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How a HELOC Works
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.
The 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.
There are three primary types of HELOCs: fixed rate, adjustable rate and interest only. For all HELOCs, your monthly payment is calculated based on your interest rate and outstanding loan balance. While your loan balance depends on how much you have drawn down the line, your interest rate depends on they type of HELOC you have. We explain how each type works below.
A home equity line of credit is are typically broken into a draw period and a repayment period. 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. Please note that some interest only HELOCs require a balloon payment at the end of the loan although this is relatively uncommon. The table below outlines the key loan terms for a HELOC.
Most HELOCs offer a low introductory period interest rate for the first month to one year of the line which is also known as teaser rate. The introductory period rate is lower than the current market rate for a first mortgage. You may be required to take a minimum initial draw -- also known as an advance -- when the HELOC closes and maintain a minimum loan balance for a certain period of time to be eligible for the lower introductory rate.
When the introductory or teaser period expires, you are required to pay the after introductory period rate which is significantly higher than the initial rate. For example, the after introductory period rate may be 2.000% to 3.000% higher than the teaser rate, which means your monthly HELOC payment may increase significantly depending on your loan balance. The after introductory period rate may be fixed or adjustable depending on the type of HELOC you have.
The interest rate for an adjustable rate HELOC is based on an underlying index rate, such as a treasury note 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.
If you have an adjustable rate HELOC, the interest rate during the 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 line 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.
The after introductory period interest rate for a HELOC is typically 0.250% - 1.250% lower than the rate on a home equity loan, depending on the CLTV ratio, property type and loan term
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 lenders rebate certain closing costs or offer lower rates if you open an account or set up autopay so be sure to ask 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. The table below shows interest rates, monthly payments and loan terms for HELOC lenders near you. We recommend that you compare loan proposals for at least four lenders to find the HELOC that is right for you.
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.
Use the FREEandCLEAR Lender Directory to search by lender type and loan program. For example, you can use our directory to find credit unions in your state that offer HELOCs.
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.
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.
Related FREEandCLEAR Resources
- HELOC Pros and Cons
- Comparing a Home Equity Loan and Line of Credit
- Comparing Refinancing to a Home Equity Loan
Sources
“My lender offered me a Home Equity Line of Credit (HELOC). What is a HELOC?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.
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