Being a homeowner always comes with pros and cons. It can help or hurt your finances depending on where you live, the debt you take on, and your goals. The joys include having a place to call your own, stable housing costs, and the chance to build equity.
In fact, according to a 2018 J.D. Power study, Americans are enjoying more lendable equity than ever. Rising home prices have pushed the amount of equity that homeowners can tap up 10 percent from the previous pre-recession peak in 2005.
So, if you’re a homeowner watching your equity tick higher and higher, you might wonder if you should dip into it with a home equity line of credit, or HELOC. In this post, I’ll cover what a HELOC is and the requirements to get one. Plus, you’ll learn the recent tax deduction changes, if you can use a HELOC to pay off a primary mortgage faster, and the main pros and cons to consider.
What Is a HELOC?
Just like a mortgage and a home equity loan, a HELOC is debt that’s secured by your home. But a HELOC is fundamentally different because it’s actually not a loan, but a line of credit.
A mortgage and a home equity loan are installment loans with fixed maturity or ending dates, such as 15 or 30 years. In contrast, a HELOC is a revolving debt, which means you can access it any time you like up to the available maximum credit limit, similar to a credit card. Your lender gives you a line of credit in an amount that depends on the available equity in your home.
Another similarity between a HELOC and a credit card is that they typically have variable interest rates. The rate is tied to a financial index, such as the prime rate, which means it can go up or down.
In some cases, you may be required to make an initial draw on a HELOC, such as $5,000 or $10,000, depending on the total line amount, to make sure the lender earns some amount of interest. You can spend it, pay it back, borrow more, or just set it aside for an emergency fund.
Once you take money from a HELOC, it’s deposited into a companion checking account that you access with a debit card, paper checks, or through an online account. You can spend it on just about anything, such as credit cards, college expenses, home improvements, a down payment on another home, or even paying down your mortgage. I’ll discuss more on that topic in a moment.
5 Requirements for Getting a HELOC
It’s important to remember that when you spend a HELOC you’re borrowing against your home equity. And not every homeowner has enough equity or other financial qualifications to get a HELOC.
If you’re considering tapping your home equity, here are five HELOC requirements you should know:
1. Having enough home equity.
Most HELOC lenders require you to have at least 20% equity in your home to qualify. This is measured by your loan-to-value (LTV) ratio, which compares the total loans on your home to your home’s fair market value. To know what your home is worth, lenders typically require you to have a professional appraisal.
Lenders typically won’t approve you for a home equity loan or a HELOC that would cause you to exceed an 80% to 90% LTV.
For example, let’s say your home is worth $200,000. If your mortgage balance is $140,000 and you want to borrow $20,000 using a new HELOC, then your LTV (including the new debt) would be 80% [($140,000+ $20,000) / $200,000 = 0.8 = 80%].
Lenders typically won’t approve you for a home equity loan or a HELOC that would cause you to exceed an 80% to 90% LTV. However, lenders have different requirements and also evaluate you by other factors that we’ll cover next.
2. Your debt-to-income (DTI) ratio.
This is an important factor that HELOC lenders use to measure how much total debt you have compared to your gross income. Your DTI is a strong indicator of how easy or difficult it may be for you to manage an additional debt in your financial life.
Your DTI includes all debt, such as credit cards, auto loans, student loans, and mortgages. For example, if your total debt payments are $2,500 and your income is $5,000 per month, then your DTI is 50% ($2,500 / $5,000 = 0.5 = 50%).
Most lenders have a DTI cutoff of 40% to 49%, and the lower the better. If your DTI exceeds acceptable levels, you’ll need to pay down your debt, increase your income, or do both in order to get a HELOC.
3. Your income.
Just like with all creditors, the amount you earn is key for getting a HELOC. You must be able to show that you earn enough to cover your current debts, plus the additional line of credit you’re seeking.
You’ll typically need to show at least two years of banking records or tax returns to prove that your income is high enough.
4. Your ability to repay.
HELOC lenders also consider if you’re likely to have the ability to repay a debt in the future. They review how consistent your income has been over the past few years. Plus, they look at assets you own, such as savings and investments, that you could liquidate to maintain debt payments if needed.
5. Your credit score.
Another important way that all creditors, including HELOC lenders, evaluate your financial responsibility and willingness to repay debt is your credit score. While the minimum score varies, the higher the better for getting approved at the lowest possible interest rate.
If your credit isn’t good, you may still be eligible for a HELOC if you have plenty of income and home equity. All the factors I’ve covered are taken into account. So being slightly deficient in one financial area may be okay if you’re strong in another.
How Do You Pay Back a HELOC?
After you tap your home equity with a HELOC, you must pay some portion back each month. There are typically two phases for repayment: the draw period and the repayment period.
The draw period is when you’re allowed to continue borrowing from a HELOC, up to the total line amount, with interest-only payments. For instance, if you have a HELOC with a 20-year term and a 10-year draw, you would just have to pay minimum interest payments for the first 10 years.
After the draw period ends, you can no longer borrow against your HELOC, and the repayment period begins. Your payment changes to amortize, which means it’s composed of principal and interest, over the remaining 10 years. That ensures that your balance is paid off by the end of the term.
But HELOC terms can vary depending on the lender. Some may have a balloon payment, which is a larger-than-usual payment at the end of the term. And some HELOCs may not have a repayment period, but require full payment at the end of the draw period.
