Home Equity Line of Credit (HELOC)
What is a HELOC?
A home equity line of credit (or HELOC) is a low-cost, flexible loan that lets you to turn your home's equity into cash whenever you need it, up to a certain amount. A HELOC uses your home as collateral just like a home equity loan or cash out refinance, but works more like a credit card because it's revolving credit.
HELOCs are attractive to homeowners needing cash for spending or emergencies because they offer easy accessibility with the repayment flexibility of credit cards, but with annual percentage rates (APRs) that are half as high, potentially saving the borrower hundreds or thousands of dollars in interest charges over time. And when home prices go up, homeowners may have more equity in their home and are treated to more borrowing power through a HELOC.
Because HELOCs use a homeowner's property as collateral, they are easier to qualify for than unsecured loans. But this also means the borrower is at risk of losing their property should they fail to repay the lender.
How Does a HELOC Work? (Example)
HELOCs are designed for homeowners that want to borrow cash at a low interest rate and are willing to borrow against the equity they've built up in their home to get it. But unlike with a typical loan where the lender gives you money up front, a HELOC allows you to "tap" your credit line at any time until you reach your credit limit.
HELOCs work much like a credit card. Assuming you're approved, the lender gives you a credit limit that you may borrow up to for an agreed-upon length of time (typically up to 10 years), where the size of your credit limit is based on the amount of equity you've built up in your home and your credit rating. Each month you'd make minimum payments (or pay more than the minimum to pay off your borrowings faster), but you may borrow again up to the limit as you need it.
For example, let's say you were approved for a HELOC and the lender gave you a credit limit of $20,000. You could borrow $15,000 to make home renovations, which would leave you with $5,000 in available credit. Over time as you make monthly payments, you might finish paying back the $10,000 you originally borrowed plus interest charges, which would bring your available credit back up to $15,000 (the $5,000 you had available, plus the $10,000) from which you could borrow from again if you needed more cash.
How do HELOC interest charges work? HELOCs carry variable APRs, meaning if interest rates go up then so will the required minimum payments on your HELOC. The APRs charged on HELOCs are typically 0.5% to 1% higher than the federal prime rate, which is often 3 percentage points above the federal funds rate. If the federal funds rate is 1%, the interest charged on a HELOC may be 4% or 5% APR.
Differences Between a HELOC Vs Home Equity Loan
Home equity loans (often called second mortgages) let you borrow against your home's equity by opening up a second loan in addition to your existing mortgage payment. Just like with a traditional mortgage, the lender gives the borrower cash up front, and expects to be repaid in fixed monthly installments over an agreed-upon term (up to 30 years).
By contrast, a HELOC lets you borrow whatever amount you need (up to the credit limit) when you need it, and repay the lender a minimum amount (or more) each month. The required payments may change in size depending on how much credit you've used under the HELOC.
HELOCs also have APRs that change with interest rates, unlike home equity loans which carry fixed rates that are set when you are approved for the loan.
Differences Between a HELOC Vs a Cash Out Refinance
A cash out refinance is a type of mortgage loan that pays off your existing mortgage and gives you a larger mortgage to (the amount of your old mortgage plus the amount of cash you need). The cash out refinance loan is tied to your home's collateral just like with a HELOC, but a cash out refinance is a fixed-term loan with fixed payment amounts.
For example, if you wanted to borrow $50,000, a cash out refinance would pay off your existing mortgage and give you a newly-negotiated mortgage with a principal balance of $200,000 (that's $150,000 for the original mortgage plus the new $50,000 borrowed amount). You'd get the $50,000 in cash when you closed on the loan.
As discussed in detail above, HELOCs let the borrower take out smaller portions of their credit limit as needed, rather than all of the loan in one lump sum.
How Do I Get Approved for a HELOC?
For the best options, borrowers may want to have a credit score of 620 or higher and have at least 20% equity in their home, meaning they owe their mortgage lender an amount equal to 80% or less of the property's value. For example, if your home is worth $200,000, then you would need to owe $160,000 or less on the property to qualify for a HELOC.
If you meet those conditions, the lender will assess other factors that measure your ability to repay (such as income, job history and credit history) to establish an appropriate credit limit and APR for your HELOC. In all, it may take 30 to 45 days from the time you apply for your lender to evaluate your finances and let you start borrowing from your credit line.
HELOC Tax Implications
Is the interest you pay on a HELOC tax deductible after the 2018 tax law? Yes, but as with home equity loans, the borrowed funds can only be deductible if they are used to "buy, build or substantially improve" your home (or a second home you don't rent out) that secures the loan according to an IRS advisory that came out after the 2018 tax law passed.
You may not deduct the interest you pay on a HELOC if you took out the loan to pay off debt or buy something not related to a home renovation.
Assuming you meet those requirements and are using the money to renovate your home, you may deduct the amount of interest you pay for it from your taxable income to lower the amount you owe for taxes.
Are There Closing Costs on a HELOC?
It depends on the lender, but in most cases the closing fees on a HELOC are significantly lower than they would be for a cash out refinance or home equity loan.
Some mortgage lenders will charge closing fees ranging from $500 to around $1,000 for a HELOC, while others will waive the closing fees if you have the credit line open for a certain length of time or for other conditions. It makes sense to shop and compare lenders to find ones with low or waived closing costs.