The Ultimate Guide to HELOCs and Home Equity Loans

The Ultimate Guide to HELOCs and Home Equity Loans

In this article, we’ll explain exactly what a home equity loan is, how they work, and the different types of loans you may be able to get—and we’ll also offer some concrete ways to help you decide if they really make sense for you and your personal financial picture right now.

What is a home equity loan?

When you strip away all the fancy terms, a home equity loan is basically a second mortgage on your home. It’s a tool that lets you convert the portion of your home that you own, your equity, into cash that you can use for major purchases such as a home renovation, repair, or remodeling project, college education, or even debt consolidation.

Your home, or rather the portion of it that you own, is given as collateral to the lender to secure your loan.

At this point, it’s probably helpful to give a quick and dirty definition of home equity. At its simplest, your equity is the difference between your home’s market value and the balance of any mortgages you have against it.

For example, if your house could sell for $500,000 today and your mortgage balance is $275,000, you essentially have $225,000 in home equity.

There’s a bit more to it, but we’ll get to that a bit later. It’s just important for you to keep in mind that, while you can come up with a rough idea of your home equity based on what you think your home is worth, the final figure will be decided by your lender based on a complete appraisal of your home before the loan is closed. (You can also use Hearth’s home equity calculator to give you an estimate).

In most cases, a home equity loan is paid out in a lump sum and the repayment terms are fixed (most often between 5 and 15 years), as is the interest rate, which means you pay the same payment every month over the life of the loan.

These loans are great when you have a specific need or project in mind and you have a pretty good idea of exactly how much money you’ll need to get the job done—provided you have enough home equity to cover it.

What’s the difference between a home equity loan and a home equity line of credit (HELOC)?

The main difference between the two types of home equity-based products is that a HELOC works like a revolving line of credit—you draw against your credit line whenever you need it to fund your home improvement project or other financial priority. As with a home equity loan, it essentially functions as a second mortgage, in that your home is used as collateral.

There’s a crucial difference between a revolving line of credit like you’d get with a major credit card or store card, however, which is that most credit cards are “open ended.” You can continue to make purchases indefinitely, up to the amount of your available credit, as long as you continue to make your monthly payments on time and don’t close your account.

HELOCs, on the other hand, are generally structured with a “draw period” and a “repayment period.” The draw period is the timeframe during which you’re allowed to withdraw funds against your credit line; during the repayment period, no additional withdrawals are allowed, and you must pay off your loan balance. For example, a lender could offer a 25-year HELOC with a 10-year draw period and a 15-year repayment period.

There’s a pretty wide range of draw and repayment period combinations available today; some lenders offer draw periods as short as 6 months, although you’ll most commonly see either a 15-year (5-year draw, 10-year repayment period) or a 25-year HELOC.

But don’t let those terms confuse you—you still have to make payments during the draw period, although they will generally be interest-only during the draw. Of course, you can always elect to pay against your principal during the draw, but your minimum monthly payment typically won’t include principal and interest until the repayment period kicks in.

There are other important differences between HELOCs and home improvement loans, as well. HELOCs almost always have variable interest rates, which means your payments can fluctuate significantly based on your loan balance and your interest rate. This can blow a hole in your budget if you haven’t planned for increases in your APR.

As an example, a $25,000 HELOC balance at 4.5% would have monthly payments of about $260; at 7.0% APR, the payment jumps to nearly $300.

And you need to be aware that some HELOCs come with a balloon payment at the end of the repayment term. Lenders use this trick to artificially lower your monthly payments during the repayment period—and you have to come up with a large lump-sum payment to pay it off. If that’s a feature of your HELOC, you need to start planning for it well before your repayment term ends.

What is the typical interest rate on a home equity loan or HELOC?

This is where things get complicated. Overall, loans secured by your home equity tend to have lower interest rates than unsecured personal home improvement loans and home improvement credit cards.

That said, however, there’s still a lot of variability. With great credit, you can probably get a home equity loan at around 5% APR. For HELOCs, rates can start in the 4% range, but rise over time.

Keep in mind that many lenders offer a special introductory interest rate on HELOCs to bring in new customers—but it’s exactly that, an introductory rate that won’t last during the entire draw period.

And that brings us to a few more things to know about your HELOC interest rate. Variable APRs are pegged to some index, often the prime lending rate, and then a margin is added, which is usually in the 2% range.

For example, if the index is 3.75% and your margin is 2%, your APR will be 5.75%. Your margin will remain the same during the life of the loan, although the index may change many times.

That’s where the introductory rate comes in—some lenders offer a limited-time discount on the margin for a certain period of years. Be sure you know when it ends, and what the real margin will be so you don’t have any nasty surprises down the road.

A few other wrinkles to be aware of with HELOC interest rates:

  • Some lenders offer a rate cap, which can be a good thing during a period of rising interest rates. What it means is that even if the index rises beyond a certain point, your APR is capped at a fixed rate.
  • You may also be able to get a hybrid HELOC, which means that if you borrow beyond a certain amount, you can lock in your loan balance, or a portion of it, at a fixed interest rate, giving you a little more dependability in your monthly payments.

What factors affect my interest rate?

Aside from market conditions, there are a lot of individual factors that affect what you’ll be charged for your home equity loan or HELOC.

Obviously, your credit score is a huge determining factor; those with the best credit get the best rates. If your credit isn’t great, however, you could pay a high premium for your loan. Generally speaking, if you don’t have a FICO score of 640 or higher, you may have trouble qualifying.

Your debt-to-income ratio, which is the total of your monthly payments expressed as a percentage of your total gross income, also plays a part. The lower your ratio, the better you look to lenders. Most lenders look for a debt-to-income ratio of 43% or lower to qualify.

