7 Step Process to Taking out a HELOC
A home equity line of credit (HELOC) is a type of secured loan that gives you a revolving line of credit by using your home as collateral. If you’re looking for a flexible way to finance a major purchase, a home equity line of credit may meet your needs. Here’s what to expect as you move through the decision-making and HELOC application processes.
What is a HELOC Loan?
A HELOC a second mortgage that functions somewhat like a credit card, in that, your lender sets a maximum credit limit that you can borrow against, as needed. A HELOC is broken into two phases: the draw period and the repayment period.
How Does a HELOC WOrk
During the draw period — typically five to 10 years — you can borrow as little or as much as you want within your credit limit. Your minimum payments will usually be interest-only within this period, but you can choose to make payments toward the principal to avoid paying more over the life of the loan.
Once the draw period has ended, you’ll enter into your repayment period which generally lasts around 20 years. Your monthly payments will likely dramatically increase because you’ll be repaying the principal and interest for the remainder of the loan.
Risks to consider before using a home equity line of credit
Because your home is used as collateral — meaning you may be at risk of losing your home if you default on the loan — you should only use a HELOC to strategically build long-term wealth (e.g. home repairs or renovations). Other common uses of a HELOC include: funding higher education, consolidating debt with high interest rates, and paying off excessive medical bills.
Avoid using a HELOC if:
You need it for day-to-day purchases. A HELOC isn’t worth the risk if you need the funds for your basic needs. Consider using your emergency fund or picking up a side gig that can bring in more income to help make ends meet each month.
Your income isn’t stable. If you can’t make consistent, on-time payments, the lender could foreclose on your home. Make sure your monthly income is reliable and sufficient to meet your financial obligations.
You don’t need to borrow a large amount. Upfront costs, like application fees and appraisal fees, can add up quickly. If you only need a small line of credit, you may benefit more from a zero-interest credit card or low-interest personal loan.
You also need to consider how a variable interest rate may affect your finances later down the line. A variable rate might cause your payment to fluctuate from month to month. If you aren’t able to afford the lifetime cap, or highest-possible rate, then a HELOC may not be the best choice for you.
Read: Pros and Cons to Borrowing Against Your 401(k)
HELOC Process: Approval for Qualifying for a home equity line of credit
The steps for getting a HELOC are similar to buying or refinancing a home. Your lender will require the same documentation and evaluate your creditworthiness before approving your application and releasing funds.
1. Review your finances and determine your home equity
It’s important that you carefully review your financial situation before moving forward with a home equity line of credit. You’re putting your home on the line; therefore, you need to ensure the purchase is truly worth it and that you’ll be able to fulfill your end of the deal with on-time monthly payments.
Calculate your home equity by taking the current market value of your home and subtracting what you still owe on your mortgage. You want this number to be at least 20% of your home’s value to realistically qualify for a HELOC, however, some lenders may make exceptions.
2. Estimate how much you’ll need to borrow
You can typically borrow up to 85% of the value of your home minus the amount you owe. For example, if your home is worth $300,000 and you have a balance of $150,000 on your mortgage, you can establish a HELOC with a $105,000 limit:
$300,000 x 85% = $255,000
$255,000 - 150,000 = $105,000 maximum line of credit
Determine how much you’ll need for the project or purchase you plan to make. Remember to factor in additional loan costs, like an application fee and closing costs. If there’s a dramatic difference in the projected line of credit and the estimated cost that you’ll need to borrow, you may need to look at other financing options that better fit your situation.
3. Shop lenders
Interest rates and qualification requirements vary by lender, so be sure to shop around for the best fit. Lenders typically require that you have at least 20% equity in your home and a credit score of 620 or higher. Lenders may also look at your credit payment history, debt-to-income ratio, or other methods to determine your risk and ability to make payments.
Compare rates from at least three lenders. Use these rates to negotiate better terms with your preferred lender. Your bank or current mortgage provider may provide discounts for existing customers. Whereas, a new lender might provide an introductory offer or reduced rate to earn your business.
4. Submit your application
Along with your application, you’ll need to submit additional financial documentation. Your lender will likely request personal and employer information, two years of income documentation, proof of homeownership and insurance, and a mortgage statement. Your lender will also want access to any documentation related to existing debts or liens on your home.
5. Thoroughly review all disclosures
Similar to when you purchased your home, you’ll receive disclosures that lay out the terms of the agreement and any additional requirements. Read through them carefully and don’t hesitate to ask your lender questions. This is your final chance to ensure the HELOC meets your needs and that you understand all the conditions of the loan.
6. Underwriting process
The underwriting process may only take a few hours, or it could take several weeks. Your lender may even require an additional appraisal which can prolong the process. Be patient and plan for an extended waiting period.
7. Sign closing paperwork
Your final step is to sign all closing paperwork. You’ll then have access to your funds within a few business days.
A HELOC can provide you with a flexible, low-interest option to finance large purchases, but it must be used responsibly. Keep in mind that a home equity line of credit is borrowed money that will have to be paid back with interest, not free money.
If you are unable to make your required monthly payments — or in some cases, a lump sum payment at the end of the draw period — you could risk losing your home. Weigh out the potential risks and benefits to determine if a HELOC will benefit you over the long-run.
Still unsure whether a HELOC makes sense for your next big purchase? Speak to a financial coach to learn more about your financial situation and financing options.