the end of the loan term when the borrower is required to pay the outstanding loan balance in full with a single payment.  For example, for a 15 year interest only equity line of credit with an ending loan balance of $45,000, the borrower is required to make a $45,000 payment at the end of year 15.
    • Borrowers can always pay down the loan balance over time before the balloon payment is due to avoid having to make one very large payment at the end of the loan.  Borrowers should make sure they fully understand the risks associated with any loan with a balloon payment feature.
  • HELOC Rates
  • The interest rate for an adjustable rate or interest only HELOC is based on an underlying index rate, such as the monthly LIBOR or prime interest rate, plus a fixed margin of 0% to 3.25%. The index plus the margin equals the interest rate you pay on the line.  Some lines of credit have a minimum floor interest rate that your rate cannot fall below even if the index rate plus the margin is less than the floor rate.

    Depending on the type of line you obtain, the interest rate during the initial draw period period adjusts monthly (most common), semi-annually, annually or every five years and fluctuates based on changes in the index rate. The interest rate typically remains adjustable, or variable, for both the draw period and repayment period but in some cases the rate becomes fixed for the repayment period, based on a formula determined at the time you obtain the HELOC.

    The interest rate for HELOCs with a combined loan-value (CLTV) ratio ratio above 80% can be 0.5% - 1.0% higher than the rate on a loan with a CLTV ratio below 80%. Additionally, the interest rate on lines for non-owner occupied properties can be .75% - 1.25% higher than the rate on owner occupied properties and the lender may also limit the loan term.

  • Great Mortgage IdeaThe draw period interest rate for a home equity line of credit is typically 0.25% - 2.5% lower than the rate on a home equity loan, depending on the CLTV, property type and loan term
  • Some lenders offer HELOCs with a low introductory interest rate for the first month (and possibly longer), also known as teaser rate, that is lower than the market interest rate for a first mortgage. At the end of the teaser period, the interest rate increases and becomes adjustable for the remainder of the line.

    The closing costs for a home equity line of credit are usually significantly lower than for a mortgage refinance.  Lenders typically charge a processing fee and and the borrower is also required to pay third party closing costs such as the appraisal report fee. In some cases the lender rebates certain closing costs so be sure to ask lenders about potential discounts when you shop for a HELOC.

    HELOC rates vary by lender and market conditions. Lenders that offer home equity lines include banks, credit unions and mortgage bankers with credit unions offering especially attractive terms. When shopping for a HELOC, we recommend that you contact at least four lenders to find the best terms.

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    Points: Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
     
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    Principal & Interest: A periodic payment, usually paid monthly, that includes the interest charges for the period plus an amount applied to the reduction of the principal balance.
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    Mortgage Insurance: The monthly cost for a policy that protects the lender in case you’re unable to repay the full amount of the loan. It is typically required for loans that have a loan-to-value ratio between 80% to 100%.
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    Property Tax: (Also called "Real Estate Tax.") Property taxes are government assessments on real estate property. With mortgage financing, the local, county or state tax assessment on real estate property is considered part of the monthly housing obligation and typically collected and set aside by the lender ...
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    Homeowner Insurance More Info
    Homeowner Insurance: or also commonly called hazard insurance, is the type of property insurance that covers private homes. It is an insurance policy that combines various personal insurance protections, which can include losses occurring to one’s home, its contents, loss of its use, or loss of other personal possessions of the homeowner, as well as liability insurance for accidents that may happen at the home or at the hands of the homeowner within the policy territory.lender ...
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    Homeowner Association Fee More Info
    Homeowner Association fee: (HOA) fees are funds that are collected from homeowners in a condominium complex to obtain the income needed to pay (typically) for master insurance, exterior and interior (as appropriate) maintenance, landscaping, water, sewer, and garbage costs.
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    Points More Info
    Points Fees you are willing to pay in order to get a lower interest rate. The number of points refers to the percentage of the loan amount that you would pay. For example, "2 points" means a charge of 2% of the loan amount.
    Origination Fee More Info
    Origination Charge: A loan origination charge is a fee charged by the lender for evaluating, processing, and closing the loan.
    Credit Report Fee More Info
    Credit Report Fee: Fee charged to obtain an applicant’s credit history prepared by one or all of the three major credit bureaus. Used by lender to determine the borrower’s creditworthiness.
    Tax Service Fee More Info
    Tax Service Fee: A fee charged by the lender to cover the cost of retaining a tax service agency. These agencies monitor the property tax payments on the property and report the results to the lender.
    Processing Fee More Info
    Processing Fee: A processing fee is a charge by the lender for clerical items associated with the loan. Examples of processing include loan set up, organization of loan conditions for underwriting, and preparing required disclosures for the borrower.
    Underwriting Fee More Info
    Underwriting Fee: A fee charged by the lender to verify information on the loan application, authenticate the property’s value, and perform a risk analysis on the overall loan package.
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    Wire Transfer Fee: In most cases lenders wire funds to escrow companies to fund a loan. Commercial banks that perform this function will charge the lender so the fee is generally passed on to the borrower.
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    FHA Upfront Premium More Info
    FHA Upfront Premium: A fee paid in cash at the close of escrow or more commonly it is financed into the loan. These premiums are pooled together by the FHA and are used to insure the risk of borrower default on FHA loans. FHA upfront premiums are prorated over a five year period, meaning should the homeowner refinance or sell during the first five years of the loan, they are entitled to a partial refund of the FHA upfront premium paid at loan inception.
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    Other fees could be either additional Administrative Fees that a lender charges or it could be a Flat Fee to cover all lender charges such as: (Origination Fees, Points, Underwriting and Processing Fees, Credit Reports and Tax Service Fees)

