Being a homeowner always brings advantages and disadvantages. It can help or hurt your finances depending on where you live, what debt you take on and what your goals are. The joys include having your own place, stable housing costs, and the opportunity to build equity.
In fact, according to a J.D. Power study from 2018 more loanable equity than ever before. Rising home prices have increased the equity that homeowners can add by 10 percent from the previous pre-recession peak in 2005.
So if you're a homeowner watching your equity tick higher and higher, you may be wondering if you should go for it with a home equity line of credit or HELOC. In this post, I will cover what a HELOC is and the requirements to get one. You'll also learn about recent changes to the tax deduction when you can use a HELOC to pay off a principal mortgage faster, and the key pros and cons to consider.
What is a HELOC?
Just like a mortgage and home equity loan, a HELOC is a debt secured by your home. But a HELOC is fundamentally different because it's not actually a loan, but a line of credit.
A mortgage and home equity loan are installment loans with fixed terms or end dates, such as 15 or 30 years. In contrast, a HELOC is a revolving debt, d. H. You can access it at any time up to the maximum available credit limit, similar to a credit card. Your lender grants you a line of credit in an amount that depends on the equity available in your home.
Another similarity between a HELOC and a credit card is that they usually have variable interest rates. The interest rate is tied to a financial index like the prime rate, which means it can go up or down.
In some cases, you may need to make an initial draw on a HELOC, z. B. 5.000 USD or 10.000 USD, depending on the total amount to ensure that the lender receives a certain 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 is 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, z. B. For credit cards, college expenses, home improvements, a down payment on another home, or even to pay off your mortgage. I'll discuss more on this topic in a moment.
5 requirements for obtaining a HELOC
It's important to remember that when you issue a HELOC, you are borrowing against your home equity. And not every homeowner has enough equity or other financial qualifications to qualify for a HELOC.
If you're considering tapping into your home equity, here are five HELOC requirements you should know:
1. With enough home equity.
Most HELOC lenders require that you have at least 20% equity in your home to qualify. This is measured by your loan-to-value (LTV) ratio, which compares your total home loans to your home's fair market value. To know what your home is worth, lenders typically require a professional appraisal.
Lenders typically won't approve you for a home equity loan or a HELOC that would cause you to exceed an LTV of 80% to 90%.
For example, let's say your home has a value of 200.000 USD. If your mortgage balance is 140.000 USD and you have 20.000 USD to borrow with a new HELOC, your LTV (including new debt) is 80% [(140.000 USD + 20.000 USD) / 200.000 USD = 0.8 = 80%].
Lenders typically won't approve you for a home equity loan or a HELOC that would cause you to exceed an LTV of 80% to 90%. However, lenders have different requirements and will also evaluate you based on other factors, which 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 additional debt in your financial life.
Your DTI includes all debts such as credit cards, car loans, student loans and mortgages. For example, if your total debt payments are 2.500 USD and your income is 5.000 USD per month, your DTI is 50% (2.500 USD / 5.000 USD = 0.5 = 50%).
Most lenders have a DTI cutoff of 40% to 49%, and the lower the better. If your DTI exceeds an acceptable level, you will need to pay off your debt, increase your income, or do both to obtain a HELOC.