A HELOC works much like a credit card, offering you credit that’s available when you need it. But these loans can be difficult to qualify for, often requiring you to have a substantial amount of equity along with a high credit score. In this article, we’ll go through the nuts and bolts of how a HELOC works and the requirements you typically must meet to get approved for one. Click the following links to jump to what a HELOC is, requirements for obtaining a HELOC, and the pros and cons of a HELOC.
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What Is a HELOC?
A HELOC is a type of second mortgage, a line of credit based on the amount of equity you’ve built in your home. Instead of receiving a lump sum like you might with a home equity loan, you can spend up to your credit limit. Once you pay down the balance, you can spend up to the limit again within the draw period.
One of the biggest benefits of a HELOC is its flexibility. You can use a HELOC when you need it and make payments only when you’ve spent money. With a loan that you receive all at once, you are locked into monthly payments until it is completely paid back.
How a HELOC Works
A HELOC is divided into two parts: the draw period and the repayment period. The draw period is how long the line of credit remains open, often around 10 years. You’ll typically make interest-only payments, then principal and interest payments during the repayment period, which generally runs up to 20 years. The balance typically accrues interest at a variable rate, though some lenders may offer fixed-rate HELOCs.
Requirements for Obtaining a HELOC
The requirements for a HELOC are straightforward but can be stringent. In most cases, you’ll need to have a significant chunk of equity in your home — at least 15% to 20% or more, according to our research. You’ll also likely need to have a solid credit history. If your credit is poor, you may not qualify.
Below, we’ll go into more depth about what requirements lenders typically have when considering your application for a HELOC.
Adequate Equity in Your Home
Equity is the difference between what your home is worth and the amount you have left on your mortgage, but there’s more to it than that. To measure this, lenders typically use a metric known as your loan-to-value (LTV) ratio. Generally, you need an LTV of 85% or less to qualify for a HELOC.
For example, say your house is worth $300,000, and you still owe $225,000 on your mortgage. Your loan-to-value ratio would be 75% ($225,000 is three-quarters of $300,000). In this case, you may be able to qualify for a HELOC because your LTV is less than what’s typically required.
>> Related: Learn more about how to calculate the equity in your home.
Sufficient Income To Pay Back the Loan
Lenders want to know that they’ll be repaid. Typically, your lender will judge this by assessing your debt-to-income ratio, or DTI. Your DTI compares how much debt you currently hold with the amount of money you make monthly.
To arrive at this number, divide your monthly debt payments, such as your car loan and mortgage, by your monthly income. For example, if you owe $1,500 a month in debt payments but make $4,500 gross, your DTI would be about 33%.
Most lenders like to see a DTI of 43% or lower before approving a HELOC application — and that’s after you take into account the potential new loan. Ultimately, a lower DTI can help you meet approval requirements.
Good Credit Score and History
Having a good credit score and history can also generally improve your chances of HELOC approval. While every lender will have its own requirements, the higher your credit score typically equates to the greater likelihood you have of being approved.
In some cases, lenders may require a credit score of 680 or higher for HELOC applications, according to the credit rating agency Experian, but 720 or above may be preferable.
Recent Property Appraisal
Since your HELOC depends heavily on the value of your home, your lender will likely require a recent property appraisal. In many cases, your lender will order a new appraisal as part of the underwriting process on your loan. There may be some fees associated with this, which typically run up to $400.
However, not all HELOC applications require a new appraisal. Lenders may also be able to calculate the value of your home by pulling information from public records. For instance, your local tax records may have enough information about your home’s value to provide a reasonable estimate to your lender.
>> Related: Learn how to get the best HELOC rates.
Pros and Cons of a HELOC
HELOCs allow you to spend as much as you need, when you need it, up to your credit limit. But like any time you borrow money, there are downsides as well. You may not know the full cost of interest and could face steep fees. Consider these pros and cons when deciding whether to apply for a HELOC.
Pros
Lower interest rates: As credit secured by your home’s equity, HELOC rates are generally lower compared to unsecured loans, such as personal loans or credit cards.
Flexibility: Instead of a lump sum that you can spend only once, you can spend from your revolving credit line over and over during the draw period. You also don’t need to use a HELOC right away. You may choose to open one so that you’re prepared for any unexpected expenses.
Interest-only payments: During your draw period, you may only be required to pay interest on the amount you spend. This can help you keep your costs low and better budget for repayment.
Cons
Variable rates: HELOCs are typically repaid at variable interest rates, meaning your payments can go up over time.
Fees and other costs: The costs associated with applying for and maintaining a HELOC may include application fees, closing costs, appraisal costs and an annual fee.
Equity limitations: Since the amount you can borrow on a HELOC is limited by your equity, your credit limit could be less money than what you could borrow with a different type of loan.
Secured debt: HELOCs are typically secured by your home, which could put your property at risk if you fail to make your payments.
>> Related: Learn more about the pros and cons of a HELOC.
Applying for a HELOC
Applying for a HELOC is typically a straightforward process. You can follow these steps to prepare for your application.
Step 1: Research Potential Lenders
HELOCs may be available from a wide variety of lenders, each with different requirements and interest rates.
As you investigate these lenders, compare fees and interest rates. Though one lender may have a lower interest rate, if its application and annual fees are high, you may end up paying more in the long run. Read reviews from organizations like the Better Business Bureau (BBB) to see how other customers felt about borrowing from a particular lender.
