Being a homeowner has its pros and cons. It can help or hurt your finances depending on your location, mortgage debt, property taxes, insurability, and goals. The joys include having a place to call your own and the chance to build equity.
According to a 2024 report, the average homeowner has just under $300,000 in home equity, with $193,000 available to be tapped, the highest amount on record. If you’re a homeowner watching your equity grow, you might wonder if you should dip into it with a home equity line of credit or HELOC.
This post will review what a HELOC is, who qualifies for one, how you can spend it, and the pros and cons to consider. Plus, I answer a question from Jason about my opinion of velocity banking and how it relates to getting a HELOC.
What is a home equity line of credit (HELOC)?
You’re probably familiar with a home mortgage, an installment loan with a fixed maturity or ending date, such as 15 or 30 years. Like a mortgage, a HELOC is a debt secured by your home.
But a HELOC is fundamentally different from a mortgage because it’s actually not a loan but a revolving line of credit. That means you can access it any time you like up to your available credit limit, similar to a credit card. Your lender gives you a line of credit for an amount that depends on the available equity in your home.
Another similarity between a HELOC and a credit card is that they typically have variable interest rates. The rate gets tied to a financial index, such as the prime rate, which can go up or down.
In some cases, you may be required to make an initial draw on a HELOC, such as $5,000 or $10,000, depending on the total credit line amount, to ensure the lender earns some interest. You can spend HELOC funds, pay it back, borrow more, or set it aside for emergencies.
Once you take money from a HELOC, it gets deposited into a companion checking account that you access with a debit card, paper checks, or online account. As I mentioned, you can spend it on anything, such as education, home improvements, a down payment on another home, or even paying down your mortgage. I’ll discuss more about that in a moment.
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What’s required to get a HELOC?
If you’re considering tapping your home equity, consider the following five HELOC requirements:
- You must have enough home equity.
Most HELOC lenders require you to have at least 20% equity in your home to qualify. Equity gets measured by your loan-to-value (LTV) ratio, which compares the total debt on your home to your home’s fair market value, as determined by a certified home
appraiser.
For example, let’s say your home is worth $400,000. If your mortgage balance is $340,000 and you want to borrow $20,000 using a new HELOC, then your LTV (including the new HELOC) would be $360,000 divided by $400,000, or 90%. Having 90% debt on your home leaves you with 10% equity, which is typically too low to satisfy a HELOC lender.
So, not every homeowner has enough equity to get a HELOC. However, lenders have different requirements and evaluate you based on other factors I’ll review.
- You must have an acceptable debt-to-income (DTI) ratio.
Your DTI includes all your debt, such as credit cards, auto loans, student loans, and mortgages. For example, if your total debt payments are $2,500 and your gross income is $5,000 monthly, your DTI is 50% ($2,500 / $5,000 = 0.5 = 50%).
Most lenders have a DTI cutoff of 40% to 49%; the lower, the better. It’s a strong indicator of how easy or difficult it may be to manage additional debt. So, if your DTI exceeds an acceptable level, you’ll need to pay down your debt, increase your income, or do both to get a HELOC.
- You must have ample income.
Just like with all creditors, the amount you earn is a factor in getting approved for a HELOC. You must show that you earn enough to cover your current debts plus the additional line of credit you want.
You’ll typically need to show at least two years of banking records or tax returns to
prove your income is high enough.
- You must have a consistent income.
HELOC lenders also consider if you can repay a debt. They review how consistent your income has been in the past few years. Plus, they look at assets you own, such as savings and investments, that you could liquidate to pay debts if needed.
- Your credit score.
Another important way that all creditors, including HELOC lenders, evaluate your financial responsibility and willingness to repay debt is your credit score. While the minimum score varies, the higher the better for getting approved at the lowest possible interest rate.
If your credit isn’t good, you may still be eligible for a HELOC if you have plenty of income and home equity. All the factors I just covered get taken into account. Being slightly deficient in one financial area may be okay if you’re strong in another.
How do you manage a HELOC?
After you tap your home equity with a HELOC, you must repay a minimum amount each month. There are typically two phases for repayment: the draw period and the repayment period.
