What is a HELOC?

A HELOC is a revolving source of funds, like a credit card, that you can draw on and use as you see fit. In this case, the credit limit is set by how much your home is worth.

Your home’s equity is determined by the value of the property minus what you owe on your current mortgage. Your maximum loan amount is calculated using a two-step process:

• Step 1: Your home’s value is multiplied by the percentage of its total value that the lender authorizes you to borrow.
• Step 2: The total amount you still owe on the mortgage is subtracted from that amount.

Say you have a $500,000 home. You’ve still got $300,000 to pay off on the mortgage. If you were approved to borrow 85% of the home’s value (.85 x 500,000) you’d be able to borrow a maximum of $425,000. You still owe $300,000 so your total loan amount would be $125,000 ($425,000-$300,000).

As long as you pay off the amount you withdraw on time, you can continue to use this line of credit, repay, and repeat the process until the loan period is finished. If you can’t pay back the loan, you run the risk of foreclosure because this loan uses your home as collateral.

How does a HELOC work?

Once you apply and get accepted for a HELOC, whatever institution grants the loan will set the interest rate. Since the funds being granted to you are backed by your home value, meaning there’s less risk for the lender, your rate will often be relatively low.

This initial rate is called the index rate. Most HELOCs will have adjustable rates, meaning they’ll fluctuate with the interest rates of the market. Your rate will also have an additional markup added to it based on your credit score. The higher your score, the lower the markup.


The markup amount is called the margin. Always ask to see this before you sign the dotted line on your HELOC. Also note that HELOCs are different from home equity loans, which are fixed amounts of money that are disbursed once and paid back in installments.


Take the variability of interest rates into account when budgeting for your loan. A good way to calculate the maximum potential payment is to check the periodic cap—the amount the interest rate can change at any given time—and the lifetime cap—the highest rate you can be charged over the life of the loan. Those two figures will give you an idea of how high your rates are likely to get.


HELOCs are split into two time frames: the draw period and the repayment period. During the draw period, you can use any amount of the funds within your credit limit, whenever and however you want. This period usually lasts about ten to fifteen years.


Once the loan enters repayment, you can no longer use the credit line and must repay the loan until the balance is zero. During this phase, monthly payments can jump up to twice what they were during the draw period.

What are the pros and cons of a HELOC?

Any line of credit comes with risks and rewards. Let’s examine some of the pros and cons of taking out a HELOC.

Pros

Flexibility. You get to decide when and how you use the funds from your HELOC, as well as how much you take out. The amount you can borrow is higher relative to other loans. 


You also get to control how much you pay back, as long as you pay the minimum payment every month. Home equity loans, by contrast, require you to make a fixed payment monthly. 


Lower interest rates. Because they’re secured by the value of your home, HELOCs often come with lower interest rates than other credit options. A lower rate makes HELOCs an option worth considering for paying off high-interest debt or making a large purchase without needing a high-interest loan.

That means HELOCs will have a lower overall cost than other loan types. But you’re also assuming more risk.

Tax-deductible interest payments. Paying down the interest on a HELOC can lessen the amount you’ll pay in taxes at the end of the year. Some or all of interest payments on a HELOC are tax-deductible. It’s generally recommended that you consult a tax advisor for all the ways that your interest can be deducted.

You’re often required to make monthly interest payments during the first phase of a HELOC—the draw period. That money can add up. You may also be eligible for tax breaks if you use the money for home renovations that increase your property value.

A HELOC can potentially help your credit score. Credit bureaus don’t typically view using the entire amount of a HELOC loan the way they would maxing out a credit card. If used responsibly and paid back in full, a HELOC could improve your credit score in the long run.

Cons

Diminished equity. The more you cash out on the equity in your home, the more you owe on it. The more you owe on it, the less equity you have. 

If you’re not careful, you can end up owing as much as—or more than—your home is worth. If the real estate market dips enough, people with a higher combined loan-to-value ratio (CLTV) are particularly vulnerable to this happening. Owing more than the home is worth is known as being “underwater” on the loan.

You put your home up as collateral. If you default on a HELOC, you run the risk of losing your home. You could end up being foreclosed on, even if your original mortgage loan is still in good standing.

You could be tempted to overspend. Whatever your goals, it can be hard to manage the significant amount of money accessed via a HELOC. You may be tempted to make large purchases you wouldn’t otherwise make just because the money is at hand.


But those purchases all have to be paid back with interest. If you’re not good with money management, it’s strongly recommended that you build up those skills before getting involved with a HELOC. Make a plan for how the money will be spent before you even take out the loan, and then stick to that plan.

The process

If you decide to go ahead with a HELOC, the process will be similar to a refinance or mortgage loan.

