Spring Cleaning with the Help of a Home Equity Line of Credit (HELOC)

What is a HELOC?

A home equity line of credit, commonly known as a HELOC, is a way of borrowing against the equity you have built up in your home. If you haven’t paid off your home, the loan would be considered a second mortgage. If you own your home outright, it would be your only mortgage. The lender will let you borrow up to a certain percentage of your home’s equity based on its current market value. Many lenders cap HELOCs at around 85% equity, but this figure varies widely based on a number of factors, including your credit history, the amount borrowed, whether the home is your primary residence or a rental and your overall debt-to-income ratio.

The money is then paid out through a line of credit, much like a credit card. With some lenders, you can request funds via check or instant transfer if the loan is connected to your bank account or credit card. The money is typically given out as needed, so you can pay for expenses as they occur. As you spend the money, you will need to pay it back in monthly installments, including interest.

How Do HELOCs Work?

You can apply for a HELOC at a bank or your local credit union if you have built up equity in your home. The lender will consider the value of your home, your debt-to-income ratio, credit score and other financial factors when considering your application to make sure you can repay the loan on time.

The lender will use these factors to determine an interest rate for the loan. They will first assign a base interest rate based on market conditions, also known as the market index rate. They will then add a mark-up rate based on your credit profile. The better your financial standing and the more equity you have in your home, the lower your interest rate.

Once you get approved for a HELOC, you can start borrowing funds for your home improvement project. HELOCs come with two phases:

Draw Period: During this time, you can request funds by making a withdrawal. In some cases, you can make purchases with these funds using your regular credit or debit card if it is connected to the loan. The amount owed will start accruing interest immediately. HELOCs come with fixed or adjustable interest rates during the draw period.

Most lenders only require you to pay off the interest during the draw period, but you can start paying the principal to save money in the long run. The length of the draw period depends on the terms and conditions of the loan.

Repayment Period: Once the draw period ends, the loan becomes amortized and works similar to other installment loans. You can no longer borrow money from the line of credit and will need to start making regular monthly payments. In most cases, HELOCs have adjustable interest rates during the repayment period. The interest rate will vary slightly over time based on the market index. Check current HELOC rates. It's best to pay down the principal amount as much as possible before the repayment period begins to avoid paying more in interest.

The length of the repayment period depends on the terms and conditions, usually 15, 20 years or more. You will need to pay off the principal amount by the end of the repayment period. If you still owe money to the lender at this time, you will need to pay off the remaining amount in a lump sum. You can also apply for an extension to increase the length of the repayment period.

How to Apply for a HELOC

If you are thinking of using a HELOC to fund your upcoming spring projects, you need to do some research to make sure you are eligible to apply.

To qualify for a home equity line of credit, most lenders ask that you have at least 15% to 20% home equity, which is the value of your home minus what you still owe on your mortgage.

To get started, subtract how much you still owe on your mortgage from the listing price of your home. For example, if your home costs $300,000 and you still owe $60,000 on your mortgage, your home equity would be $240,000 or 80%. Use this home equity line of credit calculator to find out how much equity you have in your home. 

If you meet the home equity requirement, you will need to find a lender that offers HELOCs. Shop around for the best interest rates to save money over time. Once you find a specific loan that meets your needs, you will need to submit your financial information to the lender as part of the application process, including:

• Copies of your pay stubs, bank records, W2s, real estate income or 1099s if you are self-employed.
• Tax records.
• Assets, debts, and holdings in your name.
• Mortgage information.
• Other financial records, such as monthly expenses, past bankruptcies or foreclosures.

Once the lender has this information, they will usually need several days to review your application. Your chances of approval depend on your overall financial standing. Most lenders require a minimum credit score of 620 and a debt-to-income ratio at or below 40%.

If you are approved, the lender will put together the disclosure documents going over the terms and conditions of the loan. Go through the details carefully to make sure you understand what’s included. Ask the lender questions if you need clarification.

The lender will begin underwriting the loan, which may take several weeks or more. They may need to conduct an appraisal of your home to make sure it’s worth as much as it was when you purchased it.

There will be closing costs associated with the loan, including an underwriting fee, origination fee and possibly loan recording fees. These are one-time fees that usually range from 2% to 5% of the principal amount of the loan.

Once the loan is set up, you can start using these funds for your home improvement project.

When to Use a HELOC for Spring Cleaning

Now that you understand how HELOCs work, consider whether this type of loan is right for your situation. A home equity line of credit can be a great way to fund a home improvement project, but these loans are best used for medium to large-scale projects that add to the overall value of your home.

Consider these factors before applying for a HELOC:

How Much Money Do You Need?

Find out how much you need to spend to improve your home this spring. You shouldn’t take out a second mortgage on your home to cover small expenses this spring, such as organizer racks, cleaning supplies and other common goods. Most of these items are relatively inexpensive. HELOCs are better suited towards long-term projects that will increase the asking price of your home, such as renovating the basement, adding a new wing or repairing damaged sections of your home that could hurt your chances of recouping its value.

HELOCs are perfect for paying for items as you go. This may come in handy if the cost of the project varies over time.  If you need a certain amount of money for your project, consider taking out a home equity loan instead. Home equity loans differ from HELOC loans because they are paid in lump sums so that you can pay your contractor upfront. Home equity loans also come with fixed interest rates to help you save money over time.

Your Credit Standing

If you don’t have a lot of equity in your home or your credit score is lower than you’d like it to be, taking out a HELOC may not be in your best interest. You will likely get stuck with a high interest that can make it hard to pay off your original mortgage and get out of debt.

Consider holding off on your dream renovation project until you have more equity in your home and your financial standing improves.

Tax Deductions

The government may reimburse you for home improvement projects that add value to your home. You can also deduct the interest payments on your HELOC if the funds are used to “buy, build or substantially improve the taxpayer’s home.” Research the potential tax incentives of your project to see if you qualify.

Fear of Foreclosure

HELOCs and home equity loans use your home as collateral. That means the lender may repossess your home if you fail to pay back the loan on time. Do not borrow against your home if you are having trouble paying your bills or are living paycheck to paycheck. You shouldn’t have to worry about losing your home if you get into an accident or lose your job.

Keep this information in mind to find the right loan for your next home improvement project.