The Wonderful World of Home Equity Lines of Credit

A Home Equity Line of Credit (HELOC) is typically used to consolidate debts, finance home improvements, or other personal expenses. A HELOC can be a smart choice if you have enough equity in your home and the discipline to repay the debt.

Why Get a HELOC

A Home Equity Line of Credit is provided by the bank or financial institution that holds your home mortgage. A HELOC is similar to a second mortgage; it allows you to borrow money against the value of your house, just like a home equity loan may do.

There are several reasons why someone might want to get a HELOC, and one of them is because there are lower interest rates on this type of loan than there are on a traditional loan. This means that you will pay less money in interest over time.

Another advantage of getting a HELOC is that it provides an alternative source of funds when you might need one. For example, if you decide that you need some extra cash for unexpected expenses or an emergency repair, but don't want to bother with applying for a second mortgage, then getting a HELOC could be a good option for you.

Applying for a HELOC

To begin the process, you'll need to gather your information and fill out an application. You will also have to go through a credit check, which is used to determine if you qualify for a Home Equity Line of Credit or not.

When you apply for a line of credit, the bank is using your home as collateral to cover any losses or defaults. Housing prices are not the only factor that credit unions consider when lending. When you apply for a loan, you can increase your chances of approval by having a good credit profile.

HELOC Credit Score and DTI Requirements

A good credit score will give you a HELOC with favorable terms that slash your borrowing costs. Most HELOC lenders want to see a credit score in the mid-600s, which means you're at least managing your current debt obligations. A score above 700 is considered the fastest way to qualify for a HELOC. If your score is in the mid-600s, expect a bit of a wait before you're approved.

If you're having trouble maintaining a good credit score, you might want to consider improving it by paying off your outstanding debts and lowering your outstanding balance.

According to FICO, the three most essential factors in determining your credit score are payment history (35%), amounts owed (30%), and length of credit history (15%).

Apart from credit score, most banks have minimum debt-to-income (DTI) requirements for HELOCs. And if your DTI ratio exceeds 43 percent, you're probably not going to get approved for a HELOC.

How HELOCs Work

HELOC loans are typically short-term, 10-15 year loans. The loans entail a monthly payment, and the loan can be amortized or "interest only." The HELOC gives you access to cash based on the equity in your home.

You usually get a credit limit equal to a percentage of the appraised value of your home and can borrow as much or as little as you want up to that amount. For example, if your bank appraises your home at $200,000, and you get a $100,000 HELOC, you can draw out $100,000 for renovations or any other purpose. You pay interest only on the amount that you borrow.

Tips When Taking a HELOC

If you're thinking about taking out a HELOC, here are some considerations that might help you make the right decision for your financial needs.

Get pre-approved before shopping for lenders

This will enable you to shop around and get quotes without having to go through the application process each time. When shopping around at different lenders, use this information to find the best deal.

Shop around for the best rate and fees

If you're looking at lenders in person, compare fees with other lenders so you can make sure you're getting the most competitive deal in terms of interest rates and fees. If you're comparing offers online, look at fees as well as rates, so your calculations are accurate.

Choose a local bank

When it comes to HELOCs, location is critical. You want to make sure the bank will be around if you need to access your money in an emergency or if you need to refinance the loan at some point. A large national bank may not be as willing to negotiate with you on fixed loan terms and interest rates as a smaller, regional bank that knows its customers personally.

Set up the HELOC like a checking account

You should be able to use your HELOC as a checking account. That means you should be able to write checks or make withdrawals off the line of credit, rather than borrowing all of the money at once and then having it repaid overtime on a set schedule. Many banks have set up their HELOC product this way for consumers' convenience, but double-check with yours to make sure.

Let's say you get an $80k HELOC checking account. You get a routing number, an account number, and possibly some checks and a debit card. When you open your HELOC, the balance is zero. Imagine that you spend $3,000 on school fees. Your HELOC now has a $3,000 balance. You spend $2,000 on a kitchen renovation. Now the balance is $5,000. The balance represents what you have spent.

How do you repay that $5,000? You can do this by having a direct deposit of your paycheck siphoned off into the HELOC — which means you're paying yourself first rather than buying stuff with it. You should cultivate the discipline to regularly repay, so you keep the balance near or toward zero.

Takeaway

A HELOC is an excellent way for homeowners to access quick cash when needed.