Applying for a HELOC can be a powerful way to tap into your home's equity. The Home Equity Line of Credit offers that flexibility because of one key factor: you can borrow against home equity without changing your underlying mortgage. With a cash-out refinance, for example, you would have to change the mortgage rates for the remainder of your loan term. Not so with a HELOC.
So why doesn't everyone use a HELOC to borrow against their home equity affordably, and use that money for projects like renovation, investing, or debt consolidation? Well, many people do. But before you do, it will help if you ask yourself some simple math questions. HELOCs, for many, come down to straightforward equations. And if you know what these are, you might stand a really good chance of maximizing the value of your HELOC and expanding your financial options as a homeowner.
What is a HELOC?
A Home Equity Line of Credit is a loan you can take out, secured by your home. You can borrow more of your equity even while you're still paying off the mortgage. As long as you don't overextend your debts, you should have no problem paying off a HELOC and holding on to the home equity you've established.
What you should ask yourself before applying for a HELOC
Now that you know the lay of the land, let's get to the key mathematical questions you should ask before applying for one yourself.
Is the HELOC's interest lower than the combined interest of the debt you're consolidating?
Let's say that you're using a HELOC to pay off a lot of consumer debt like credit card debt. In this case, you can have some reasonable expectation that a HELOC's interest rates, secured by your home, are going to be lower than the interest rate you have on your consumer debt. (For example, it's common to pay as high as 20% on credit card debt, while HELOCs can be as low as 5-10%).
What's the key math question here? Simple. What is the combined interest rate of the debt you're paying off? For example, if you have one loan of $1,000 at 10% and $1000 at 20%, you're looking at a combined interest rate of 15%, the average between the two. If you were to secure a HELOC below that number, you would be doing yourself a favor in debt consolidation.
How much home equity do you currently have?
Before you apply for a HELOC, you have to know what you can borrow. That means calculating the current equity you have in your home.
The way to do it is straightforward. You want to find out first how much you still owe on your home, and then the home's appraised value. For example, if you still owe $100,000 on your home with an appraised value of $250,000, then your home equity ise $150,000. Having the number handy will help you understand how much security you can provide to a HELOC lender, lowering your potential interest payments on the HELOC.
What is your loan-to-value ratio?
Because lenders typically look for a ratio below 85% on this number to make sure you qualify for a HELOC, you'll want to verify it for yourself. So what is the loan-to-value ratio?
This is the amount of the mortgage(s) in relation to the value of the underlying property. Let's say you needed a mortgage of $160,000 to buy a property worth $200,000 in appraised value. That's 80% of the property’s value, or the loan-to-value ratio. If that's the only loan you have on your home, then it would meet the qualification many lenders have in issuing a HELOC, giving you the flexibility to take one out for yourself.
What is your personal debt-to-income ratio?
Any lender who wants to have a reasonable expectation that they're going to get full value out of their loan to you needs to know that you can pay them back. To do this, they often assess your personal debt-to-income ratio, or DTI. Typically, you're aiming for less than 50% here.
DTI is the amount of money you owe in relation to your income, which helps calculate your potential to pay it back. To calculate this ratio, you need to figure out every payment liabilities you must make, such as alimony payments, debt payments, mortgage payments, etc. Then you would divide that by your monthly gross income.
Ideally, your debts would not exceed about half of your monthly gross income, giving you some flexibility to pay loans back. Having a good DTI gives you "wiggle room" to take out more debt against your home's equity, which gives lenders more confidence when they loan money to you.
Is a HELOC right for you?
If you find yourself asking this question, the first place you should turn is to the four questions above. You can use the examples provided to run the numbers on your own financial situation. Calculate your DTI, the equity you own in your home, and more. Then weigh it against the typical requirements of a HELOC, as we noted. This will help you figure out whether a HELOC is in the cards for you.
But that's not what we asked. We asked if a HELOC is right for you. Once you've done the calculations above, you should have a sense of whether you can afford one. But is it right for you? This is where you have to do a little bit of projection into the future. To do so, ask yourself what your HELOC payments would look like if you were to borrow against your home's equity at current rates. And compare these payments to the current payments you're making, especially if you're using the HELOC for debt consolidation. You can also put the HELOC payments into your budget to get a sense of whether you have the room to pay off that HELOC as necessary.
Figure out your HELOC situation and your finances today
Work with Figure to find out whether a HELOC makes sense for you. With Figure's fast turnaround once you're approved, you could use your HELOC to start getting your debts under control. You could also realize the cash value of your home's equity, putting that money towards productive projects like investments, debt payments, and home renovations.