If you're a homeowner you might wonder if it's a good idea to dip into your equity using a HELOC. Laura explains what a HELOC is, how to get one, recent tax changes, if you should use one to pay off a primary mortgage faster, and the main pros and cons to consider.
Being a homeowner always comes with pros and cons. It can help or hurt your finances depending on where you live, the debt you take on, and your goals. The joys include having a place to call your own, stable housing costs, and the chance to build equity.
In fact, according to a 2018 J.D. Power study, Americans are enjoying more lendable equity than ever. Rising home prices have pushed the amount of equity that homeowners can tap up 10 percent from the previous pre-recession peak in 2005.
So, if you’re a homeowner watching your equity tick higher and higher, you might wonder if you should dip into it with a home equity line of credit, or HELOC. In this post, I’ll cover what a HELOC is and the requirements to get one. Plus, you’ll learn the recent tax deduction changes, if you can use a HELOC to pay off a primary mortgage faster, and the main pros and cons to consider.
What Is a HELOC?
Just like a mortgage and a home equity loan, a HELOC is debt that’s secured by your home. But a HELOC is fundamentally different because it’s actually not a loan, but a line of credit.
A mortgage and a home equity loan are installment loans with fixed maturity or ending dates, such as 15 or 30 years. In contrast, a HELOC is a revolving debt, which means you can access it any time you like up to the available maximum credit limit, similar to a credit card. Your lender gives you a line of credit in 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 is tied to a financial index, such as the prime rate, which means it 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 line amount, to make sure the lender earns some amount of interest. You can spend it, pay it back, borrow more, or just set it aside for an emergency fund.
Once you take money from a HELOC, it’s deposited into a companion checking account that you access with a debit card, paper checks, or through an online account. You can spend it on just about anything, such as credit cards, college expenses, home improvements, a down payment on another home, or even paying down your mortgage. I’ll discuss more on that topic in a moment.
5 Requirements for Getting a HELOC
It’s important to remember that when you spend a HELOC you’re borrowing against your home equity. And not every homeowner has enough equity or other financial qualifications to get a HELOC.
If you’re considering tapping your home equity, here are five HELOC requirements you should know:
1. Having enough home equity.
Most HELOC lenders require you to have at least 20% equity in your home to qualify. This is measured by your loan-to-value (LTV) ratio, which compares the total loans on your home to your home’s fair market value. To know what your home is worth, lenders typically require you to have a professional appraisal.
Lenders typically won’t approve you for a home equity loan or a HELOC that would cause you to exceed an 80% to 90% LTV.
For example, let’s say your home is worth $200,000. If your mortgage balance is $140,000 and you want to borrow $20,000 using a new HELOC, then your LTV (including the new debt) would be 80% [($140,000+ $20,000) / $200,000 = 0.8 = 80%].
Lenders typically won’t approve you for a home equity loan or a HELOC that would cause you to exceed an 80% to 90% LTV. However, lenders have different requirements and also evaluate you by other factors that we’ll cover next.
2. Your debt-to-income (DTI) ratio.
This is an important factor that HELOC lenders use to measure how much total debt you have compared to your gross income. Your DTI is a strong indicator of how easy or difficult it may be for you to manage an additional debt in your financial life.
Your DTI includes all debt, such as credit cards, auto loans, student loans, and mortgages. For example, if your total debt payments are $2,500 and your income is $5,000 per month, then your DTI is 50% ($2,500 / $5,000 = 0.5 = 50%).
Most lenders have a DTI cutoff of 40% to 49%, and the lower the better. If your DTI exceeds acceptable levels, you’ll need to pay down your debt, increase your income, or do both in order to get a HELOC.