Is Taking Out a HELOC Right for You?

Your home isn’t just a place to live. It can also be a source of cash once you’ve accumulated some equity. One way to tap that equity is through a home equity line of credit, or HELOC. A HELOC can be a convenient and relatively inexpensive way to borrow, but it also has some downsides—the main one being that you might lose your home if you’re unable to make the required payments. This article explains when a HELOC could be the right choice for you.

How Much Can You Borrow With a HELOC?

The more equity you have in your home—that is, the larger the difference between what you owe on the home and how much the home is currently worth—the more money a lender might be willing to provide you.

Generally speaking, you’ll need at least 15% equity even to qualify for a HELOC, with a 20% minimum being common. For example, if your home is appraised at $500,000 and you owe $300,000 on it, your equity would be $200,000, or 40%.

Lenders won’t let you borrow an amount equal to your entire equity, only a portion of it. To determine that amount, they will calculate your combined loan-to-value ratio (CLTV ratio). That ratio includes not your current mortgage balance and the sum you want to borrow with a HELOC. In other words, the ration includes both loans combined.

Using the same scenario as above, assume your home is worth $500,000 and you still owe $300,000 on your first mortgage. If you were to take out a $50,000 HELOC, your combined debt would be $350,000, giving you a CLTV of 70%. Most lenders want to see a CLTV of 85% or less, so your loan is likely to be approved, assuming you meet certain other requirements, such as having a sufficiently high credit score.

Suppose you wanted to borrow more than $50,000. How much could you reasonably ask for? Using the same facts as above (and a lender willing to accept a CLTV as high as 85%), the maximum would be $125,000.

To arrive at that number, you’d first multiply the home value of $500,000 by 85%, which equals $425,000. Since you already owe $300,000, this allows for another $125,000 in potential borrowing.

How a HELOC Works

A HELOC is a form of revolving credit that works similarly to a credit card. Rather than a single lump sum, as with a home equity loan, the lender provides you with a predetermined credit line that you can borrow against as needed as long as you don’t exceed the limit.

With a $50,000 HELOC, for example, you might take out $10,000 at the outset to pay for a home repair or other big bill, leaving the remaining $40,000 untouched. A year later, you might withdraw another $5,000 for some other purpose, in which case your available credit line would then be $35,000.

This can go on for the duration of your HELOC’s draw period, which is often five or 10 years. As with a credit card, and unlike a home equity loan, you only pay interest on the amounts you actually borrow. During the draw period you have to make minimum monthly interest payments as set by your lender. You can also make principal payments if you wish to, which will restore that portion of your available credit and also save you on interest over the long term.

After the draw period ends, your HELOC goes into its repayment period. You must then repay whatever you borrowed, with interest, over a specified period, such as 20 years. At this point you can now longer make withdrawals.

What You Need to Qualify for a HELOC

Besides having sufficient equity in your home, you’ll need to prove to the lender that you’re a good risk.

For example, some lenders will require that you have a credit score of at least 620, while others set their minimum at 660 or even 680. The higher your score, the more likely you are to qualify a loan with an attractive interest rate.

Lenders will also want to assure themselves that you’ll have enough income to keep up with the monthly payments and ultimately pay the loan off in full. For that reason, they are likely to ask for pay stubs, W-2 forms, recent income tax returns, or other back-up.

In addition, lenders are likely to require information on any other debts you have, such as car or student loans. They’ll use that to calculate your debt-to-income (DTI) ratio. Your DTI compares your monthly debt obligations to your monthly gross income to make sure you aren’t getting in too deep. Lenders vary widely in their DTI requirements, and some will include your prospective HELOC payments in the calculation, while others won’t. Generally speaking, you’ll be in good shape if your DTI is 36% or less, although some lenders will accept 43% or even 50%.

The Dangers of Using Your Home as Collateral

A HELOC is a form of secured debt. Credit cards, by contrast, are generally unsecured.

Because your home serves as collateral for the HELOC (as it also does for your main mortgage), the lender has the right to seize and sell it to recoup its money if you fail to make payments, a process known as foreclosure.

While the odds of that may be low, it’s a good idea to borrow no more than you actually need and to have a realistic plan for paying it off.

Variable vs. Fixed Interest Rates

Most HELOCs carry variable interest rates that can go up or down, based on the particular benchmark index that they are tied to. They also have rate caps that limit how far or fast your rate can rise.

It’s worth inquiring about the caps on any HELOC you’re considering and asking yourself whether you’d be able to handle the worst-case scenario.

HELOCs with a fixed-rate option are less common, but available from some lenders. These loans start out with a variable rate but allow you to lock-in one or more fixed rates later on.

The Bottom Line

HELOCs can be a relatively inexpensive way to borrow money if you own a home, have equity in it, and meet the lenders other requirements. The major downside to a HELOC is that you’ll be putting your home at risk, so you may also want to look at other alternatives, such as an unsecured personal loan, if you have any doubts about your ability to repay.