How to Qualify for a Home Equity Line of Credit (HELOC)

Understanding HELOC: What is a home equity line of credit?

A Home Equity Line of Credit (HELOC) is a revolving line of credit secured by your home's equity. Unlike a traditional loan, a HELOC allows you to borrow funds as needed up to an approved limit during a specified draw period. You are only required to pay interest on the amount you borrow, and as you repay the principal, those funds become available again for borrowing. After the draw period – usually 5 or 10 years, you enter the repayment phase, whereby you can no longer borrow and must repay the outstanding balance(both principal and interest).

Benefits of a HELOC include:

• Flexibility: You borrow only what you need when you need it.
• Lower interest rates: HELOCs typically have lower rates than unsecured loans and credit cards because the home is the security. This can be beneficial in debt consolidation planning. A consolidation loan calculator can help you evaluate potential savings.
• Potential tax advantages: Interest on HELOCs is deductible in some cases. The IRS (2024) stipulates that “interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.”

Eligibility criteria: How to qualify for a HELOC

If you're wondering, "Do I qualify for a HELOC?" lenders consider several factors to determine eligibility:

Home equity

First and foremost, you generally need at least 15% to 20% equity in your home. This means your loan-to-value (LTV) ratio should be 80% or less. For example, if your home is worth $300,000, your total mortgage debt should not exceed $240,000.

Credit score

A good credit score is the second key factor. Most HELOC lenders require a score of 660 or higher, but some lenders accept lower scores. A higher score improves the likelihood of approval and may secure a lower interest rate.

Debt-to-income ratio

Your debt-to-income (DTI) ratio measures your monthly debt obligations against your gross monthly income. Lenders typically prefer a DTI ratio of 43% or lower. A DTI below 43 indicates you have sufficient income to handle additional debt payments.

Income and employment history

Stable and verifiable income assures lenders of your ability to repay your HELOC. To prove income, you will have to submit W-2 forms, tax returns, and recent pay stubs. Self-employed individuals need to provide additional documentation.

Property type and condition

Primary residences are more likely to qualify. The property's condition and marketability are also assessed, as they impact the home's value, which secures the HELOC.

Steps to qualify for a HELOC

Here's a step-by-step guide on how to qualify for a HELOC loan:

1. Evaluate your home equity

Determine your home's current market value through online real estate platforms like Zillow or a professional appraisal. Subtract your outstanding mortgage from the appraised amount to calculate your equity. Depending on the lender, your home equity should be at least 15% or 20%. You can compute your available equity using Ent's HELOC calculator.

2. Check your credit score

Obtain your credit report from any of the three major bureaus (Experian, TransUnion, Equifax). Review it for accuracy and address discrepancies. If necessary, take steps to improve your score by paying down debts and avoiding late payments.

3. Calculate your debt-to-income ratio

Sum up your monthly debt payments, including student and auto loans, credit card payments, and mortgages. Then, divide this by your gross monthly income. If your DTI ratio is above 43%, consider paying off some debts to improve it.

4. Gather necessary documentation

Prepare the following documents:

• Proof of income: Recent pay stubs, W-2s, and tax returns.
• Asset statements: Bank and investment account statements.
• Mortgage statements: Current balance and payment details.
• Identification: Driver's license, state ID, or passport.

5. Research and compare lenders

Different lending institutions offer varying terms and interest rates. In addition to banks, consider credit unions and online lenders. Compare their HELOC offers and terms to find the best fit for your needs.

6. Submit your application

Complete the application process with the lender who offered the best terms, providing all required information accurately. Be ready to provide additional clarification or documentation if requested.

7. Undergo property appraisal

The lender will undertake an appraisal to confirm your home's market value. The appraised value will determine how much you can borrow.

8. Review loan terms and close

Once approved, review the loan agreement carefully. Pay attention to HELOC rates, fees, repayment terms, and any potential penalties. If everything is satisfactory, proceed to close the loan.

Common challenges: How hard is it to qualify for a HELOC?