The draw period is when you can borrow from a HELOC up to your credit line amount, with interest-only payments. For instance, if you have a HELOC with a 20-year term and a 10-year draw, you must pay minimum interest payments for the first ten years.
After the draw period ends, you can no longer borrow against your HELOC, and the repayment period begins. Your payment then gets amortized, which means it’s made up of principal and interest over the remaining ten years. That ensures your balance gets paid off by the end of the term.
However, HELOC terms can vary depending on the lender. Some may have a balloon payment or a larger-than-usual payment at the end of the term. Some HELOCs may not have a repayment period but require full payment at the end of the draw period.
Deducting interest paid on a HELOC
One significant benefit of a HELOC is that it may come with a tax deduction, depending on how you spend it. For example, if you use a HELOC to buy, build, or remodel your home, you can deduct interest on up to $750,000 or $375,000 if you’re married and file taxes separately. That debt limit includes your mortgage, the HELOC, and any other home-related debt you have.
For instance, let’s say you have a $500,000 mortgage and get a $150,000 HELOC to remodel your home. You could deduct interest on up to $650,000 or all your home-related debt.
But if you have a $200,000 mortgage and use $25,000 from a HELOC to pay for college expenses, none of the interest paid on the HELOC would be tax-deductible. Again, you can spend a HELOC on anything you like, but only the portion used for home-related expenses is eligible for an interest tax deduction.
So, if you’re considering a HELOC, understand that you may not be eligible to deduct your interest expense, depending on how you use the money and whether you itemize deductions on your tax return.
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Can you use a HELOC to pay off a mortgage faster?
With the rising popularity of low-interest HELOCs, many homeowners use them to pay off other debt. Whether you should use a HELOC to pay off your primary mortgage faster is a hotly debated topic and is often part of a strategy called velocity banking.
I received an email from Jason G., who said, “Hello Laura, I see so much about velocity banking. What are the hidden truths about this? It seems like a high-risk, high-reward trend.”
Thanks for your question, Jason. Yes, velocity banking comes with a lot of potential risks. Without going too deep into the math, the general concept in velocity banking is using debt with simple interest, such as a HELOC, to pay off amortizing debt, such as a mortgage.
Plus, if your HELOC has a lower interest rate than your mortgage, you could save money by spending a HELOC to pay down your primary mortgage faster.
The problem is that drawing down your HELOC can be risky because it’s typically a variable-rate product, which means you could have substantially higher interest rates and monthly payments in the future. Also, you must have a lot of home equity to get a HELOC big enough to make a dent in your primary mortgage.
Unless you save at least 10% of your gross income for retirement, have an ample emergency fund, and have zero debt (besides your mortgage), paying down a mortgage early using a HELOC or even your savings is not wise.
But if your finances are in great shape, with plenty of retirement savings and no debt, you may be in a position to pay off your mortgage ahead of schedule. Instead of using a HELOC to do it, I’d recommend paying extra toward the mortgage principal each month.
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Pros and cons of getting a HELOC
In addition to the potential tax deduction I covered, a HELOC has other benefits. Using your home equity for renovations could increase the market value of your home, helping you grow your net worth.
The primary advantages of a HELOC are:
- Having the flexibility to tap a line of credit whenever you need it
- Only paying interest on amounts you use
- Paying a relatively low interest rate
- Spending it on anything you like
The biggest downside of a HELOC is that borrowing against your home puts you at risk. Since your property is collateral for a HELOC, the lender can force a home sale to satisfy your debt if you can’t repay it.
Also, if you take a HELOC and the value of your home drops, you may have to come up with cash to repay it. If you qualify for a HELOC, the primary cons are:
- Paying interest on amounts borrowed
- Paying lender fees to originate the line of credit
- Having a variable interest rate that can increase significantly, depending on your lender and the laws in your state
- Missing payments can hurt your credit scores or cause your interest rate to increase
Applying for a HELOC can be a sensible and convenient way to cash out part of your home’s equity. Remember that your net worth can decrease if you spend it on something that decreases in value or has no value over the long term, such as consumer credit card debt or a vehicle.
While tapping your home equity can be convenient, carefully consider whether decreasing your equity and paying interest on a HELOC is worth it. It likely isn’t if it doesn’t bring you closer to achieving your financial goals.