What is a HELOC (home equity line of credit), and how does it work?

The amount you can borrow is based on the value of your home minus any mortgage(s) you may have as well as your income to help give you a payment you can afford.

As you pay off your mortgage, you'll build equity in your home. You can then leverage this equity via a HELOC to further your financial goals or cover significant expenses, like a home renovation.

HELOC funds have a multitude of uses, including debt consolidation, emergency funds, paying educational expenses or an alternative to a personal loan. HELOCs generally offer lower interest rates than other financing options, so it can be a big advantage for homeowners. Interest rates for HELOCs are variable, which means they adjust with the prime rate.

How does a HELOC work?

A HELOC works similarly to a credit card in that you are approved for a set amount of credit to use based on the equity in your home. But you do not have to use it all at one time as you would for a home equity loan.

You can easily access HELOC funds by writing a check. You may also have the option to transfer money through online banking or via a mobile banking app. The term of a HELOC is divided into two distinct phases:

The draw period

During the borrowing or draw period of the HELOC, credit is available for you to withdraw. This period typically runs for 10-15 years. You can take out either small amounts or a larger lump sum. It's up to you and your credit limit.

During this time, you're only required to make monthly interest payments on the money borrowed and not on the entire credit line. Of course, you can always pay more to reduce your balance faster.

The repayment period

After the draw period ends, the repayment period begins. The repayment period length may vary by lender and could last anywhere from 10 to 20 years.

Before you finalize a HELOC, it's a good idea to research the range of options to determine which payment structure best fits your budget. Remember, when you enter the repayment period, you're responsible for both interest and principal payments.

Most HELOC interest rates are variable and adjust with the prime rate. This means the amount of interest you pay could fluctuate up or down along with market interest rate trends throughout the draw and repayment period.

TIP: A HELOC can provide peace of mind by providing access to funds that you won't pay for unless you need them.

How to qualify for a HELOC

If you'd like to use the equity in your home to open a line of credit, you'll need to know how to apply and the amount of funds you can expect to receive. Generally, the process starts when you fill out an application and provide supporting documents requested by the lender.

Qualification

Lenders will review your application to determine if you have enough equity in your home to support a HELOC. They will also review your credit report and income. Your qualification generally depends on the following factors:

• Home equity amount. You'll probably need to have at least 15% to 20% equity in your home to qualify for a HELOC.
• Income. Lenders will ask about your income to determine if you can cover the cost of the HELOC payments.
• Credit history. A good credit score demonstrates satisfactory payments of current and past debt.
• Debt outstanding. Lenders will calculate your debt-to-income (DTI) ratio to ensure that you make enough money to cover current amounts owed, including credit card balances, auto loans and your primary mortgage.

Borrowing amount

When you're approved for a HELOC, the lender will also give you a total amount you can borrow from the line of credit. This credit line is determined after calculating your home equity and applying a loan-to-value ratio to calculate a borrowing amount. For example, if your bank uses an 80% loan-to-value ratio and the equity in your home equals $100,000, you may be offered a HELOC with an $80,000 max borrowing amount.

What are the pros and cons of a HELOC?

HELOCs give you the ability to access the equity in your home and use the funds for a wide range of purposes. When considering a HELOC, understanding the pros and cons can help you decide if an open line of credit is the best fit for your borrowing needs.

What you can use a HELOC for

A HELOC is similar to having a credit card with a large limit. Essentially, you can use the money for whatever you want, such as debt consolidation or paying for college. However, exercise caution. Just because you can borrow money doesn't mean you should.

Three great reasons to use a HELOC include:

• Home improvement. Under the new tax bill, if you use your line of credit to make improvements on your home, the interest you pay may be tax-deductible. Talk to a tax professional first, as that indoor bowling alley may not qualify.
• Education. A HELOC can be an excellent way to pay for the cost of a college education. You can borrow against your line as tuition payments come due, and you can use it for multiple years and multiple children. Interest rates on HELOCs are often lower than other student loan types.
• Safety net. If your emergency fund has been depleted or you don't have a substantial savings account, having an open HELOC may give you peace of mind. Life happens whether we're prepared or not. While you're busy building your "just in case" fund, you can always tap your HELOC when your water heater decides to stop working in the dead of winter. Once again, you only pay interest on what you withdraw.

TIP: Consider the financial risk versus reward of using a HELOC for any purpose. Will the money you borrow help to further a personal financial goal?

When you should avoid using a HELOC

Using your home equity puts your home on the line. If you fail to pay it back, you could lose your home. It's important to use your credit wisely and not be tempted to treat your home like an ATM.

Most homeowners limit borrowing on their HELOC to important purchases that add value to their lives or help them manage their finances. Replacing a leaky roof is a great way to use a HELOC as it's a large and necessary expense. Although a cruise around the world sounds amazing, it might not be the best option for this type of secured credit.

HELOC FAQs

What's the difference between a HELOC and a home equity loan?

Although both a HELOC and a home equity loan allow you to access your home equity by using your property as collateral, you should understand the differences between these home equity products. A HELOC is a line of credit that you only borrow from as needed, while a home equity loan provides you with an initial lump sum amount that you pay back over the term of the loan.

Also, HELOCs generally offer variable interest rates while a home equity loan is typically a fixed-rate product.

Is HELOC interest tax-deductible?

In some cases, the interest paid on a HELOC may be tax-deductible. Under the current IRS rules on home mortgage interest deductions, you may report interest paid on a HELOC as an itemized deduction in certain circumstances. The HELOC must be secured by your primary home or a second home, and the money borrowed must be used to "buy, build or substantially improve the taxpayer's home that secures the loan," according to the IRS.

Also, there are limitations on the total interest deduction. Tax filers who itemize deductions may combine interest associated with all mortgage loans and HELOCs up to a principal value of $750,000.

Can you refinance a HELOC?

Yes, as long as you have enough equity in your home and meet the lender's qualifications. Refinance options include opening a new HELOC, taking out a home equity loan or refinancing your primary mortgage.

Can you pay off a HELOC early?

Yes, but before you do, check with your lender about any prepayment fees.

A HELOC can bring you financial flexibility

Home equity lines of credit can be an attractive way for homeowners to use their equity to provide financial flexibility to help them achieve big goals. However, a HELOC isn't the only way to tap into your home's equity. Weigh your options to find what's right for you and your financial plan.

Interested in applying for a HELOC? Citizens FastLine® can help you get started.