What Is a HELOC?

Understanding HELOC Loans: What Is a HELOC and How It Works

A home equity line of credit, often referred to as a HELOC, is becoming a routine method for homeowners looking to access their property’s equity. 

Due to recent inflation and ongoing economic uncertainties, HELOCs have risen in popularity. They allow borrowers to leverage their home equity and borrow up to a certain amount while still preserving low mortgage rates. This useful financial tool can be a great resource for funding large expenses like home improvements or consolidating high-interest debt.

HELOCs are an excellent option for converting one’s home value into cash. However, it is crucial to comprehend the various features of a HELOC before taking one out. That includes knowing the qualification requirements, understanding the process from application to repayment, and having insight into this loan’s benefits and potential drawbacks. 

The following guide will touch on everything about home equity lines of credit, from what they are to how they work and even how to get one. Wesley Mortgage currently offers HELOCs, and our loan originators can evaluate whether they are the best option for you.

Key Takeaways on Home Equity Lines of Credit

A HELOC is a revolving secured loan that allows homeowners to borrow money against their equity, with the property as collateral. Home equity, in particular, is the difference between the property’s current market value minus what is owed on the mortgage. 

Like most loans, borrowers apply for money they agree to repay with interest. However, HELOCs differ in that they provide a pre-approved open line of credit instead of a lump sum. The homeowner can borrow and repay this line of credit as needed, more akin to a credit card. Also, homeowners only pay interest on the amount they borrow, often resulting in lower mortgage rates than traditional loans. 

If you cannot repay the loan, HELOCs are often used for projects that improve property value. It is best practice to avoid using a home equity line of credit to finance depreciating assets such as a new vehicle or a vacation. This loan is also not ideal for someone planning to sell their home. 

Advantages of a HELOC

Refinancing with a HELOC can be a great way to access cash flow, make payments more manageable, and save money. Many homeowners consider this revolving loan to take advantage of unique features such as lower interest rates, repayment flexibility, and tax benefits. 

If you are a candidate for HELOC, below are some benefits:

Lower Interest Rates  

One of the more critical benefits for most borrowers with HELOCs is that they often have lower interest rates than other loans. Since they are secured by the home’s equity, lenders take on less risk and, as a result, offer more affordable interest rates. By paying less interest over the loan period, homeowners can save money.

Repayment Flexibility 

Another advantage of a HELOC loan is the flexibility regarding repayment. In contrast to traditional loans, HELOCs let homeowners borrow and pay back the money as needed. Homeowners who want to make renovations or need access to funds at specific times may find this financing option helpful. 

Tax Benefits 

HELOC loans can also provide tax benefits for eligible homeowners who meet IRS guidelines. The interest paid from HELOC borrowing is often tax deductible as long as the loan limits are not surpassed and there is proof that the funding went toward home construction or renovations. If that is the case, borrowers may see a reduction when filing their taxes.  

Disadvantages of a HELOC 

Although refinancing with a HELOC can be advantageous, there are a few pitfalls. The process can be time-consuming, interest rates are uncertain, and there is always a risk when your home becomes collateral. 

​If you are a candidate for a HELOC loan, below are several noteworthy downsides:

Risk of Foreclosure 

One of a HELOC loan’s most prominent drawbacks is the possibility of foreclosure. If the borrower fails to repay, the lender can foreclose on their home since that is the collateral. When taking out a HELOC, homeowners should be aware of repossession risks. 

Variable Interest Rates 

Another disadvantage of a HELOC loan is the possibility of interest rates increasing. Unlike home equity loans that offer fixed rates, home equity lines of credit have variable rates. That implies that costs may go up or down depending on the Federal Reserve — meaning even if you take out a HELOC with a low rate, you could pay higher rates over time.

Limited Availability 

Last, HELOCs might not be accessible. Certain lenders might only provide HELOC loans in particular regions or have minimum equity requirements. Before applying, research and confirm if a HELOC loan is offered in your area.

How to Qualify for a HELOC Loan

The application process for a HELOC is similar to other refinance methods, whereas homeowners must fulfill specific conditions to meet eligibility. For most lenders, a qualified borrower must have a strong credit history, sufficient financial means, and certain equity in their property. 

Although the lender’s criteria may vary, the general requirements for HELOC qualification are below.

Credit Score Requirements 

Creditworthiness conditions for a home equity line of credit may vary based on the lender and other factors. On average, though, most lenders require a credit score of at least 620 to qualify, but some may have higher limits. The chances of getting approved increase with a credit score above the mid-600s, while a score over 700 is ideal.

Income Requirements 

HELOC lenders consider a borrower’s income and employment history when determining eligibility. Minimum requirements may vary, though most creditors request proof of a stable and sufficient income. A borrower’s debt-to-income ratio (DTI) is calculated to decide that. The lower it is, the better the chance of approval, with most lenders favoring a DTI of 40 percent or less. 

