What Is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is a line of credit that uses the equity you have in your home as collateral. The amount of credit available to you is dependent on the equity in your home, your credit score, and your debt-to-income (DTI) ratio. Because HELOCs are secured by an asset, they tend to have higher credit limits and much better interest rates than credit cards or personal loans. While HELOCs usually have variable interest rates, there are some fixed-rate options available.
- HELOCs are credit lines secured by your home. They most frequently are issued as credit cards or as a checkbook.
- HELOCs have both a draw period and a repayment period. The draw period involves minimal interest-only payments, and the repayment period involves much higher payments.
- While fixed-rate HELOCs do exist, most have variable rates, meaning minimum payments can skyrocket as interest rates increase.
- If you can't afford to pay your HELOC back, you may be at risk of losing your home to foreclosure.
How a Home Equity Line of Credit (HELOC) Works
Home equity lines of credit (HELOCs) are based on the amount of equity you have in your home. To calculate the equity you have in your home, you would take the estimated value of your home less the total balance of any existing mortgages, HELOCs, home equity loans, etc., to get your equity.
Most well-qualified borrowers are able to take out up to 85% of the equity they have in their home. For example, someone with a good credit score and DTI ratio with a home valued at $300,000 with a loan balance of $100,000 could get approved for a HELOC up to $170,000 ($300,000 - $100,000 = $200,000 x 0.85% = $170,000).
HELOC rates vary but are generally significantly lower than the interest rates for credit cards or personal loans but slightly higher than the rates on a mortgage. HELOC rates are usually variable, which means that they can fluctuate with the market. HELOCs tend to have very low or no origination fees and are relatively simple to get, which makes them a more attractive option than a refinance or cash-out refinance for many borrowers.
The terms of every HELOC vary but they most commonly have a draw period of 10 years and a repayment period of around 15 years. During the draw period, borrowers have the option to use up to their credit line limit on their HELOC and make minimal interest-only payments. Once the draw period is up, borrowers have to make substantially bigger payments to pay back the balance owed on the credit line they used during the draw period.
Debt Reloading Risk
HELOCs come with a high risk of debt reloading specifically because they are easy to obtain and because of their draw and repayment periods. Over the last decades as home values have continued to rise substantially, borrowers have found themselves with ever-increasing equity in their homes and access to cheap credit through their HELOCs.
Many borrowers get used to the low interest-only payments on their HELOC during the draw period and aren't prepared to pay back their HELOC during the repayment period, so they take out another HELOC or home equity loan to pay off the first one. They may then continue this cycle as long as their home's value continues to rise. During the financial crisis when home values plummeted, many borrowers who used this method found their homes in foreclosure.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
An Example of HELOC Debt Reloading
There is no real limit to how many HELOCs a borrower can take out as long as they continue to have decent credit and increased equity in their home. The downside is that continuing to take out HELOCs could lead them to spiral into substantial debt if they aren't careful.
Let's say a borrower in 2010 had a mortgage balance of $100,000 on a $200,000 home. That would enable them to take out a HELOC for up to $85,000. In this example, they take out this maximum amount. In 2012, they had the mortgage and HELOC No. 1—given some payments on the mortgage, the outstanding balance is now $150,000—but their house is now worth $300,000, allowing them to take out another HELOC for up to $112,500. That brings their balance to $262,500.
Eight years later, the combination of the two HELOCs plus their mortgage gives them a balance of $250,000, and the house is now valued at $600,000. This means they can take out yet another HELOC for up to $297,500. The homeowner is now in the repayment period for that first HELOC, and in two years, the repayment period for the second HELOC will begin.
The major risk for this borrower would be using that third HELOC not to pay off the first two but to make minimal payments on all three while spending the rest frivolously. In 2022, their second HELOC will go into the repayment period. If their home value hasn't increased at all, then they cannot open another HELOC to help cover the increased payments, they will be used to a substantially inflated lifestyle, and they will be in debt for more than $500,000 for a house they owed $100,000 on just 12 years earlier.
Is Interest on a HELOC Tax-Deductible?
Interest paid on HELOCs and home equity loans used to be tax-deductible but since 2017, the interest has only been deductible for the amount used on a HELOC to "buy, build, or substantially improve" a home. Additionally, with the standard deduction increasing to $12,950 for single filers and $25,900 for married couples filing jointly in 2022, most HELOC interest paid will not be high enough for most filers to justify itemizing deductions unless they are doing so already for other reasons.
Can You Have Multiple HELOCs or Home Equity Loans on a Property?
Yes. There is technically no limit to how many HELOCs and home equity loans you have on the same property. Most lenders will allow a well-qualified borrower to access up to 85% of their home's equity through HELOCs and home equity loans. If your home value continues to rise, you can continue to take out multiple HELOCs and home equity loans.
What Are the Requirements for a HELOC?
Lender requirements vary, but generally, borrowers will need:
- More than 15% equity in their home
- A 600 or better credit score
- At least two years of verifiable income history
- A DTI ratio of 40% or less
The Bottom Line
HELOCs, when used conscientiously, can be an excellent tool for borrowers to consolidate high-interest debt at a lower rate, make substantial improvements to their home, invest in real estate, and so on. However, they come with significant risks, and borrowers should be aware of those issues before signing up for a product that erodes their ability to build wealth through the equity in their home.