What is a Home Equity Line of Credit (HELOC) & How Does it Work

Life can hit unexpectedly—from emergency expenses to a job loss or career change, or perhaps a housing opportunity you just can’t pass up—there are a lot of factors that can impact the course of your life (and your personal finances).

The bad news? It’s downright difficult to prepare for life’s unexpected changes. The good news? There are financial resources out there that you may help you solve life’s sudden curveballs.

One of these solutions is a home equity line of credit, otherwise known as a HELOC. According to a study by TransUnion, home equity lines of credit are expected to double in 2018 to 2022, with approximately 10 million consumers expected to originate a HELOC.

What Is a Home Equity Line of Credit (HELOC)?

A HELOC is a type of credit in which your home serves as collateral, according to the Federal Reserve Board. The Board notes that, since a home is typically a consumer’s most valuable asset, homeowners tend to reserve using a HELOC exclusively for big expenses such as education, medical bills, or investments in home improvement.

In this article, we’re discussing HELOCs, how they work, and what it takes to qualify for a home equity line of credit. If you decide that this form of financing is right for you, we’re offering some tips on how to shop for a home equity line of credit. Looking for information on a specific topic? Use the links below to navigate.

• What is a Home Equity Line of Credit (HELOC)?
• HELOC Advantages and Disadvantages
• Is a Home Equity Line of Credit Right for Me?
• How to Get a Home Equity Line of Credit
• Be On the Lookout for Abusive Loan Practices
• Consider Your Other Loan Options
• HELOC Guide Takeaways

What Is Home Equity?

The U.S. Department of Housing and Urban Development says that home equity is “the difference between your home’s fair market value and the outstanding balances of all the loans and other liens on your property.” With a home equity line of credit, a lender loans the borrower a specified amount of money based on the equity in their home. The home serves as collateral for the loan—if payments are not made, the property could be seized.

How Much Money Can You Borrow on a HELOC?

According to the Federal Trade Commission, the amount of money you can borrow on a HELOC varies depending on a variety of factors evaluated by your lender. This number may be impacted by the following variables:

• Your lender
• Your creditworthiness
• Your outstanding debt
• The appraised value of your home
• How much you still owe on your mortgage

When you apply for a HELOC, your lender will likely take these factors (and other details) into consideration to determine how much money you qualify for. The FTC says that depending on these factors, you may be able to borrow up to 85% of the appraised value of your home, minus the amount you owe on the mortgage. Keep in mind that this rate may vary depending on how your lender calculates the loan you qualify for.

What Can a Home Equity Line of Credit Be Used for?

A HELOC is a bit like a credit card so, technically speaking, you can use your home equity line of credit for whatever you please. However, there are strategic ways to use your HELOC, as well as some potential pitfalls.

The Federal Reserve Board notes that since a home is typically a consumer’s most valuable asset, homeowners should only take a loan against their home with a HELOC to finance major investments rather than small, day-to-day expenses.

Top Reasons to Use a HELOC

• Investing in a new home or property
• Home improvements
• Education expenses
• Medical bills
• Large purchases

HELOC vs. Home Equity Loan — What’s the Difference?

If you’ve already done some research online, or you’ve asked your financial advisor, “what is a home equity line of credit?” chances are that you’ve also come across “home equity loans” in your search. While both a home equity line of credit and a home equity loan each use a consumer’s house as the loan collateral, and they’re both lending vehicles, they each present different terms that may appeal to different consumers.

Depending on when you need the cash, whether you’d prefer loan proceeds as a lump sum or as smaller installments over time, and how you want to pay off your loan, you may find that one is better suited to your needs than others. Let’s discuss the differences between HELOCs and home equity loans.

Home equity line of credit (HELOC)

• Adjustable interest rate: HELOCs generally have a variable interest rate associated with the loan— meaning that your monthly loan payments might increase or decrease throughout the lifetime of your loan. According to a publication from the Consumer Financial Protection Bureau, lenders often offer an introductory interest rate at the beginning of the loan for a short period of time—about six months or so—before adjusting the rate. Some lenders will allow you to switch to a fixed interest rate at that time, so ask your lender if this is a possibility before you sign onto a HELOC loan agreement.
• Borrow as you need: A HELOC gives homeowners the freedom to borrow smaller amounts of money from their maximum loan amount as they need, rather than having to withdraw a lump sum of cash with a home equity loan. For some consumers, this may be a more manageable loan structure if you need to make continuous payments for an expense such as a college education. In other cases, such as a full kitchen remodel within 1-2 months, a singular, lump sum might be more attractive.

