What is an equity line of credit

Credit cards are a popular way to have steady access to a line of credit you can borrow from and pay back over time. Though, they aren't the only way to finance an expense — especially if you're going to end up spending tens, or even hundreds, of thousands of dollars on a home remodel, paying off debt or even buying a second house. But if you own a house that you've been making mortgage payments toward, you just might be sitting on funding for that renovation or second property, and it's called a home equity line of credit.

A home equity line of credit (or HELOC for short) is a form of credit that you can use for large expenses—like a home renovation. The credit is secured by your home, which means if you fail to make payments toward the credit balance, the lender can use your home as collateral. While putting your home on the line can be a daunting decision, this form of credit comes with some benefits that other types of credit don't.

Below, Select explains how a home equity line of credit works, how to qualify for one and how it can actually be an advantageous way to fund large expenses.

How does a HELOC work and how do you qualify?

A home equity line of credit is a form of revolving credit — much like a credit card. When using a credit card, you have a credit limit and you can spend your credit up to that specified amount. As you make monthly payments toward the balance you spent, your available credit is replenished. A HELOC works in the same fashion. The main difference, though, is that you're borrowing against the equity in your home to establish that line of credit.

Because of this, in order to qualify for a home equity line of credit you'll need to own a home and have available equity in it. Keep in mind that the amount you owe on the home would have to be less than the market value of the home. Lenders will also look at your debt-to-income ratio, your credit score and whether or not you have a history of paying your bills on time.

There are also two main moving parts when it comes to a home equity line of credit: the draw period and the repayment period. During the draw period, you can borrow money up to the specified limit, pay it back and borrow again and again until the draw period ends. The draw period typically lasts between five and 10 years.

During this period, only interest on what you borrow is due, but the interest can be charged as a monthly amount that will vary depending on your withdrawal limit and how long the credit terms last. Also keep in mind that the interest can be variable or fixed. Once the draw period ends, you can't borrow any more money.

The repayment period begins once the draw period is over. It typically lasts 10 to 20 years and during this time, you'll make monthly principal and interest payments on your remaining balance.

How much credit can you qualify for?

When it comes to a home equity line of credit, the amount of cash you qualify for will depend on how much equity you have in your home. Most lenders will allow you to access up to 80% of the equity you have in your home. And although you may have access to this much, you don't necessarily need to spend it all.

Let's say you've been making payments on a $500,000 home but still owe $200,000 on it, meaning you have $300,000 in equity. You'd qualify for up to 80% of $300,000 — so you could potentially receive $240,000 from your lender.

Do you pay interest on a HELOC?

You will be responsible for making interest payments on the amount you borrow. The interest rates will vary from lender to lender but on average, but the current average rate for a HELOC is 4.1%, according to Bankrate.

And, the interest rate you pay can also depend on your credit score. According to Experian, lenders usually like to see a credit score of at least 680 to qualify for a HELOC. But the higher your credit score, the more likely you'll be to get a lower interest rate for your line of credit. Remember that the higher the interest rate, the more you'll ultimately spend when taking out cash against your home.

Before you apply for a HELOC, check your credit score to see if you're likely to qualify. If your score isn't where it needs to be for a line of credit, you'll want to make the necessary improvements to increase your score (and, thus, the likelihood of getting more favorable terms) before a lender runs a credit check.

You can check your FICO score, the most commonly used credit score, through Experian for free. And, the platform will actually analyze your credit history to make recommendations for actions you can take that'll actually improve your score.

How can a HELOC help you?

Compared to other forms of credit, a HELOC may come with some extra guidelines but it can still be an advantageous way to get cash to pay off other debt, support your family if you're laid off or have a reduction in income or pay for a big renovation or repair.

For starters, using a home equity line of credit gives you access to a larger amount of money since the amount available to you depends on the equity you have in your home.

Credit cards can help you fund smaller, less costly projects but you aren't likely to have a large credit limit available to you. And, the interest rate on a credit card is often four times more than the interest rate on a HELOC. But if you think a credit card most closely suits your needs, you can still save on some interest payments by using a credit card with an interest-free introductory offer — like the Citi Simplicity® Card, which lets you make purchases at 0% interest for the first 12 months from date of account opening (after, 16.99% - 27.74% variable APR).

Additionally, while a personal loan can give you access to more money compared to a credit card, most lenders will only approve you for up to $100,000. If you believe you'll need more money, you might explore your options through a HELOC.

And unlike the interest charges on a personal loan, the interest paid on a HELOC is tax deductible if the money is used to cover a home-related expense.

If you took out your mortgage before December 15, 2017, you can deduct up to $1 million in interest when filing your taxes. If you took out a mortgage after that date, you can deduct up to $750,000 if you are single or married filing a joint tax return, or $350,000 if you are married and filing separately. Just keep in mind that this only applies if you use the HELOC to pay for home-related expenses, like a remodel or major repair.

Bottom line

If you have a home and have been diligently making your monthly payments over the years, you may have built up enough equity in it to qualify for a home equity line of credit.

While there are some attractive advantages to financing expenses through a HELOC — like larger sums of money at lower interest rates, and tax-deductible interest for spending on home-related costs — this option may not be for everyone. Keep in mind that your home will have to be used as collateral for a HELOC, so if you fail to make your payments, the bank could possibly seize your home.

Always analyze your personal circumstances and talk to a financial adviser or tax expert before you decide to apply for a home equity line of credit. If you find that you haven't yet built up the equity needed to apply for a HELOC, there are other financial tools out there, like personal loans, that can help you get the money you need to finance your goals.

Read more

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.

What are the disadvantages of a home equity line of credit?

What is the difference between an equity loan and a line of credit?

What is an equity line of credit used for?

Is an equity line a good idea?