Is Taking Out a HELOC Right for You?

If you have more than 20% home equity and a credit score of at least 620, you may qualify for a home equity line of credit (HELOC). A HELOC is a convenient and often inexpensive way to borrow money using your home’s value as collateral.

Let’s look at how a HELOC works and whether its features might make it a good or bad option for you.

How Much Can You Borrow with a HELOC?

The first step in deciding if a HELOC is right for you is knowing whether you have enough home equity to qualify and the amount of the credit line for which you might be eligible. Your home equity is the difference between your home’s appraised value and your mortgage balance (assuming you have an existing mortgage). If your home is worth $500,000 and you owe $250,000, your equity is 50%. If your home is worth $500,000 and you don’t have a mortgage, your equity is 100%.

To estimate how large a credit line a lender might extend you, calculate your combined loan-to-value ratio (CLTV ratio). Most HELOC lenders allow a CLTV of at least 80% on your main home, sometimes higher.

Multiply your home’s value (let’s say it’s $500,000) by 0.8 to get how much debt most lenders will be comfortable letting you carry against your home. In this case, it comes to $400,000. Then, subtract the $250,000 you owe on your existing home loan: $400,000 - $250,000 = $150,000. This is how much you can potentially borrow.

How Does a HELOC Work?

A HELOC is sort of like a credit card and sort of like a home equity loan. As with the former, it gives you a revolving line of credit and has a variable interest rate. As with the latter, it has a fixed term and a defined repayment period.

With a credit card, the bank gives you a credit limit based on your household income and credit score. You can spend as much or as little as you want in each billing cycle, as long as you stay under that limit. When you get your statement, you have to at least make the minimum monthly payment, but you can also repay the entire balance if you don’t want to accrue interest. After the bank processes your payment, your available credit increases by the amount of your payment that went toward the principal balance.

A HELOC functions similarly, but your credit limit is also based on how much equity you have in your home. Additionally, a HELOC has two periods:

1. First, there’s a draw period, typically 10 years, during which you can borrow up to your credit limit and make interest-only payments.
2. Second, there’s a repayment period, generally 20 additional years, when you can no longer borrow money but must repay your outstanding balance with interest.

Here’s what else you should know to decide if a HELOC might be a good choice for you.

What Else Do You Need to Qualify for a HELOC?

You’ll need to document your income as you would if you were applying for any other type of mortgage: with pay stubs, W-2 forms, and income tax returns. By comparison, banks tend to take you at your word when you state your income on a credit card application.

Lenders decide whether you have enough income to qualify for a HELOC by looking at your debt-to-income (DTI) ratio. Many home equity lenders prefer to see a DTI ratio no higher than 43%, meaning that your monthly mortgage, student loan, auto loan, credit card, and proposed home equity loan payments combined should not be more than 43% of your pretax income. Some lenders are more generous, perhaps allowing a DTI as high as 50%.

Are You Comfortable Using Your Home as Collateral?

As a HELOC is secured by your home’s value, you could end up in foreclosure if you don’t repay the loan. Credit cards or personal loans, on the other hand, are forms of unsecured credit. With unsecured debt, you’re significantly less likely to lose your home if you can’t repay what you borrow. Your creditors could still sue you for nonpayment and possibly win a judgment against you in some states. However, you may be less likely to lose your principal residence when it doesn’t secure your loan.

Will an Unpredictable Interest Rate Stress You Out?

HELOCs, like most credit cards, have variable interest rates that change over time as economic conditions change. When you consider a HELOC offer, you’ll want to know the lowest and highest rate you could possibly pay and how often the rate will adjust.

If interest rates increase, will you still be able to afford the monthly payments? A HELOC is more manageable if you keep your borrowing well below your means and have enough flexibility in your budget to deal with fluctuating payments.

The Bottom Line

If you want to borrow against your home using a HELOC, make sure that you understand exactly how it works before you sign the loan paperwork. In particular, you need to know when your interest rate might change and by how much.

Make a spreadsheet and run some calculations to see how much you can afford to borrow against your credit line at different interest rates and how much this form of borrowing might cost you over 10, 20, or 30 years. Also, think about how you plan to use the money and your past borrowing behavior to decide whether a HELOC is likely to help or hurt your finances in the long run.

If you have a habit of using credit to spend beyond your means, you may be better off leaving your home equity intact. Focus on other strategies for paying off your existing debts, such as the debt snowball or debt avalanche methods. You could also refinance your debts with another loan that’s not secured by your home, such as a personal loan or a lower-rate credit card.