Approximately 0.5 million HELOCs were originated in the first and second quarter of 2024 (Haughwout, Lee, Mangrum, Scally, & Klaauw, 2024). After a decade of decline, HELOC originations are on the upswing but still comprise a tiny percentage of household debt. So, how hard is it to qualify for a HELOC? While many homeowners can qualify, certain challenges may arise:

Insufficient equity

If you haven't built enough equity in your home, you may not qualify. Focus on paying down your mortgage or wait until your property's value increases.

Low credit score

A credit score below 660 can hinder your chances. Improve your score by:

• Paying bills on time.
• Reducing outstanding debts.
• Avoiding new credit inquiries.

High debt-to-income ratio

A high DTI ratio suggests you might struggle with additional debt. To improve your ratio:

• Increase your income if possible.
• Pay off existing debts.
• Refrain from taking on new debts.

Unstable income

Lenders prefer borrowers with steady employment. If you're self-employed or have variable income, provide comprehensive documentation to demonstrate consistent earnings.

Property issues

Homes in poor condition or in areas with declining property values may pose challenges. Investing in necessary repairs and maintenance can improve your eligibility.

Next steps: What to do if you qualify for a HELOC

After qualifying and receiving approval, consider the following steps:

Understand the terms and conditions

Go through the HELOC agreement to understand the terms. Some of the key terms and conditions to familiarize yourself with and keep in mind include:

• Interest rates: HELOCs often have variable rates that can change over time. Therefore, monitor your HELOC rate.
• Draw period: Pinpoint the duration you will be able to borrow. The time frame is usually 5-10 years.
• Repayment period: After the draw period, you'll enter the repayment phase, typically 10-20 years.

Plan your financial strategy

Use your HELOC funds wisely. Since your home is collateral, defaulting on payments could result in foreclosure. Prioritize expenses that add value or improve your financial situation.

Monitor your HELOC usage

Keep track of how much you borrow and ensure you can meet the repayment requirements. If possible, set up automatic payments to avoid missing due dates.

Consult financial professionals

A financial advisor or planner can help provide personalized advice on managing your HELOC effectively and integrating it into your overall financial plan.

FAQs

How does a HELOC work?

First, what is a HELOC? A HELOC is a revolving line of credit secured by your home's equity. It works by allowing you to borrow funds up to an approved limit during the draw period. During this period, you only pay interest on the amount borrowed, and as you repay the principal, those funds become available again. You enter the repayment phase after the 5- or 10-year draw period ends.

What are the basic requirements to qualify for a HELOC?

Basic requirements include:

• Sufficient home equity (typically at least 15-20%).
• A good credit score (around 680 or higher).
• A low debt-to-income ratio (43% or less).
• Stable income.

How can I determine if my credit score qualifies me for a HELOC?

Lenders’ requirements vary but typically range between 620 to 680. Therefore, check your credit score through reputable agencies like Experian, TransUnion, or Equifax. If your score is below the lender's requirement, work on improving it before applying.

What documentation do I need to apply for a HELOC?

You'll need proof of income (pay stubs, W-2s, tax returns), asset statements (bank accounts, investments), mortgage statements, and identification documents.

How long does it typically take to get approved for a HELOC?

Approval can take two to six weeks, depending on the lender. How quickly you provide the necessary documentation matters.

Citations

Andrew Haughwout, Donghoon Lee, Daniel Mangrum, Joelle W. Scally, and Wilbert van der Klaauw, (2024, August 6). Mortgage Lock-In Spurs Recent HELOC Demand. Federal Reserve Bank of New York Liberty Street Economics. https://libertystreeteconomics.newyorkfed.org/2024/08/mortgage-lock-in-spurs-recent-heloc-demand/

Internal Revenue Service (2024, September 9). Publication 936 (2023), Home Mortgage Interest Deduction. https://www.irs.gov/publications/p936#en_US_2023_publink1000229891

St. Louis Fed (2024, September 12). Households; Owners' Equity in Real Estate, Level. https://fred.stlouisfed.org/series/OEHRENWBSHNO