How a Home Equity Line of Credit (HELOC) Works
- Home Equity Line of Credit Overview
- The monthly payment on an equity line of credit is typically lower than the payment on a home equity loan, especially if you are only paying interest on the line of credit. Your outstanding loan balance may also be lower with a line of credit because you are able to borrow only the amount you need.
- Types of Home Equity Line of Credit
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.
- 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 Home Equity Line of Credit Works
- 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.
- 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.
- 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.
- Home Equity Line of Credit Interest Rate
- The 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
- Combined Loan-to-Value Ratio (CLTV) Requirement for a Home Equity Line of Credit
- Home Equity Line of Credit Borrower Qualification Requirements
- Related FREEandCLEAR Resources
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 home equity line of credit but only initially borrow, or draw down, $10,000 from the line, 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. If a borrower has a $50,000 home equity line of credit, the borrower can draw $50,000 from the line in year two, pay back $15,000 in year three and then draw $15,000 from the line in year four.
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 home equity line of credit 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 use equity in their properties without refinancing their first mortgages which can be costly, time-consuming and cost thousands of dollars more in total interest expense over the life of the new mortgage. Additionally, a home equity line of credit enables the borrower to borrow and pay interest on only the amount of money they need at any given time, which can make it less expensive 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 second mortgage or home equity line of credit. You typically do not need to get approval from your first mortgage lender to put in place a home equity line but the home equity line lender will want to review the first mortgage note to make sure that there is no acceleration clause in the note that makes the first mortgage payable in full if the borrower puts a second mortgage in place.
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 home improvements or remodeling, then the interest expense on the HELOC 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 on the HELOC 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 HELOC on your primary residence to buy a vacation home, the interest expense on the HELOC is not tax deductible. We advise you to consult a tax professional to understand how the HELOC interest tax deduction applies to you.
There are two primary types of home equity lines of credit: adjustable rate and interest only. We explain how each type works below.
HELOCs are typically broken into a draw period and a repayment period although some interest only home equity lines require a balloon payment at the end of the loan. We explain each component of a equity line of credit below. Most HELOCs 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 HELOC and is required to pay down 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 of the HELOC, the loan balance is paid in full, unless the HELOC has a balloon payment structure which is relatively uncommon.
The interest rate for an adjustable rate or interest only HELOC is based on an underlying index rate, such as the monthly or six month LIBOR or prime interest rate, plus a fixed margin of 0% to 3.25%. 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 of credit 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 (variable) for both the draw period and repayment period of the line of credit but in some cases the interest rate becomes fixed for the repayment period, based on a formula determined at the time you obtain line.
The interest rate for lines of credit with a CLTV 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 loans 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.
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 current market interest rate for a first mortgage. At the end of the teaser rate period, the interest rate increases and becomes adjustable for the remainder of the home equity line.
For a home equity line, lenders typically charge a processing fee and and the borrower is also required to pay third party closing costs such as the appraisal fee. In some cases the lender will rebate certain closing costs so be sure to ask lenders about potential discounts and rebates when you shop for a home equity line of credit.
The interest rate and fees on HELOCs vary by lender and market conditions. Home equity lines of credit are offered by banks, credit unions and mortgage bankers with credit unions offering especially competitive terms. FREEandCLEAR recommends that you contact at least four lenders when shopping for your home equity line of credit to find the loan with the lowest interest rate and fees. Click on lenders in the table below or INTEREST RATES to compare lenders.
You can also use the FREEANDCLEAR LENDER DIRECTORY to find lenders in your state that offer HELOCs
In order to obtain 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 home equity line. CLTV ratio equals the total of all the mortgages on a property divided by the estimated value of the propertyWith a home equity line, the lender assumes that the line is fully drawn down when determining the CLTV ratio at the time the borrower applies for the loan. 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 $100,000 and the borrower obtains a $60,000 home equity line of credit, the CLTV ratio is 80%, even if the borrower only plans on borrowing $30,000 initially when the line of credit closes ($100,000 (first mortgage balance) + $60,000 (fully drawn down equity line)) / $200,000 (property value) = 80% combined loan-to-value ratio).
While most traditional lenders apply the 80% CLTV ratio limit to HELOCs, some banks and credit unions offer more aggressive terms including CLTV ratios up to 90%. Please note that credit unions have membership eligibility requirements that may not apply to all borrowers. Additionally, the interest rate for a home equity line of credit with a CLTV ratio greater than 80% is typically higher than a line with a lower CLTV 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% CLTV 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 in determining what size home equity loan you can obtain it is important that you understand the estimated value of your property before you apply for a home equity line. You can use web sites like Realtor.com, Trulia and Zillow to review the estimated value of your property and lenders may also have proprietary property valuation tools. The property value estimates provided by these sites are unofficial approximations but can be helpful in assessing if you have sufficient equity in your home to apply for a home equity line. After reviewing these sites, consult your lender to determine if it makes sense to incur the time and expense required to apply for the loan. When you apply for a HELOC, the lender will order an appraisal report from a certified appraiser to determine the actual property value used to calculate the CLTV ratio.
In order to qualify for a HELOC, the borrower must meet the lender’s qualification requirements. Lender qualification guidelines for a home equity line are similar to the qualification guidelines for a mortgage and focus on a borrower’s front end and back end debt-to-income ratios. The front end debt-to-income ratio represents the maximum acceptable percentage of a borrower's monthly gross income that can be spent on total monthly housing expense (MHE) which includes your mortgage payment, home equity line payment, property taxes, insurance and other applicable expenses such as homeowners association fees, private mortgage insurance (PMI) and FHA mortgage insurance premium (MIP). The lender assumes that the line of credit is fully drawn to determine the monthly payment on the line of credit and total monthly housing expense.
The back end debt to income ratio represents the maximum acceptable percentage of a borrower's monthly gross income that can be spent on total monthly housing expense plus other monthly debts such as auto, credit card, student loans and spousal support. Lenders typically focus on the back end debt-to-income ratio to determine a borrower’s ability to qualify for a HELOC. Depending on the lender and CLTV ratio, lender qualification guidelines typically allow a maximum back end debt-to-income ratio of 55%. Lenders may allow higher back end debt-to-income ratios at lower CLTV ratios (CLTV of less than 65%).