Property Requirements 

Home equity is the most apparent yet essential requirement to qualify for a HELOC loan. Alas, borrowers must not only possess equity but at least 15 to 20 percent, depending on the lender. In addition to equity, financiers may also consider other elements, such as the home’s condition, location, and property type.

How Does a HELOC Loan Work?

Applying for a HELOC loan is simple and similar to the average mortgage process. Borrowers choose a lender, gather financial documents, submit a loan application, and then await approval. The loan is then closed, the equity funds are dispersed through a line of credit, and the borrower begins making payments. To expedite this process, several HELOC lenders offer streamlined online applications. Applying for a HELOC, like other loans, can be daunting. However, with preparation and knowledge, it doesn’t have to be. 

Gather Necessary Documents 

First, collect all the required documents before applying for a HELOC. This step often includes compiling proof of identity, income, employment, home ownership, and other financial documentation. Preparing all this paperwork beforehand will make the application process faster and smoother. 

Specific document requirements may vary by lender, but the following is a list of what borrowers can expect to provide:

• Form of identification
• Property title or deed
• Pay stubs
• Tax returns
• W2 forms
• Bank statements
• Asset statements
• Homeowners insurance policy
• Home Appraisal
• Credit report

HELOC Application Process

Before applying for a HELOC, borrowers need to check their credit. A good score makes it easier to get approved and helps qualify for better interest rates. The next step is determining how much money is needed. Then, find a HELOC lender that meets your needs. Compare different lenders’ rates, terms, and fees to ensure you get the best deal. 

After finding a lender and collecting all the required paperwork, it is time to fill out the loan application. Once submitted, the lender will review it and begin the approval procedures. 

HELOC Approval Timeframe 

The timeline for HELOC approval can vary. In most cases, getting accepted can take a few days to a few weeks. If and when approved, the lender will provide a loan agreement outlining the terms and conditions. The borrower must read and sign this agreement before the funds are released.

Once signed and executed, loan proceeds can be dispersed in a number of ways. The lender may deposit the money into the listed bank account, wire the funds, or mail a check. Some lenders even allow borrowers to access funds via an online portal.

Closing and Repayment of a HELOC 

Understanding the closing and repayment process, including interest rates, repayment terms, and potential tax implications, is essential for those considering a HELOC. During closing, the final loan agreement documents get signed and executed, closing costs get paid, and the credit line is approved. Closing costs are often lower than a primary mortgage but still range between two and five percent of the loan’s total cost. 

The homeowner then begins making loan payments. The amount and frequency depend on the terms and the lender’s requirements. Homeowners should ensure they understand the terms and make payments on time to avoid late fees or penalties.

HELOC Interest Rates

Understanding the interest rates attached to a loan is crucial with HELOCs, considering they are often variable rates. While interest differs based on several factors, such as the lender, the home’s equity amount, and economic conditions, HELOC rates, in general, are related to the prime rate. The Federal Reserve sets the prime rate, which is the value at which banks lend to their most creditworthy clients. 

Most HELOC rates range between 2 and 21 percent. As of 2023, the average interest rate for a HELOC is around 7.5 percent. Because these are variable rates, they change depending on the prime rate and other factors. This can make it tougher to forecast how much interest you pay over the course of the loan.

HELOC Repayment Terms

Depending on the lender, a HELOC’s repayment terms can vary. For the first few years, borrowers often pay only interest during the draw period. Once the draw period ends, the repayment period begins, and borrowers then switch to principal and interest payments. Most HELOC lenders also require borrowers to keep a minimum balance during both periods.  

The draw and repayment length depends on the specific loan and creditor. For instance, a popular HELOC choice is a 30-year loan with a 10-year draw period and a 20-year repayment period. 

HELOC Tax Implications

When taking out a HELOC, homeowners should understand the potential tax ramifications. While the borrowed funds are not taxable, the interest paid on a HELOC is often deductible up to certain limits. Yet, these restrictions might be intrusive compared to other loans. In some locations, borrowers must pay a mortgage recording tax when taking out a home equity loan or HELOC. 

Consider the tax ramifications of a HELOC before signing the paperwork because the interest may be lower on other loans.

Alternatives to a HELOC Loan

For those for whom a HELOC is not suitable, other loan options are available. Some borrowers might consider a traditional loan financing method, while others look for opportunities to tap into home equity. Homeowners should always research to ensure they make the best decision for their financial situation.

Below are several alternatives to HELOCs:

• Home Equity Loan

• Cash-Out Refinance

• Conventional Mortgage

• 0% Interest Rate Credit Cards

• Reverse Mortgage

Summary

A HELOC loan is ideal for homeowners looking to finance home improvements, consolidate debt, or have access to a line of credit. Potential borrowers should be aware of the terms and ensure they acknowledge the risks. Homeowners should consider all the alternatives and evaluate the advantages and disadvantages of refinancing the loan. In the end, the homeowner’s specific needs determine the loan option.

For more information or questions about what other mortgage products are available, contact a Wesley Mortgage representative today!