Changes to the HELOC Interest Tax Deduction
One big benefit of getting a HELOC is that it may come with a tax deduction. However, the rules for homeowners changed due to the Tax Cuts and Jobs Act of 2017, which went into effect in 2018. It reduced the cap on deductible mortgage interest from $1 million to $750,000 for those filing a joint return, and $375,000 for single taxpayers.
The new law also changed how HELOCs and home equity loans are treated. Previously, you could deduct all the interest paid on up to $100,000 for home equity loans or HELOCs. It didn’t matter how you spent the money; the interest was deductible whether you used it for home improvements or a trip around the world.
Beginning in 2018, the ability to deduct interest on anything other than home-related expenses has been suspended until 2026.
Beginning in 2018, the ability to deduct interest on anything other than home-related expenses has been suspended until 2026. Until that time, HELOC debt must be used to buy, build, or substantially improve your home in order for the interest paid to be tax deductible.
The new regulations also allow you to combine the total of all types of home acquisition debt, including mortgages, home equity loans, and HELOCs, and deduct interest paid on a maximum amount. As I mentioned, you can deduct interest paid on up to $750,000 of acquisition debt if you file taxes jointly, or up to $375,000 if you file as a single.
For instance, let’s say you have a $500,000 mortgage and get a $150,000 HELOC to remodel your home. You could deduct the interest on up to $650,000, or all of your home-related debt.
But if you have a $200,000 mortgage and use $25,000 from a HELOC to pay for college expenses, none of the interest paid on the HELOC would be deductible. Again, you can spend a HELOC on anything you like, but only the portion within the total limit that’s used for home-related expenses is eligible for an interest tax deduction.
So, if you’re considering a HELOC, understand that the tax law recently changed. You may not be eligible to deduct your interest expense, depending on how you use the money, and whether you itemize deductions on your tax return.
Can You Use a HELOC to Pay Off a Mortgage Faster?
With the rising popularity of HELOCs, many people are using them to pay off other debts. Whether you should use a HELOC to pay off your primary mortgage faster is a hotly debated topic.
The idea is that if your HELOC has a lower interest rate than your mortgage, you could save money by spending a HELOC to pay down your primary mortgage faster. This is basically refinancing your mortgage with a HELOC.
Problem is, drawing down your HELOC is risky because it’s typically an adjustable-rate product, which means you could have substantially higher interest rates and monthly payments. Also, you’d have to have a large amount of home equity in order to get a HELOC big enough to really make a dent in your primary mortgage.
If, and only if, your finances are in great shape, with plenty of savings and no debt, you may be in a position to pay off your mortgage early. But instead of using a HELOC to pay down your mortgage, I’d recommend that you just pay extra toward the principal each month.
You could also refinance your mortgage for a shorter, fixed-rate loan, such as a 10- or 15-year term. But you can accomplish the same thing and avoid the cost of doing a refinance by setting up your own schedule and just paying extra each month. Use the Excel Mortgage Loan Calculator template to easily see how much faster you can pay off a mortgage by making additional lump sum or ongoing payments.
Unless you’re saving at least 10% of your gross income for retirement, have an ample emergency fund, and zero debt (besides your mortgage), you shouldn’t even be thinking about paying down your mortgage early.
But if you are a good candidate to use a HELOC to refinance your mortgage, ask your lender if it’s possible to get a rate lock. That would make all or a portion of your HELOC a fixed-rate loan, with a set monthly payment. And by the way, locking your HELOC rate is also a good idea when interest rates are moving up.
While it might be awfully convenient to tap your home equity, don’t use it as a band-aid if you’re having a financial hardship.
Using a fixed, lower-rate HELOC to pay off a higher-rate primary mortgage could make sense, but it’s not a feasible or wise solution for most people. Always discuss your plans for using a HELOC with potential lenders and be clear about upfront fees or prepayment penalties.
4 Pros of Getting a HELOC
In addition to the potential tax deduction I covered, there are other benefits of a HELOC. One is that using your home equity for renovations could increase the market value of your home, helping you increase your net worth.
Here are four main pros for getting a HELOC:
- You have the flexibility to tap a line of credit whenever you need it.
- Interest is charged only for amounts you use.
- Adjustable interest rates can be lower than fixed loan rates (but not always).
- You can spend it on anything you like.
4 Cons of Getting a HELOC
Now, let’s cover the downsides of a HELOC. The biggest con is that borrowing against your home puts you at risk. Since your property is collateral for a HELOC, if you can’t repay it, the lender can force a home sale to satisfy your debt.
Also, if you take a HELOC and the value of your home drops due to local market conditions or an economic downtown, you may have to come up with cash to repay it. If you qualify for a HELOC, here are four cons to consider:
- You must pay interest on amounts borrowed.
- Lenders charge fees and closing costs to originate the loan.
- Adjustable rates mean your minimum monthly payment can go up significantly, depending on the laws in your state.
- Missing payments can hurt your credit.
Applying for a HELOC can be a sensible and convenient way to cash out part of your home’s equity. Just remember that if you spend it on something that decreases in value or has no value over the long term, such as consumer credit card debt or a vehicle, your net worth can decrease.
While it might be awfully convenient to tap your home equity, don’t use it as a band-aid if you’re having a financial hardship. Carefully consider whether decreasing your equity and paying interest on a HELOC is worth it. If it doesn’t bring you closer to achieving your financial goals, it probably isn’t.
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