Credit cards can be highly convenient since they allow you to make purchases you couldn't otherwise afford. However, this feature can also cause you to overspend, especially if you're easily tempted to buy things you can do without. Credit card debt is particularly undesirable because it has a higher interest rate than most other types of loans.
A home equity line of credit (HELOC) is a popular solution for paying off high-interest debt such as credit cards. While this option essentially involves transferring your debt from one lender to another, HELOCs have a much lower rate of interest than credit cards because they’re secured by the equity in your home. Unfortunately, most homeowners have a poor understanding of what a HELOC is and how to use one to their advantage.
How does a HELOC work?
Conventional home equity loans generally work the same way: A lender provides the borrower with a lump sum up front, using the homeowner’s home equity as the collateral for the loan. The borrower then makes regular payments to the lender, which include both interest and principal. The length of time the borrower has to repay the loan is known as its term, which can be as long as 30 years in the case of a home-equity loan.
HELOCs work more like a credit card instead of a conventional loan. Instead of an upfront lump sum, the lender provides the borrower with a fixed line of credit to borrow against. However, you can borrow against the credit line only during a period of time known as the draw period, typically up to ten years. You must then repay the loan in a lump sum or installments, depending on the lender. Some lenders also allow you to renew the draw period.
Figure's HELOC shares characteristics of both conventional home-equity loans and HELOCs. For example, the borrower receives the full amount of the loan up front like a home-equity loan, but also receives a line of credit for the loan amount like a traditional HELOC. You can then make additional draws on the HELOC as you pay off the amount you’ve already borrowed.
The biggest benefit from using a HELOC to replace existing credit card debt is that a HELOC typically has a much lower interest rate. This is because credit cards are unsecured loans, while a HELOC is secured by your home equity. A HELOC therefore poses a lower risk for lenders. For the sake of comparison, the average annual interest rate on a HELOC was about 5% in March 2020, according to the National Credit Union Administration. Most credit cards charged at least 20% annual interest during that same period.
HELOCs also have advantages over home equity loans. You only pay interest on what you borrow with a HELOC, not on the amount of the credit line, whereas you’ll pay interest on the entire amount you borrow with a home equity loan. Furthermore, you regain your credit as you repay a HELOC, allowing further withdrawals. With a home equity loan, there are no further draws after receipt of the upfront payment from the lender. In addition, the closing costs on HELOCs tend to be lower than those of home equity loans and traditional mortgages.
Lenders require HELOC borrowers to meet certain standards, just as they do for other types of loans. The factors that matter most to HELOC lenders are the following:
- Credit rating
Equity is the value of your ownership in a property, which you can calculate by subtracting the total amount you owe on it from the property’s fair market value. Assume for this example that your house is valued at $300K and you still owe $175K on the mortgage. Your equity is $300K - $175K = $125K.
Equity is the most important factor to a lender, because your equity will become the collateral for the loan. It gives the lender a safety net. Lenders use your equity to calculate a loan-to-value (LTV) ratio for your house, a figure that determines the maximum amount they’ll lend. This value is the amount you owe on your house divided by its market value, usually expressed as a percentage. Continuing from the above example, assume the lender allows a maximum LTV of 80%, meaning you can’t have more than $240K in loans on a house worth $300K. You already owe $175K on the mortgage, so you wouldn’t be able to borrow more than an additional $65K ($240K - $175K) in this example.
The borrower’s credit score is relatively important for a HELOC, although not as important as equity. Equifax’s 2017 U.S. Consumer Credit Trends report shows that 80% of HELOC borrowers had a Vantage credit score of 700 or more. Homeowners with lower scores may still qualify for a HELOC, but they’ll probably pay a higher interest rate.
A low income may prevent you from qualifying for a HELOC, even if you have substantial equity and a high credit score. In this case, lenders could worry about your ability to make minimum payments.
If you have substantial equity and income, a large amount of debt might not disqualify you from getting a HELOC, especially if you have a proven history of making payments. Lenders may well consider you to be a good risk.
This may be a good time to consider a HELOC, because the Federal Reserve is keeping interest rates low to offset the economic damage from COVID-19. Run the numbers and see whether paying off high-interest debt with a HELOC will save you more than the cost of the loan. At the same time, be aware of how hard you’ve worked to build your home equity and don’t put your residence at risk unnecessarily.