1. Figure out your equity

Before you do anything else, you’ll need to see if you even have enough equity in your home to qualify for a HELOC. There are plenty of free calculator tools that can help you calculate a loan estimate based on your home’s value. 



2. Get your paperwork in order

Prepare any documentation you’ll need to apply for your loan in advance. You’ll need official paperwork to verify your income, assets, and debts.

If you’re a W-2 wage earner, you’ll need:

• Your W-2 form
• Your two most recent paycheck stubs

If you’re an independent contractor or self-employed freelancer, you’ll need:

• A year-to-date profit and loss statement
• Two years of records, including 1099s

At the time of this writing, many lenders are unable to service self-employed borrowers. But it’s easy to check—just give us a call.

If you have other assets, you’ll need 60 days' worth of bank statements to verify them. You’ll also need two months of statements for any retirement accounts, investment accounts, or CDs. 


3. Submit your application

Once you’ve got the paperwork together and you’ve found the lender you believe will give you the best rate, turn in your application. The lender will typically process it, conduct a soft credit check, and get back to you with the next steps. You shouldn’t have to pay an application fee, and if you do, that fee should be refunded to you on closing.


4. Read the disclosure documents

Lenders are required to provide you with disclosure documentation spelling out the rate and terms of your loan once they’ve processed your application. Review this document carefully. Write down any questions you have so they can be addressed before you finalize the contract. 

Make sure the HELOC being offered fits your needs and budget. Keep an eye out for fees you didn’t anticipate. For example, some HELOCs require you to borrow money up front (called an “initial draw”). Are there prepayment penalties? Do you have to open a separate bank account to get the best rate? 

Some HELOC agreements charge you for not withdrawing anything. Look for balloon payments—payments at the end of the loan that are much larger than the previous ones. Know when the draw period ends. Check everything and ask questions.

5. Go through the underwriting process

Underwriting on your loan can take anywhere from hours to weeks. You may have to get an appraisal to assess your home’s value, and a fee for the appraisal could be tacked onto your total loan amount. Keep an eye out for messages with requests for more documentation and respond as quickly as possible. Doing so will help you move ahead in the process more quickly.

6. Close on the loan

This is the stage where you’ll dot the i’s, cross the t’s, and finalize the loan contract. Make sure every question you have about your loan is answered to your satisfaction before signing the contract. Document the entire loan process thoroughly for your records. Once the contract is finalized, the money will be made available.

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Should you get a HELOC?

Whether you should or shouldn’t take out a HELOC comes down to what your goals are and what your financial situation is. 


When it’s a good idea:

If you’re using the money to put value into your home with a renovation project, for example, that’s probably a good use of the funds. It ultimately contributes to your home’s equity and helps build your credit. 


Debt consolidation is another popular use for HELOC loans. If you can get your debts under one payment and reduce the interest rate you pay on them, a HELOC could be a responsible way to pay your debts down. 


When it’s a bad idea:

You shouldn’t take out a HELOC just to pay for something like an expensive car or vacation. Those things don’t help build wealth and only pile on more debt that you have to pay back later with interest. 


If you have an unstable income, you can’t pay the upfront requirements for the loan, or you can’t afford an unexpected interest rate increase, hold off on a HELOC. These factors all make it more likely you’ll default on the loan and dig yourself into an even deeper financial hole. 


You’ll also want to look elsewhere if you don’t need a large line of credit. Chances are you can find another credit option that meets your needs with less upfront cost and risk than a HELOC if you aren’t looking to make that large of a purchase. 


Taking out a HELOC for the purpose of making ends meet is a very risky option. You’re better off looking elsewhere for credit options and finding ways to rehab your personal finances that aren’t as expensive and don’t entail this much risk.

A final word

HELOCs are fine as long as you're very clear about your goals and finances going in. Know how much money you’ll have at your disposal, and make sure you can cover the amount of the highest payment you’re likely to see.


Document everything meticulously. Calculate the interest rate caps for your loan. Check for balloon payments at the end of the loan. Check for fees you might not anticipate. 

Make sure you’re able to pay the upfront costs of your loan. Do not be afraid to ask questions about anything and everything you do not understand.

Be aware of the consequences of defaulting on a HELOC loan. It can result in foreclosure, or extensive damage to your credit if you can’t pay back the loan. Spend the money on things that make sense and have long term value—like home renovations—and have a plan to pay it back. Do not spend it on frivolous high-dollar items like a new car.


Is a HELOC for you?

Consider multiple loans and multiple credit options before deciding on a HELOC. It could be that you can get what you need with less expense and less risk elsewhere. If you decide to take out a HELOC, just get in touch with our team here at Lower.