What Is a Home Equity Line of Credit and How Does It Work?

Home prices in the United States are at an all-time high, but Americans are reluctant to borrow money secured by their house, and balances on home equity lines of credit (HELOCs) continue to fall. Should you avoid taking out a HELOC, or does borrowing against your home make sense? These are the things you need to know before taking out a HELOC.

So What Is a HELOC, Anyway?

A HELOC is a revolving form of credit. The bank extends a line of credit to you, and you can use as much or as little as you choose. As you pay off the HELOC, more credit becomes available.

However, a HELOC isn’t just a line of credit. It’s also a mortgage against your house. If you can’t pay back your HELOC, you risk losing your home.

What Do I Need to Apply for a HELOC?

To qualify for a HELOC, you need “tappable equity.”

“Tappable equity is the amount of home equity that can be borrowed and still leave owners with at least 20 percent equity in their home,” says Odeta Kushi, deputy chief economist at First American.

But that isn’t the only thing you need. A great credit score and a low debt-to-income ratio (debts below 45 percent of your monthly income) are also must-haves.

“In the early and mid-2000s, we saw a lot of abuses of home equity lines of credit, so lenders have much stricter criteria these days. The documentation and underwriting standards can be very onerous,” says Joel Kan, associate vice president of economic and industry forecasting for the Mortgage Bankers Association.

When Is a HELOC a Good Idea?

If you’ve got substantial equity in your home, taking out a HELOC may seem like a good deal. But before you apply for a HELOC, there are two questions to consider: Does a HELOC make financial sense? And are you borrowing for a good reason?

When a HELOC Makes Financial Sense

HELOC balances are at their lowest level in 14 years, but overall household debts are growing. Instead of borrowing against home equity, households are taking out credit card debt, auto loans, and student loans.

This means many households are using high-interest debt when they could use low-interest debt.

For example, the average interest rate on a credit card is nearly 17 percent, but HELOC interest rates are closer to five percent. Using a HELOC to fund a home remodel makes a lot more sense than buying materials on a high-interest credit card.

Good Reasons to Take Out a HELOC

Of course, borrowing against your house could erode your biggest source of wealth (your home equity). To avoid losing the wealth you have stored in your home, it’s important to only use a HELOC to pay for investments or to avoid high-interest debt. Some good reasons to take out a HELOC include:

• Improving your home
• Covering an emergency
• Building a small business

Using a HELOC to buy consumer goods (like appliances, ATVs, cars, or a boat) will usually lead to overspending. It’s better to save for those items rather than take out debt to pay for them.

How Does a HELOC Work?

If you have a lot of equity in your house, taking out a HELOC could be a great way to borrow money. But before you take out a new loan, it’s important to understand the risks associated with HELOC borrowing. These are the most important things to know.

Your House Is on the Line

One of the biggest risks associated with a HELOC is that you could lose your home. If you lose your job, and you can’t make the payments on your HELOC, you’ll have to work with your lender to avoid foreclosure. Depending on how much you’ve borrowed, keeping your house could become difficult.

“If there’s ever a distress situation, it’s always easier to help someone who isn’t in a tight equity situation,” Kan says.

A HELOC Isn’t Free Money

One of the most important facets of a HELOC is that it isn’t free money — it has to be paid back. Overborrowing on a HELOC means that a small decline in property values could trap you in a house with negative equity. During the recession from 2007 to 2009, many people found that out the hard way.

Tom and Tonya of North Carolina used a HELOC on their former home in Virginia to help their children pay for college. Unfortunately, their house value dropped in the housing crisis.

Between their mortgage and the HELOC, the couple owed more than the house was worth.

When the couple decided to move to North Carolina in 2014, they were still trapped with negative equity. To cover their payments, they had to convert their home into a rental property. Today, the rental income barely covers payments on both mortgages, and selling the house would just barely pay off both the mortgage and the HELOC.

How Much Can I Borrow?

The amount you can borrow depends on your home equity levels, your credit score, and your income. Lenders usually require at least a 20 percent equity cushion, according to Kushi. That means if your house is worth $250,000, and your primary mortgage is $150,000, your maximum line of credit would be $50,000.

What Will My Payments Be?

When you first take out a HELOC, ask your lender about the monthly payments, but be aware the monthly payments may change over time. “Most HELOCs will have a fixed interest rate for a period of time, and then the loan will turn to a variable rate,” Kan explains. That means the interest rate (and the corresponding monthly payment) could increase over time, even if you don’t borrow more.

Is a HELOC a Good Idea for Me?

Before you decide to take out a HELOC, it’s important to consider all your options. Could you find a better interest rate? Perhaps using a zero-percent credit card could help you pay off an expensive medical bill. Or does it make more sense to save up money rather than borrow? If you’re looking to buy a snowmobile, it makes more sense to save up and pay for it with cash.

If a HELOC is your best option, compare rates and terms to be sure that you’re taking out the best one for you.