- HELOCs are mortgages secured by your home.
- HELOCs are revolving lines of credit that you can use and reuse much like credit cards.
- Most HELOCs have variable interest rates.
The HELOC, or home equity line of credit, is a flexible loan secured by your home. Like all loans secured by real estate, HELOCs are mortgages. If you fail to repay a HELOC, the lender can foreclose, evict you and sell the property to recoup your loan balance.
How Does a HELOC Work?
Most home equity loans are simple. You close your loan and receive a lump sum, which you repay in equal monthly installments. However, the HELOC is more complicated than a fixed-rate home equity loan.
HELOC interest rates
HELOC rates are usually variable and change over the life of the loan. Your HELOC interest rate equals the value of a published financial index – the Prime rate is a popular one – plus a fixed margin. When the index changes, so does your interest rate. If the Prime rate is 3.5%, and the loan margin is 3.5%, your interest rate would be 6%. If the Prime rate rises to 4%, your interest rate increases to 6.5%.
HELOC rates may be subject to ceilings, limiting how high your rate can go over the life of the loan and floors, which define how low they can go. Ceilings protect you, and floors protect your lender.
How you get your money with a HELOC
With a HELOC, you don’t receive money at closing. Instead, you are approved for a predetermined amount of credit. Your lender gives you one or more ways to access funds – checks, a card similar to a credit card, or online transfers to your bank account. You don’t accrue interest charges with a HELOC until you tap the credit line.
Paying your HELOC
HELOCs have two phases – the draw period and the repayment period, and the lender calculates your payment differently in each stage. The draw period is typically one-third of your HELOC term – five years for a 15-year loan and ten years for a 30-year loan.
Your HELOC functions a lot like the credit cards you probably have in your wallet during the draw period. You tap the line as needed up to your credit limit, and you only need to make a minimum payment. You can pay the balance down and reuse your HELOC repeatedly.
Your minimum payment during the draw period equals the annual interest rate divided by 12 months times your balance. If your balance is $10,000 and your interest rate is 6%, your minimum payment would be $10,000 * .06/12 = $50.
You only need to pay the minimum payment during the draw period, and you can tap your credit line up to its limit. However, during the repayment period, you can no longer borrow against your HELOC. You must use the remaining term to pay off your HELOC balance. Be prepared for your minimum payment to increase during this time.
If you owe $10,000 on a 15-year HELOC and your five-year draw period is up, your payment at 6% adjusts upward to $111.02. When you have a HELOC, it's important to consider what will happen to your payment once your loan enters the repayment phase.
How Much Can You Borrow With a HELOC?
The maximum amount you can borrow with a HELOC depends on your lender, the amount of home equity you have, and how strong you are as a borrower.
HELOC lenders typically set their maximum loan-to-value, or LTV, between 75% and 90% of your home’s value. LTV equals the total of all loans against your home, including the HELOC, divided by your property value. If your home value is $500,000, for example, and your lender’s maximum LTV is 80%, the maximum total of all loans against the house would be $400,000. Because $500,000 * .8 = $400,000.
Here’s how you can calculate your maximum loan amount:
- Estimate your current home value. You can use a home valuation tool on a real estate site or ask a local real estate agent.
- Multiply that number by your lender’s maximum LTV.
- Subtract the total balance of all loans against your home. The result is your maximum loan amount.
Suppose your home value is $500,000, your lender’s maximum LTV is 85%, and your current mortgage balance is $375,000. How much can you borrow with a HELOC?
- $500,000 * .85 = $425,000
- $425,000 - $375,000 = $50,000
Your maximum loan amount with this lender is $50,000.
Recently, some mortgage lenders have begun offering a fixed-rate HELOC. Fixed-rate HELOCs are a hybrid between traditional HELOCs and fixed-rate home equity loans. They may also be called convertible HELOCs.
When you borrow with a fixed-rate HELOC, you might fix your interest rate when you close on your loan or during the loan’s lifetime. If you draw the entire available amount at closing, you could make a fixed HELOC work as a home equity loan. Or you might fix the rate at a later time, perhaps when your loan enters the repayment period.
Fixed HELOCs offer protection from interest rate increases and can make it easier to budget for your payments. However, there are tradeoffs. If you fix your HELOC rate and interest rates drop, you will pay a higher rate than you otherwise would. And fixed-rate HELOCs have higher interest rates than comparable variable-rate HELOCs. They may also have higher lender fees.
HELOC Closing Costs
HELOC closing costs tend to be lower than those of fixed-rate home equity loans. Some lenders even offer HELOCs with no closing costs. Because HELOC closing costs can vary widely among lenders, comparing offers from several competing providers makes sense.
The list of HELOC closing costs includes things like application fee, underwriting fee, origination charge, appraisal fee, title insurance, escrow service fee, tax service, settlement fee, recording fee, and more. But it doesn’t matter – a lender could call its $500 charge a “loan origination fee” or a “hamburger,” and it’s still a $500 cost to you. What really matters is the bottom line – the total of all charges that you’ll pay to close your loan.
How to Shop for a HELOC
When you shop for a loan, in addition to the loan setup charges and interest rate, compare annual percentage rates, or APRs. The APR is mandated by the federal government and makes it easier to compare loans with different fees and interest rates. APR calculations include what you pay in interest over the loan’s life in addition to the upfront charges. Just make sure you compare loans with the same term – 15-year to 15-year, 30-year to 30-year, etc.
HELOCs work best when you need to borrow over an extended period, when you don’t know how much you’ll need, or when you just want the ability to borrow in an emergency.
Here are examples of good uses for a HELOC:
College tuition that you pay over several years
Ongoing home renovations taking place in stages
Emergency cash for your small business
Medical costs for a long-term illness
On the other hand, if you’re borrowing to buy a vacation home, consolidate high-interest debt, or pay for an expensive medical procedure, a fixed-rate home equity loan or fixed-rate HELOC might be better choices.
When comparing HELOC offers from lenders, check the fine print. Here are some fees that you don’t see with traditional mortgages, but you may with a HELOC:
Annual membership/account maintenance fees
Transaction fees for withdrawals from your HELOC
Early payoff or early termination fees may apply if you close the account before a specified date.
Nonuse, inactivity, or minimum balance fees may apply if you don’t use the HELOC or don’t use it enough.
Your loan is more likely to come with such fees if it has low or no closing costs. The lender is absorbing your costs upfront and won’t make them back if you don’t use the credit line.
A HELOC freeze occurs when a lender cancels, limits, or suspends the borrower’s access to the credit line. If your HELOC is frozen, you won’t be able to access your credit, or your credit line may be reduced. Your lender might freeze your HELOC for one of these reasons:
Your home value has fallen (this happened to many homeowners during the Great Recession when property values plummeted throughout the country).
The lender has reason to believe that you won’t be able to make your payments, perhaps because you are behind or because of a job loss.
Your credit rating has dropped significantly.
In addition, if the lender finds that you were not truthful on your HELOC application, your account might be frozen. You may be able to contest a HELOC freeze for any reason if the lender’s concerns are not justified.