Home equity line of credit (HELOC): Requirements, terms, and repayment

How a HELOC works

A HELOC can be a complex financial product. When you apply for one, there are some terms you should understand.

Variable rate

Some HELOCs may have a variable rate that can fluctuate as market interest rates change. When the interest rate on your HELOC changes, your payment will also change.

Variable-rate HELOCs typically have two types of rate cap: the periodic cap limits how much your rate can increase each time it's adjusted, and the lifetime cap sets the maximum rate you'll be charged, even if market rates go higher.

You'll only be charged interest for the loan amount of your HELOC that you draw, not the full balance available to you.

HELOC draw period

Your draw period is a set time frame of usually 5, 7, or 10 years during which you can borrow funds from your HELOC. You'll typically have to make a minimum payment during your draw period if you draw any funds from the line of credit. You may be allowed to make interest-only payments during this period, depending on your lender’s terms and requirements. If you repay any part of your loan balance during your draw period, you will typically be able to draw those funds again if you need them.

HELOC repayment period

Your home equity line of credit repayment period is a set time frame during which you'll have to repay the funds that you borrowed. Your repayment term's length depends on how your HELOC is structured. During this period, your monthly payment will include principal and interest.

Your repayment period starts when your draw period ends unless your lender approves an extension, or you may be able to refinance your existing HELOC into a replacement HELOC with a new draw period.

Paying back a HELOC may involve a balloon payment at the end of the draw or repayment period. The amount will depend in part on how much you borrowed and repaid during your draw period. If you are required to make a balloon payment, you should plan ahead and budget for a payment that may be significantly larger than your minimum payment during your draw or repayment periods. Make sure you understand your lender’s requirements for repayment before you apply for a HELOC.

Conversion option

During your repayment period you may have an option to convert your HELOC into a home equity loan with a fixed rate and fixed monthly payment that includes principal and interest. This option may make sense for you if you want a fixed payment while you're paying back a HELOC.

How to get approved for a HELOC

To qualify for a HELOC, you'll have to meet your lender's guidelines for this type of financing.

While the details vary from lender to lender, examples of typical requirements include:

Typically more than 20% equity in your home

Before you can borrow against your home's equity, you need to have some equity. If you're focused on getting a HELOC, that number should typically be at least 20% of your home's current market value. However, some lenders may let you borrow with less equity available. Your home equity is equal to your home's current value minus any amounts you owe on your existing home loans.

Your equity percentage is your equity divided by your home's value.

Here's an example:

When you apply for a HELOC, your home's current value will be determined by an appraisal. The value may not be the same as your purchase price or property tax assessed value.

Debt-to-income ratio less than 43%

Your debt-to-income ratio (DTI) is your monthly income divided by your monthly minimum payments for your mortgage, car loans, student loans, credit cards and other debt. Your mortgage payment includes your property tax, insurance, homeowner or condo association dues, and any other mortgage-related fees that you pay every month.

The 28/36 Rule is a bit of personal finance wisdom that means you should try to avoid letting your DTI get higher than 36%, with no more than 28% of that debt going towards housing costs or mortgage costs. In many cases, 43% is the highest debt to income ratio that you can have and obtain a mortgage. Calculating your DTI is an important part of how to get a home equity line of credit.

Here's how to calculate your debt-to-income ratio:

Total of Monthly Debt Payments ÷ Gross Monthly Income = DTI

Multiply the number you get from that equation by 100 to make it a percentage. The lower it is, the better, because it means you haven't piled up too many debts. The higher the number, the more precarious your financial situation, because you have less wiggle room for unexpected expenses.

Your monthly income may include your salary, hourly wages, side hustle or gig income, interest, dividends, rent, alimony, or other income that you receive regularly.

If your DTI is too high for you to qualify for a HELOC, you can lower it by paying off some of your debt to lower your monthly minimum debt payments.

A minimum credit score requirement

Your credit score is a three-digit number that is based on your personal financial information such as on-time bill payments, credit utilization, and age of credit accounts. When researching how to get a HELOC, the higher your credit score, the more financially trustworthy lenders typically consider you to be. And in some cases, the higher the score, the lower the interest rate you'll pay on your HELOC. Credit scores are based on many variables including your payment history, total amount owed, length of credit history, types of credit accounts and new credit accounts.

Here's what credit score ranges typically mean:

• Exceptional: 800 to 850
• Very good: 740 to 799
• Good: 670 to 739
• Fair: 580 to 669
• Poor: Under 580

Two ways to potentially improve your credit score are:

• Establish a strong history of making your payments on time
• Lower the percentage of your available credit that you utilize

You shouldn't rush into getting a HELOC, but once you understand how a HELOC works and what the typical guidelines are to get one are, the decision to go ahead and apply may be easy.

Documents for HELOC application

Of course, there will be paperwork. You'll fill out an application that asks for estimated property value, the amount of credit line you're requesting, employment and income information, and information about other debts you have like car loans, student loans, credit cards and any other financial obligations.

Potential examples of the type of documents that may be required for a HELOC application include:

• Pay stubs: Most recent, showing 30-day and year-to-date (YTD) earnings.
• W-2s: Two most recent documents from your employer.
• Tax returns: If you are employed, lenders will want to see the most recent year's tax returns. If you are self-employed or on a pension, they'll want two years' worth of returns including all schedules. Some lenders will accept copies from you, but others may want you to fill out IRS form 4506-T (a request for a transcript of a tax return) so they can get them straight from the IRS.
• Bank and investment statements: If you are relying on Social Security, retirement or pension benefits to pay your HELOC, you'll need bank and investment statements showing the amounts being deposited in your account on a regular basis.
• Mortgage statement: Your lender will need to see how much you owe on your house so they can determine the equity that's in it.
• Proof of homeowners, hazard and flood insurance: This can be a policy or certificate of coverage, declarations page, insurance binder, or payment receipt. If you own a property that's serving as collateral in an area designated as a flood zone by the Federal Emergency Management Agency (FEMA), you'll need proof of flood insurance.

In addition to these examples of documentation, a lender may order a home appraisal and examine the appraisal report along with your mortgage statement to decide the maximum amount you may be eligible to borrow with a HELOC.

Closing thoughts: HELOC requirements

When you have equity available in your home and need to access cash for other expenses, you may have several options for borrowing using your home as collateral for a loan.

A home equity line of credit works best when you can plan for payments that may change due to the variable interest rate, and you want the flexibility to withdraw funds as you need them during your draw period. If you know that you have a large expense coming up and would like the consistency of a fixed monthly payment over a set term, then you may want to consider a home equity loan instead.