Home Equity Line of Credit (HELOC), Home Equity Loans, and Cash-Out Refinancing
06/28/2022 Erik Ringerud
Home equity is one of the main benefits of owning a home. Renting puts money into a landlord’s pocket, but owning a home helps you increase the value of your investment over time. When you do build home equity, it opens up cash-out options that can be used for home improvements, paying off debt or other projects. Cash like this is usually accessed through a second mortgage, such as a HELOC or a one-time home equity loan.
What Is a HELOC?
A home equity line of credit (HELOC) allows you to take out funds based on your home equity and pay it back with a variable interest rate. You can think about it as a credit card: homeowners have access to a credit line that they can take from and pay back while using their home equity as collateral if they are unable to make payments. Essentially, HELOCs enable homeowners to borrow against their own home equity.
Generally speaking, HELOCs have lower interest rates compared to similar options, like home equity loans or personal loans. That said, because HELOCs use variable rates, the interest rate will change based on certain benchmark rates and the current market. This, along with the amount of money you’ve spent using the line of credit, will determine your payments.
How To Pay Back a HELOC
A home equity line of credit is paid back with interest on whatever you take out of your revolving funds. However, HELOCs have a unique method of paying back the credit that occurs in two phases. These two phases are split into the draw period and repayment period, though the names can be a little misleading since you will make payments during both periods.
Phase 1: The Draw Period
The draw period is the first phase when the credit line is open and funds are available to use. You can borrow funds as needed and will only have to make minimum payments, or sometimes even just interest-only payments for what you have borrowed. However, funds aren’t limitless, they’re revolving; if you hit the limit of available funds, you do have to pay back some of the money before you can continue borrowing.
The draw period is usually between 5 and 15 years. Some borrowers, like investors, commonly take out the maximum amount of funds and pay it off several times over. More commonly for homeowners, HELOCs can just be paid in minimum payments. Any other payments made on the principal loan during this time will lessen the amount you have to pay back during the repayment period.
Phase 2: The Repayment Period
Once your draw period is over, the repayment period begins when you must make recurring monthly payments. You also can’t take anything more: access to the home equity line is closed. Payments will vary depending on whether or not you paid any interest during the draw period and how long each period is. Since most HELOC loans use variable interest rates, how the rate changes also affects payments.
Minimum payments may become significantly bigger if you choose interest-only payments, so even if only paying interest during the draw period is an option, consider both the current and future financial consequences. These two periods aren’t necessarily split evenly, either; a 30-year HELOC loan is common, with a 10-year draw period and a 20-year repayment period.
It’s important to know when your draw period ends and when your repayment period begins so you can properly prepare. If you aren’t prepared to adjust financially, it’s tempting (or necessary) to open other lines of credit to pay what you owe on the HELOC, which can bury you in debt. It’s also possible to refinance if you aren’t ready to or don’t want to enter the repayment period when it arrives.
How Much Can You Borrow Using A HELOC?
You have a certain amount of home equity, but most lenders don’t allow you to loan out everything your home equity is worth. It’s important to keep the loan-to-value (LTV) ratio relatively low so you can retain that home equity and be less likely to default on the loan. As such, you can only draw from a pre-approved amount that is stipulated in your contract.
Typically, you can use up to 85% of your home equity value, though it could be less depending on your financial history and other personal qualifications. Your overall eligibility will influence how much you can borrow as well as the interest rate you may qualify for. This includes elements like:
- Credit score and credit history
- Current debt
- How much home equity you have
- Reliable income
- Payment history
Pros and Cons of a HELOC Loan
HELOCs are a great way to put the money sitting in your home to work, but there are both pros and cons that homeowners should be aware of. Not every scenario calls for a HELOC loan, so consider the following benefits and drawbacks.
- Lower upfront costs. Compared to home equity loans, HELOCs tend to have lower upfront costs, which may help a homeowner decide what type of cash-out option they prefer.
- Low or no closing costs. Speaking of saving on costs, there are typically no closing costs for HELOCs. If there are closing costs, they are very low.
- Lower interest rates. Traditional credit cards tend to have higher interest rate fees, but HELOCs are generally known to offer lower interest rates. This makes consolidating debt a bit easier.
- Interest is charged sparingly. Interest is only accrued on funds that you actually use. You may have $200,000 available to lend from, but if you’ve only used $20,000, the interest is only applied to that 10% that is being utilized.
- Flexibility. Because you don’t have to pay interest on more than what you’ve taken out, homeowners have a lot more flexibility and opportunity with their spending. If something unexpected pops up or a project needs more spending options than anticipated, homeowners have flexible and affordable options. You can use it for what you need, even for education.