Home equity loan

• Fixed interest rate: Home equity loan lenders generally place a fixed interest rate on their loans, which is the opposite of a typical HELOC.
• Borrow a lump sum: Home equity loans lend homeowners their approved loan amount in the form of a single lump-sum amount, wherein the homeowner can allocate funds as they need.

How are HELOC interest rates calculated?

Since HELOCs are generally structured on a variable or adjusted interest rate, lenders have to follow some guidelines for how much they can charge in interest so that consumers aren’t faced with wildly inflated costs upon borrowing. According to the Consumer Financial Protection Bureau, lenders must base these variable interest rates on a publicly available index.

What constitutes as a publicly available index, you ask? Many daily newspapers like the Wall Street Journal have key interest rate metrics for consumers and lenders to follow as they change week by week. Additionally, the U.S. Department of Treasury offers statistics on current interest rates for various loan types.

HELOC Advantages and Disadvantages

Anytime you’re making a major financial decision, it’s important to weigh out the pros and cons to help you make the best choice for your finances and future.

HELOC Advantages

• You have access to funding for large expenses when you need it.
• You have the ability to invest money into your home if you choose.
• Interest on HELOCs can be tax deductible if proceeds are used to further invest in the home (ie. a room addition, structural repairs), not if they’re used for other personal expenses (like paying off credit card debt, student loans).
• Some lenders waive closing costs for HELOCs or offer lower rates.

HELOC Disadvantages

• If the value of your home decreases, your lender might decide to no longer allow you to take out new credit from your HELOC plan.
• If you’re not able to make your payments or you have trouble making payments in full, then is kind of loan agreement might cause more financial trouble for you and put your home at risk.

Is a Home Equity Line of Credit Right for Me?

Deciding whether or not you should open a home equity line of credit depends on a variety of factors— including your financial health, the value of your home, and your ability to make repayments on the loan amount you’ve borrowed. If you’re unsure whether a HELOC is a good idea, try consulting with a HUD-approved housing counselor. Housing Counselors that are approved by the U.S. Department of Housing and Urban Development can offer free or low-cost advice about buying, renting, foreclosure options, credit, and navigating home loans.

How to get a Home Equity Line of Credit

HELOC requirements

Each lender will have different requirements and procedures related to their HELOC approval process. But according to documentation from The Federal Reserve Board, in general, lenders will consider your income, credit history, and your current debt to income ratio (DTI) to determine your ability to pay off the loan. This information will also likely impact how much money your lender will be willing to approve you for, also known as your credit limit.

How do I shop for a HELOC?

If you’ve decided that a home equity plan makes sense for you, the Consumer Financial Protection Bureau suggests having your lender work through a comparison worksheet with you to help you identify what the best plan option is for you. In addition, you may want to compare offers from different lenders, as well as HELOC vs. home equity loan options to help you make the most informed decision.

Take a glance at your financial profile

If you’ve established that a home equity line of credit makes sense for you, you may want to take a deeper look at your financial profile to make sure you meet the HELOC credit score requirements and any other criteria that you may need in order to qualify.

What are the credit score requirements for HELOC? Lenders look at a variety of factors when evaluating your loan application—including your credit score. While lenders each have different requirements for approving home equity lines of credit, maintaining a high credit score can have many benefits—such as a higher likelihood of loan approval. As for what credit score range you want to strive for when applying for a home equity line of credit, there’s no surefire answer, but Experian says a FICO® Score of at least 700 can help expand your mortgage options.

Note: Turbo uses TransUnion’s VantageScore to rate consumer credit scores. Before you start applying for HELOCs, check your free credit score with Turbo. If you find that your credit score and financial profile aren’t quite meeting your personal goals (or your lender’s requirements), use TurboTax financial health tools to help you get on track before taking out a second mortgage.

Why should I work toward a higher credit score before applying for a HELOC? The FTC says the reason lenders tend to approve applicants with higher credit scores is that they are considered less of a risk to lend to. Therefore, lenders may be more apt to favor applicants with a higher credit score when it comes to approving HELOCs or establishing the loan’s interest rate.

Keep in mind, the credit score is just one of the things lenders will look at when you’re shopping for a HELOC. They may also consider the amount you owe on your current mortgage, your outstanding debt, and the appraised value of your home.

Compare lending options

In a 2013 survey from the Consumer Financial Protection Bureau, they found that 47% of home buyers did not compare lenders when shopping for a mortgage. The borrowers who were self-assured about their knowledge of available interest rates were about twice as likely to shop around and compare their mortgage options. What does this mean for consumers like you shopping for a home equity line of credit? The CFPB says consumers should be shopping around when looking for financing options.

Ask your loan officer to help you fill out this worksheet to help you compare options and find the HELOC or home equity loan that works best for you. Use the chart below to help guide you.