    The flat fee does not include prepaid items and third party costs such as appraisal fees, recording fees, prepaid interest, property & transfer taxes, homeowners insurance, borrower’s attorney’s fees, private mortgage insurance premiums (if applicable), survey costs, title insurance and related services.

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  • You can also use the FREEANDCLEAR LENDER DIRECTORY to find HELOC lenders in your state

  • CLTV Ratio for a HELOC
  • To qualify for a HELOC, the borrower must have sufficient equity in the property to support the combined loan-to-value (CLTV) ratio of the first mortgage plus the line. CLTV ratio equals the total of all loans on a property divided by the estimated value of the property.  With a home equity line, the lender assumes that the line is fully drawn down to determine the ratio when you apply for the line. Lenders typically permit a maximum CLTV ratio of 80%.

    For example, for a property that is valued at $200,000 if the principal balance on the borrower’s first mortgage is $120,000 and the borrower obtains a $30,000 line of credit, the ratio is 75%, even if the borrower only plans to draw down $10,000 at closing ($120,000 (first mortgage) + $30,000 (fully drawn HELOC)) / $200,000 (property value) = 75% combined loan-to-value ratio).

    While most traditional lenders apply the 80% CLTV ratio limit for HELOCs, some banks and credit unions offer more aggressive terms including ratios up to 90%.  Please note that credit unions have membership eligibility requirements and not all borrowers are eligible to join.  Additionally, the interest rate for a line of credit with a CLTV ratio greater than 80% is typically higher than a line with a lower ratio and the lender may limit the amount of the line.

    The CLTV ratio limit may also vary by property type. Some lenders apply a 70% ratio limit for condos and a 70% - 80% limit for non-owner occupied properties (up to four units). Please note that many lenders do not offer HELOCs on non-owner occupied properties and the lenders that do typically charge a higher interest rate.

    Because CLTV ratio is such an important factor, it is important that you understand the estimated value of your property before you apply for a HELOC.  You can use real estate web sites to review your estimated home value and lenders may also have use their own property valuation services.  While these services only provide estimated property values, they can be helpful in determining if you have enough equity in your home to apply for a HELOC.  After reviewing these sites, consult your lender to determine if it makes sense to incur the cost and effort to apply for the line.  If you decide to apply for the line, the lender orders an appraisal report which provides the fair market property value used to calculate your CLTV ratio.

  • HELOC Qualification Requirements
  • Qualification requirements for a HELOC are similar to the guidelines for a mortgage and focus on a borrower’s debt-to-income ratio, credit score and employment history.  Your debt-to-income ratio is how much of your monthly gross income you are permitted to spend on your mortgage payment, home equity line payment, property tax, hazard insurance and other monthly debt payments such as credit card, car and student loans.  The lender assumes that the HELOC is fully drawn to determine the monthly payment for the line.  Depending on the lender and CLTV ratio, qualification guidelines usually permit a debt-to-income ratio up to 55%.  Lenders may allow higher debt-to-income ratios if your combined loan-to-value ratio is less than 65%.

    Lenders also review your credit score and job history to determine if you qualify for a HELOC.  If your credit score dropped significantly or you changed your employment since you applied for your mortgage, it may impact your ability to get approved for a line of credit, even if you have significant equity in your home.

  • Is Interest on a HELOC Tax Deductible?
  • The interest expense on a HELOC is tax deductible as long as the loan is used to buy, build or substantially improve the property that secures the loan. Additionally, HELOC interest is tax deductible as long as the total amount of loans secured by the property does not exceed the value of the property and the total amount of the loans, including the first mortgage, does not exceed $750,000 (in most cases).

    For example, if you take out a HELOC on your primary home to pay for renovations, then the interest expense on the is tax deductible. If you take out a HELOC and do not use the proceeds to buy, build or substantially improve your home, such to pay for a vacation, college tuition or to payoff credit card debt, then the interest expense is not tax deductible.

    Please note that the interest expense on a HELOC for a second or vacation home is tax deductible as long as the loan is secured by the second or vacation home and the the total amount of the loans on your primary, second or vacation homes does not exceed $750,000. If you use a home equity line of credit on your primary residence to buy a vacation home, the interest expense is not tax deductible. We advise you to consult a tax professional to understand how the HELOC interest tax deduction applies to you.

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