A home equity line of credit (HELOC) can be a powerful tool for tapping your home's equity. But it can also be risky. Here's how a HELOC works, where to get one, and what features to look for in a good HELOC.
- A HELOC is a credit line secured by your home's equity.
- HELOCs are available from many credit unions, banks, and HELOC-specific lending companies.
- The best HELOCs will have a low markup over the prime rate (or a fixed interest rate), no fees or prepayment penalties, and no minimum balance requirement.
How a HELOC Works
A HELOC is a credit line secured by the equity you have built up in your home. When you take out a HELOC, the lender will usually give you a checkbook or credit card that you can use to draw on it. You can borrow money as needed, up to the limit on your credit line. That differs from a home equity loan, where you typically receive a single lump sum of money at the outset.
Most HELOCs have a set draw period along with a repayment period. The draw period is typically between five and 15 years and the repayment period between 10 and 20 years. During the draw period, you may have the option of making interest-only payments, but during the repayment period, your payments will increase to include both interest and a portion of the loan principal. As you pay down the principal, more of your credit line can become available to you again.
HELOCs generally have a variable interest rate, but some fixed-rate HELOCs are available. With a variable interest rate, the amount of your monthly payment can go up significantly over time if interest rates are rising. With a fixed interest rate HELOC, your interest rate will remain the same regardless of the current market rate.
The interest you pay on a HELOC can also be tax-deductible in certain circumstances, depending on what you use the money for.
Where To Get a HELOC
HELOCs can be found at most financial institutions that offer mortgages or credit lines. A local credit union or bank branch may be a convenient option, but you can also search for a HELOC online. Because rates and terms differ, it's a good idea to shop around.
Note that some companies that advertise what appear to be HELOCs may actually be offering a home equity loan in disguise. So make sure you know what the deal is before signing up for anything.
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 step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
What To Look for in a HELOC
- No prepayment penalty: Ideally, you will want to be able to pay off your HELOC faster when you can afford to, especially if interest rates are rising. A HELOC with no prepayment penalty will give you the greatest flexibility.
- No fees: The HELOC market is competitive, so origination fees are rare and it's easy to avoid them, saving you money.
- A low interest markup (or a fixed interest rate): The interest rate markup, also called the margin, is the difference between the prime rate and the higher interest rate that your lender will charge you. A low markup of 0.5% to 0.75% will save you money in interest, regardless of how high or low the prime rate goes. To save on interest in a rising rate environment, a fixed interest rate HELOC may be a better option if you can find one.
- No minimum balance requirement: Some HELOCs will have a minimum balance requirement and it's usually a good idea to avoid them. A minimum balance requirement can trap you into borrowing more than you may need or paying extra fees if you don't maintain a high enough balance.
What Are the Risks of a HELOC?
A HELOC has three main risks. Because it uses your home as collateral, you could lose your home if you can't keep up with the payments. If you're carrying a high balance on your HELOC (or a first mortgage and HELOC combined) and your home's value decreases, you could become underwater on your loans, meaning that you owe more on your home than it is worth. Finally, HELOCs often have a variable interest rate, so if interest rates rise sharply, your payments could become unaffordable.
What Are the Alternatives to a HELOC?
The best alternatives to a HELOC are building a robust emergency fund or budgeting and saving toward future expenses so you don't need to borrow to pay for them. When saving in advance isn't an option, a 0% APR credit card or a personal loan are alternatives that don't put your home at risk if you can't afford to pay them back.
What Are the Requirements to Get a HELOC?
The Bottom Line
You can get a HELOC almost anywhere mortgages and other loans are offered. For the best deal, look for a competitive interest rate with no fees, no prepayment penalties, and no minimum balance requirement.