Step 2: Gather Your Documentation
HELOC lenders will likely ask for some documentation from you to evaluate your application. Gathering this paperwork ahead of time can help the process go more smoothly. Each lender may have different requirements, but there are some general forms to grab ahead of time. Refer to this checklist to prepare for your application:
- Income information:
- Recent pay stubs
- W-2 tax forms from the last two years
- If self-employed or earning other sources of income, include signed federal tax returns from the last two years and any relevant year-to-date profit and loss statements from investments.
- If receiving disability, Social Security or pension, include a recent award letter, current bank statements or 1099s from the last two years.
- Documentation of any applicable retirement distributions, including tax returns, W-2s or 1099s, award letters or bank statements
- Documentation of any alimony or child support
- Recent bank statements
- Homeowners insurance declaration page
- Property tax bills
- Photo ID
Step 3: Prequalify
Once you have researched some lenders you like and gathered your documentation, it’s time to prequalify. You can often do this with an online application from your potential lenders. This application may ask you to submit some identifying information and some financial details from the documents listed above.
Prequalification for a HELOC is provisional approval from a lender indicating they have informally reviewed your financial information. It can give you a good idea of whether you would be officially approved with a full application, but doesn’t guarantee that you’ll meet all the requirements.
One benefit of getting prequalified before submitting a full HELOC application is that it is typically a soft credit inquiry. The lender reviews your credit history, but this does not affect your credit score. It also can help you compare the rates and terms from multiple lenders.
Step 4: Complete a Full Application
When you feel confident with your final choice of lender, you can submit a full application for a HELOC. Many lenders have applications available online that ask for information about the property you want to use as collateral, including its value and the desired line of credit amount.
You will also likely need to provide personal information, such as your contact info and Social Security number. Applications are often relatively brief and permit lenders to do a full review, including a hard credit inquiry, to assess your creditworthiness.
Be prepared to pay an application fee if your chosen lender requires one. From application to approval to receipt of funds, the entire process should take about two to six weeks if you satisfy the requirements.
>> Related: Learn more about how much money you can borrow with a HELOC.
Alternatives to a HELOC
While HELOCs can be a borrowing option with favorable rates, they are not the only way to tap into your home equity or get a loan when you need it. You can consider discussing the best course of action with a financial adviser or credit counselor. Alternatives could include those found below.
A home equity loan is another borrowing option that uses your home equity. Unlike the revolving credit style of a HELOC, a home equity loan typically involves borrowing money as a lump sum that you repay with fixed monthly payments over the length of the loan repayment term.
Home equity loanscan be a good choice if you want to lock in a fixed rate and repayment schedule so that you can know what to expect with upcoming budgeting. However, they’re also secured by your property, meaning you could lose your home to foreclosure if you fail to make your payments.
Check out our list of thebest home equity loan rates.
With a cash-out refinance, you take out a new mortgage for a higher amount than you currently owe. The balance comes to you as cash. This can be a good way to access your equity without needing to take on a second mortgage. However, if interest rates are higher than when you first took out your mortgage, you may end up paying substantially more in interest over the life of your loan.
A personal loan generally refers to an installment loan borrowed as a lump sum and repaid with a fixed interest rate and monthly payment. In most cases, personal loans are unsecured, meaning you don’t have to use your property as collateral. While this means you don’t risk foreclosure with a personal loan, you may pay higher interest rates.
However, despite higher rates, there may be times when it makes more sense to take out a personal loan as opposed to a HELOC. If you have very little equity in your home, a personal loan may get you a higher sum. If you’re concerned at all with using your home equity as collateral on a loan, going for an unsecured personal loan may be a more viable option.
The Bottom Line
A lender’s requirements for a HELOC are fairly straightforward. In most cases, lenders want to see that you have enough equity in your home and enough income to pay back the loan, along with a good credit history.
If you meet these requirements, your HELOC application may be approved — opening up access to a flexible revolving credit product that lets you tap into your home equity.
Before applying for a HELOC, consider assessing your financial situation. You may want to gather a few key numbers, such as the equity in your home, your income and DTI, your credit score and the current value of your home. These can give you a good idea of approval potential before you even submit applications for prequalification.
Frequently Asked Questions About HELOC Requirements
You may be disqualified from opening a HELOC if you do not meet the lender requirements. This may include low equity in your home, inadequate income or a low credit score.
To qualify for a HELOC, you’ll typically need to meet fairly strict requirements. HELOC lenders typically look at several numbers before approving you for a loan, including the following:
- Your available equity
- Your income
- Your credit score
- Your property value
All of these numbers typically need to be favorable enough for you to be approved for a loan.
There are several disadvantages to a HELOC, including the following:
- Variable rates: Most HELOCs accrue interest at variable rates, meaning your monthly payments can go up over time.
- Equity limitations: The amount you can borrow in a HELOC is limited by the amount of equity in your home. If you don’t have much equity, you may not qualify for a HELOC.
- Fees and costs: There are some costs associated with taking out a HELOC, including application fees, closing costs, appraisal costs and annual fees.
- Risk of foreclosure: A HELOC is secured debt, which means your home equity is the collateral for the money you borrow. This could put your home in danger if you have trouble repaying what you borrowed.
You can open a HELOC and not use it, though some plans may require that you borrow at opening. While it may be convenient to have an open line of credit in case of unexpected expenses, you’ll still likely incur costs, such as an application fee, closing costs, appraisal costs and possible annual fee.
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
If you have feedback or questions about this article, please email the MarketWatch Guides team at editors@marketwatchguides.com.