Additional HELOC costs to consider

Aside from your principal loan amount and interest fees, you’ll also want to take into consideration any extra costs that your lender might charge. Depending on your loan agreement, your lender might be able to charge you for:

• Not activating (using) your HELOC loan
• Each year you have the HELOC — like an annual fee
• Terminating the HELOC early — functioning as a cancellation fee

Make a plan for paying back your loan

Have you found a plan that sounds like it works for your loan needs and budget? Congratulations! But before you enter a loan agreement, you will probably want to put a plan into place for how you’re going to pay back the money that you’ve borrowed. Work with your lender to determine the kind of payment plan they typically use and make sure you’re familiar with the payment guidelines. The Consumer Financial Protection Bureau advises consumers that some lenders allow borrowers to pay extra on their loan, while others might charge additional fees if you want to get ahead of your payments. Just make sure you’re aware of their rules before signing onto a binding agreement.

In addition to familiarizing yourself with how your lender structures payment plans, you’ll want to take a look at your budget and financial plan to make sure you can actually go through with your loan payments. Create a budget with all of your monthly expenses and outstanding debt—and stick to your budget! The National Credit Union Association warns home equity borrowers that if they’re unable to make their loan payments, the lender may have to force the borrower to sell their home in order to satisfy the debt.

Be on the Lookout for Abusive Loan Practices

In addition to comparing your loan options, the FTC says consumers should also be on the lookout for harmful home equity practices. The following warning signs could pose a threat to your homeownership or even go against federal credit laws.

• The lender encourages you to refinance your loan often so that you’re borrowing more money and, therefore, paying the lender more in fees and interest.
• The lender tries to sell you credit insurance that you might not need to secure your loan.
• The lender uses a bait and switch style tactic—offering a specific set of loan terms during the application process, and changing the terms when you’re finalizing the transaction.
• The lender bases the loan on the equity in your home—not on your ability to make your monthly payments. The FTC warns consumers that if you’re unable to make your payments, you could be at risk of losing your home.
• The mortgage lender charges fees that are not in alignment with mortgage contract law such as unapproved late fees or lender-placed insurance. Or, if the lender is not providing you with transparent account statements to allow you to check in on your repayment status.
• You’re offered a “home improvement loan” from a contractor that partners with a mortgage lender of their choice. This scenario can be dangerous if the contractor begins work on your home and, suddenly, you find yourself forced into a home equity loan that you can’t afford.

If you encounter these scenarios with your current mortgage lender or a lender that is reviewing your home equity line application, you can file a complaint with the Consumer Financial Protection Bureau.

What is the three-day cancellation rule?

If you find yourself in a loan agreement that you realize just isn’t going to work for you, federal law gives you some protection to back out of a loan agreement, called the three-day cancellation rule. The three-day cancellation rule gives borrowers the freedom to cancel a home equity loan agreement within three days after you’ve signed the contract and have received the Truth-in-Lending Disclosure.

Borrowers are entitled to a Truth-in-Lending Disclosure by law. This document outlines the lender’s loan agreement terms.

Keep in mind that there are some restrictions on this rule, including the following:

• The three days begin after you have signed the contract, received a Truth-in-Lending Disclosure, and have been issued information regarding your right to cancel.
• The three-day rule only applies if you are using your primary residence as collateral for the loan (not a vacation or second home).
• Saturdays are included in business days for home loan cancellation purposes—but not Sundays or legal public holidays.

During the three-day waiting period, activity related to the loan agreement cannot take place (i.e. loan money cannot be issued, a contractor cannot deliver materials or start work).

Consider Your Other Loan Options

Now that you’ve got an understanding of how HELOCs work and what the requirements are to get approved for a home equity line of credit, you might be ready to start applying—or you may be wondering what other loan options are out there.

If you’re not sold on whether HELOCs risks outweigh the potential benefits to your current situation, or you don’t have the credit score to get approved, know that there are alternatives available to you, such as government loans, private lenders, traditional credit cards, and more.

HELOC Guide Takeaways

Financial decisions are rather daunting. They require a substantial amount of research, sometimes a lot of math, and a general understanding of how all these things actually work in conjunction! When deciding what kind of home equity credit line makes sense for you, ask yourself the following questions:

• Does my credit score meet my lender’s requirements?
• Do I have all of the information I need to apply for a home equity line of credit?
• Which home equity credit structure makes the most sense for me?
• Do the benefits outweigh the risks?
• Is the lender offering me a reasonable agreement that works for my financial situation?
• Have I compared the lending options available to me?
• Will I be able to make my loan payments?
• Have I consulted my available resources—such as a housing counselor?

Use this guide to help your research process so that you make the most informed financial decision for your circumstances.