- Tax deductions. With HELOCs, in some instances, the government allows homeowners a tax deduction for interest payments. Please consult your tax advisor regarding tax benefits of HELOCs.
- Minimum draws. Some lenders require you to use a certain amount of the equity funds so they can make a profit. Even if you end up not needing the minimum, you still have to take out and pay back (with interest) that money.
- Upfront costs. Though lower than other loans, HELOCs may still require application fees, home appraisal costs and other procedures that nickel and dime homeowners in the beginning. Consider the upfront expenses and determine if they’re worth the funds you would have access to.
- Variable interest rates. Variable rates can go up and down depending on the market and federal lending rate, which can affect your monthly HELOC payments. When they are low, it’s great for borrowers, but high-interest rates can take a toll.
- Fees. Without properly vetting a lender, you may find yourself stuck with unexpected or overwhelming fees such as cancellation fees, application fees, annual fees and prepayment penalties.
- Potential credit damage. If you are unable to make payments, like any loan, your credit score will take a hit.
- Risking your home. Remember: your home is the collateral. If a homeowner mismanages their funds, doesn’t make payments and ultimately defaults when the repayment period rolls around, they could lose their home.
- Attraction to nonessentials. Having large amounts of available funds can be freeing, but some homeowners struggle to use their funds only for essential or intentional spending, which can lead to greater debt that’s harder to pay off. HELOCs are not meant for day-to-day expenses like a regular credit card.
What Rates Can Be Expected With A HELOC?
Most often, the interest rate on a HELOC is variable. Variable rates come with pros and cons, and they are largely dependent on the current market and economy. Your eligibility will also affect the kind of rate you qualify for. Rates usually start lower at the beginning of the loan, or in this case, at the beginning of the draw period.
However, the rates will change based on benchmark interest rates, which can lower or raise your payments in both HELOC phases. Still, many lenders offer caps so that your interest rate won’t exceed a certain percentage. This is especially important to look for in a contract and consider as you’re trying to decide on a lender or on applying for a HELOC.
Also consider that HELOCs are a type of second mortgage, and generally speaking, rates for second mortgages are higher because the lender is taking on more risk. If you have good credit, you may qualify for a 3-5% interest rate. Below-average credit may put you at a higher rate, such as 9-10%.
What Can You Use A Home Equity Line of Credit For?
Essentially, homeowners can use a HELOC for whatever they need to, though it’s unwise to use these funds for nonessentials or day-to-day expenses. Here are the projects and scenarios where HELOC funds are best used.
- Home improvement. From renovations to additions, projects that increase the value of your home also help contribute to your home equity. Plus, there are potential tax reductions for certain home improvement projects. This is one of the best uses of HELOC funds.
- Emergency funds. If you find yourself without a job or facing other emergencies, HELOCs are a good source of revolving funds that can be carefully managed, even in the draw period. Because interest doesn’t accrue on unused funds, you can use and pay off only what you need.
- Debt consolidation. Though you should be careful to not generate more unnecessary debt, you can also use a home equity line of credit to consolidate current credit card debt. Instead of dealing with high-cost credit card loans, you switch to a low-cost line of credit.
- Medical bills. Medical bills can quickly add up, especially for unexpected or ongoing health concerns. People often take advantage of the low cost and low-interest rates of HELOCs for these types of health expenses.
- Education costs. Some people also use a home equity line of credit to pay off student loans or pay for tuition, especially because HELOC interest rates can be lower than student loan interest rates.
How To Get Started With A HELOC
Start building home equity
Since you usually need at least 15-20% home equity to qualify for a home equity line of credit, start prioritizing increasing the value of your home. You can increase your equity by making slightly larger payments on your principal balance for your current mortgage. You can also consider refinancing your current mortgage into a shorter-term mortgage.
Know your credit score & history
Your credit score affects your eligibility for a HELOC and the kind of interest rate you’ll get. Most lenders are looking for a score of at least 620, though that changes based on your other qualifications, such as your debt-to-income ratio and current loan-to-value ratio.
Decide why you need the funds
You don’t want to be casual with your HELOC spending, so be specific and intentional with borrowing by having a plan set in place. While you may be using a HELOC to have flexible on-hand funds, that doesn’t mean you should be careless. Set boundaries from the beginning on what you can and can’t spend these funds on, how often you want to make payments, etc.
Do your research
Talk to multiple lenders, compare rates, look for benefits and find reviews online if possible. You should go with a credible lender who will be upfront about fees, timetables and other expectations. A home equity line of credit shouldn’t be taken lightly, and neither should the lender you go through.