Finally, your combined loan-to-value ratio (CLTV) plays a huge role in the terms of your loan—and whether you’ll even qualify for a loan at all.

Remember earlier when we mentioned the formula for determining your home equity? CLTV takes that a step further and places a limit on the maximum amount you can borrow against your home’s value.

Simply put, CLTV is the total amount of mortgage debt, including the proposed new loan, compared to the market value of your home.

For example, in the example we opened with, a home with a $500,000 market value and a mortgage balance of $275,000 would have a loan to value ratio of 55%. If you added a $75,000 home equity loan, the total of the mortgages against the property would be $350,000, and the CLTV would be 70%. So far, so good.

Most lenders place a cap of 80% on CLTV to qualify for a loan, although we’ve seen some lenders go as high as 85%.

Now let’s switch up the example a bit. Imagine that you have a $400,000 mortgage on that $500,000 home. Even though you have $100,000 in equity, in most cases, you still wouldn’t be able to get a home equity loan or HELOC, because the loan-to-value ratio with your first mortgage is 80%. There’s no room for a home equity loan under most lender’s underwriting standards.

So if you’re considering applying for a home equity product, do a little back-of-the-envelope calculations to see if you’re even in the CLTV ballpark before you head to the bank or finance company and fill out an application.

How do I get a home equity loan or HELOC?

You can explore home equity loan or HELOC options by clicking here.

As we mentioned earlier, home equity loan products function in every important way as a second mortgage, so the process is far more involved than with personal home improvement loans and home improvement credit cards. With unsecured loans, the process is as simple as filling out an online application, verifying your income and identity, and signing for your loan—it can happen in as few as a day or two.

Although the HELOC and home equity loan application and approval process isn’t quite as strenuous as the process for your original mortgage, it is still fairly complex and expensive—and can take several weeks to complete.

After you apply (for which you will often be charged an application fee), your lender will schedule an appraisal, which can cost anywhere between $500 and $1,500, depending on where you live and other factors.

If the appraisal backs up your proposed CLTV, your lender will then verify your income and employment and evaluate your creditworthiness (known in the business as underwriting). If everything adds up, the lender will begin processing your loan.

Closing costs can be extensive, usually in the range of 2% to 4% of the total loan amount. Where does all the money go?

Depending on your lender, you could be charged:

  • Application and loan processing fees.
  • Title search to verify any debts secured by your home.
  • Loan origination fees (these usually range between 0.5% and 2% of the amount you borrow).
  • Broker fees if you work with a broker to find the best loan instead of approaching a lender directly.
  • Document preparation fees.
  • Attorney fees.
  • Points, which are a percentage of the loan amount, and used to “buy down” your interest rate, generally used with home equity loans, not HELOCs.

Your lender should provide you with an estimate of your closing costs so you know exactly what you’re on the hook for.

And just like any other major purchase (that’s really what a home equity loan is), you should always shop around to make sure you’re getting the best deal. Talk to the lender who holds your first mortgage, and check the Internet to see what major banks and credit unions are offering. And definitely compare your other financing options—you may be surprised how the numbers shake out in the end.

A word about home equity loan and HELOC fees…

It’s not uncommon these days to find lenders who are willing to waive some or all of your closing costs. That sounds very generous, but it almost always comes with a catch—usually in the form of a prepayment penalty.

Prepayment penalties are exactly what they sound like—a fee you’ll pay your lender, in addition to your actual loan balance, if you don’t keep the loan open for a specified period of time. Prepayment penalties reimburse the bank for any closing costs they waived, plus a portion of the interest they would have made off the loan.

These can be pretty significant, so be sure to ask exactly what’s included in the prepayment penalty and how it’s calculated.

And if you get a HELOC, you may have additional fees, such as draw fees, which are added every time you make a draw against your credit line, and account maintenance fees, which the lender charges to keep your account open, even if you don’t have a balance or haven’t made any draws.

Other HELOC fees to be aware of relate to converting some or all of your variable-rate balance to a fixed-rate loan. These fees are called rate-lock fees, and they can be as much as $100 or more for each time you exercise the option.

When should I use a HELOC or home equity loan?

There’s no doubt that these products can be a great option if you’ve got a major home improvement or repair project on the horizon. Interest rates are more favorable than other types of financing, which can save you hundreds or thousands of dollars over time.

The lower interest rates and longer terms keep monthly payments low, which is helpful if you’re watching your budget.

And if you’re doing a project that adds value to your home, financing it with your existing equity doesn’t affect your overall financial picture as negatively as using the money for a depreciating asset such as a car, or an expense with no tangible value at all like a vacation.

Tapping your most significant financial asset (your home) for an expense that doesn’t hold its value or even appreciate over time can really damage your net worth and financial security over the long haul and should be done with extreme caution.

On the other hand, if you have a home improvement project of less than $10,000, you may want to consider other financing sources, such as a personal home improvement loan, because of the high fees and closing costs associated with home equity loans.

Of course, if you have an urgent repair or improvement project, you may not be able to wait 6 weeks or more to get started. In that case, a HELOC or home equity loan wouldn’t be the best choice.

Ultimately, there’s no hard and fast rule about when you should or shouldn’t use a home equity loan or HELOC for your home improvement needs or other financial priorities, but we wouldn’t be doing you any favors if we didn’t offer a note of caution: Your house is likely the single most valuable financial asset you have—and not only that, it’s your home, where you and your family live. It’s not wise to risk it on anything but the most carefully planned and budgeted expenses, and only after you’ve taken the time to evaluate all your other options and feel extremely confident you can manage your payments.

Conclusion

There are many ways to finance a home improvement project without using the equity in your home. If you’d like to learn more about other types of home improvement loans, check out our guide here.

If you’re ready to take the next step and see what’s available for home equity loans and HELOCs, visit our secured loans page for more information.