What is a home equity line of credit (HELOC)?
A home equity line of credit (HELOC) is a line of credit that uses the equity in your home as collateral. The amount of credit you have depends on the equity in your home, your credit score and your debt-to-income ratio. Because HELOCs are backed by an asset, they tend to have higher credit limits and much better interest rates than credit cards or personal loans. Although HELOCs generally have variable interest rates, some fixed rate options are available.
Key points to remember
- HELOCs are lines of credit secured by your home. They are most often issued in the form of credit cards or checkbooks.
- HELOCs have both a draw period and a redemption period. The drawdown period involves minimal interest payments and the repayment period involves much higher payments.
- While there are fixed-rate HELOCs, most have variable rates, which means minimum payments can skyrocket as interest rates rise.
- If you can’t afford to pay off your HELOC, you risk losing your home to foreclosure.
How a home equity line of credit (HELOC) works
Home equity lines of credit (HELOC) are based on the amount of equity in your home. To calculate the equity in your home, you would take the appraised value of your home minus the total balance of existing mortgages, HELOCs, home equity loans, etc., to get your equity. Most qualified borrowers can withdraw up to 85% of the equity in their home. For example, someone with a good credit score and a good debt-to-equity ratio with a house worth $300,000 with a loan balance of $100,000 could be approved for a HELOC of up to $170,000. .
HELOC rates vary but are generally significantly lower than credit card or personal loan interest rates, but slightly higher than mortgage rates. HELOC rates are generally variable, meaning they can fluctuate with the market. HELOCs tend to have very low or no origination fees and are relatively simple to obtain, making them a more attractive option than a refinance or cash refinance for many borrowers.
Since HELOCs are secured using your home as collateral, you risk losing your home to foreclosure if you can’t pay yours back. Make sure you’re using your HELOC for things worth the risk.
The terms of each HELOC vary, but most often have a drawdown period of 10 years and a repayment period of around 15 years. During the draw period, borrowers have the option of using up to their line of credit limit on their HELOC and making minimal interest-only payments. Once the drawdown period ends, borrowers must make much larger payments to repay the balance owing on their line of credit that they used during the drawdown period.
Debt reloading risk
HELOCs pose a high risk of reloading debt, particularly because they are easy to obtain and because of their drawdown and repayment periods. Over the past few decades, as home values have continued to rise dramatically, borrowers have found themselves with ever-increasing home equity and access to cheap credit through their HELOCs.
Many borrowers get used to low interest-only payments on their HELOC during the drawdown period and aren’t ready to pay off their HELOC during the repayment period, so they take out another HELOC or home equity loan to pay it off. the first. They can then continue this cycle as long as the value of their home continues to rise. During the financial crisis, when home values plummeted, many borrowers who used this method found their homes in foreclosure.
An example of HELOC debt reloading
There is no real limit to the number of HELOCs a borrower can take out as long as they continue to have decent credit and increased home equity. The downside is that continuing to take out HELOCs could lead them into debt if they’re not careful.
Let’s say a borrower in 2010 had a mortgage balance of $100,000 on a $200,000 home. This would allow them to purchase a HELOC of up to $85,000. In this example, they withdraw this maximum amount. In 2012, they had mortgage + HELOC #1 – taking into account some payments on the mortgage, the outstanding balance is now $150,000 – but their house is now worth $300,000, which allows them to take out a other HELOC up to $112,500. This brings their balance to $262,500.
Eight years later, the combination of the two HELOCs plus their mortgage gives them a balance of $250,000, and the house is now valued at $600,000. This means they can purchase another HELOC up to $297,500. The owner is now in the repayment period for this first HELOC, and in two years the repayment period for the second HELOC will begin.
The major risk for this borrower would be to use this third HELOC not to pay off the first two but to make small payments on the three while spending the rest frivolously. In 2022, their second HELOC will enter the repayment period. If their home’s value hasn’t increased at all, then they can’t open another HELOC to help cover the increased payments, they’ll be used to a dramatically inflated lifestyle, and they’ll be over $500,000 in debt. $ for a house they owed $100,000 just 12 years earlier.
Is interest on a HELOC tax deductible?
Interest paid on HELOCs and home equity loans used to be tax deductible, but as of 2017, interest is only deductible for the amount used on a HELOC to “buy, build, or substantially improve” a home. Additionally, with the standard deduction increasing to $12,950 for single filers and $25,900 for married couples filing jointly in 2022, most HELOC interest paid will not be high enough for most filers to warrant deductions. detailed, unless they already do so for other reasons.
Can you have multiple HELOCs or home equity loans on one property?
Yes. There is technically no limit to the number of HELOCs and home equity loans you have on the same property. Most lenders will allow a qualified borrower to access up to 85% of their home’s equity through HELOCs and home equity loans. If the value of your home continues to rise, you can continue to take out multiple HELOCs and home equity loans.
What are the requirements for a HELOC?
Lender requirements vary, but borrowers will generally need:
- More than 15% of the equity in their home
- A credit score of 600 or higher
- 2+ years of verifiable income history
- A debt-to-income ratio of 40% or less
HELOCs, when used mindfully, can be a great tool for borrowers to consolidate high-interest debt at a lower rate, make substantial home improvements, invest in real estate, and more. However, they come with significant risks, and borrowers should be aware of these issues before purchasing a product that erodes their ability to build wealth through home equity.