Understand typical contracts and look for fees
Understand the terms of your HELOC agreement. Are there prepayment penalties that prevent you from paying off more of your credit during the draw period? Is there a minimum amount you have to take out, and does it make sense to take out that much with your financial goals? Are there annual fees? What about application fees? Make sure you know the overall cost before signing a contract.
Know your debt-to-income ratio
The debt-to-income ratio is the percentage of your income each month that goes towards current debt. Keep in mind that you can only have so much debt before lenders no longer consider you eligible. Paying off debt is a good way to show lenders that you know how to manage your money, and the opposite is true, too. Having too much debt, especially compared to your income, will indicate to lenders that you can’t sustain a line of credit with interest. Lenders most typically look for your DTI ratio to be less than 43-47%.
How does home equity work?
The value of your home is often measured by home equity, which is the difference between your home’s value and what you owe on a mortgage. Many people want their home equity to work for them instead of being stagnant. That’s why HELOCs, home equity loans and cash-out refinance options exist. Homeowners should understand that though home equity refinancing can be helpful, you’re putting your home at risk if you aren’t properly prepared for the payments. Done correctly, though, home equity can be a great alternative source of funds and debt management.
How can you use your home equity?
You can use your home equity loan for all sorts of reasons, as long as the lender hasn’t set certain limitations. Some lenders do limit what the line of credit can be used for, so it’s always best to discuss such limitations with lenders before signing anything. Also remember that funds shouldn’t be used for nonessentials or like a traditional credit card. Most often, people use HELOC loans to add value to their home through home improvement, pay off extensive bills or expenses, or consolidate their current debt to get a better rate and lower costs.
Can you pay off a HELOC early?
As long as there are no prepayment penalties set by the lender, you should be able to pay off a HELOC early, even in the draw period. The more you pay off during the draw period, the less you’ll have to spend during repayment. If, for example, the variable interest rate is fairly low during the draw period, you could pay the interest, plus a little extra on the principal balance. Again, though, some lenders will penalize you for paying more than the required minimums, so learn about the lender’s prepayment policies.
How long does the closing process take for a HELOC?
It usually takes 1-2 weeks to close a home equity line of credit. However, it can take up to 4 weeks to get everything settled, and even after that, you may have to wait a number of days or weeks before accessing the available funds. It all depends on the appraisal process, documentation timeline and the lender’s underwriting process.
What’s the difference between a HELOC and a home improvement loan?
The main difference between a HELOC and a home improvement loan is how you receive the funds. HELOCs allow borrowers to take out smaller amounts of money depending on how home projects change and evolve. Home improvements loans are a one-time lump sum. Home improvement loans are also limited to only specific home projects whereas HELOCs can be used outside of the home.
Alternatives to a HELOC
HELOCs are flexible and offer a lot of freedom, but they aren’t for everyone. If homeowners don’t want to take out a second mortgage, there are other options like cash-out refinancing.
A cash-out refinance is a new "first" mortgage that replaces your original mortgage with a new one through refinancing. Unlike the original, a cash-out refinance allows homeowners to borrow cash that they can use as needed. The new mortgage loan will be higher than the old one, and the difference between the loan amounts is distributed directly to the homeowner.
Cash-out refinancing allows you to maintain just one mortgage rather than two while still getting the immediate cash you need. These also offer fixed rates, which some people prefer for consistency. How do you decide which you would prefer? Determine whether you’d like to replace your current mortgage to get the cash you want (cash-out refinance) or add a second mortgage to get that cash (HELOC).
What is a Home Equity Loan?
Another second mortgage option is a home equity loan. Home equity loans aren’t a revolving source of funds like HELOCs are; instead, homeowners still use their home equity funds but are given the money as a one-time lump sum. Also unlike a home equity line of credit, home equity loans usually come with fixed interest rates. There are prepaid interest costs that you have to sometimes pay at closing time for a one-time loan, and you also usually have to pay 2-5% of the loan amount in closing costs, whereas a home equity line of credit doesn’t often have closing costs.
Both HELOCs and home equity loans tend to have lower interest rates and use the value of your house as collateral. Home equity loans are often used when borrowers need a big sum of cash for a one-time expense. If you need more flexibility, a HELOC loan lets you acquire funds as needed. If you know exactly what you need the money for and prefer fixed payments, a home equity loan is probably best.
Is A HELOC right for you?
A home equity line of credit can be a great solution for homeowners who are established but need more flexible spending options. As long as funds are used carefully, for the right reasons, and through a reliable lender, borrowing against your own home equity is a viable option for many.
Although Pennymac does not currently offer HELOC’s we are available to answer any questions you have about how they work or what your other options are. Don’t hesitate to get professional advice. Contact a Pennymac loan officer to determine just what you should be doing with your home equity.