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What is a HELOC?

Kelly Frazee,  Sr. Mortgage Advisor

February 28, 2020 — 7 min read

There comes a day in every homeowner's life when you want to undertake a home improvement project that exceeds your bank account. Whether it involves hiring a contractor to build your dream kitchen or you just need a new roof doesn't matter. What's important is the specific loan product you select; specifically, should you go for a home equity loan, or a HELOC? Many people's first instinct is to apply for a home equity loan. A home equity loan is a second mortgage on your home. If you qualify, the lender provides the total amount in one lump sum check or direct deposit. After that, you'll have two monthly mortgage payments on the home for 10-15 years on average. But savvy borrowers are opting for HELOCs. These home equity line of credit products are different from traditional home equity loans. If you qualify for a HELOC, the lender provides you with a line of credit which can even include a debit card to cover the cost of renovations or repairs. Rather than pay monthly amounts and interest on the total amount borrowed, you pay only on the actual funds used to date. That makes it more similar to a credit card and a far more practical way to borrow.

Important HELOC Details

Although HELOCs are quite simple in terms of accessing funds and paying on only what you withdraw, there are a number of differences between them and traditional home equity loans. These are essential items to consider.
  • Fluctuating Rates: It is not uncommon for some lenders to offer low introductory rates that may increase quite a bit. Pay close attention to HELOCs with varying rates and know their potential uptick.
  • Period Terms: Some HELOC products allow you to withdraw funds for a set amount of time. Once that deadline is reached, lenders generally expect repayment going forward. The line of credit often has a set time limit for repayment in full.
  • Balloon Payments: There are products that offer repayment with interest for up to 10 years. Once that time has expired, a final balloon payment comes due. This can cause borrowers to refinance.
But the burning question most people want to know is: how much can you borrow?

Borrowing Limits

The majority of HELOC products use a formula to arrive at the highest amount someone can borrow. A typical amount runs upwards of 80 percent of the home's appraised value, after deducting your existing mortgage. In rare cases, lenders may be willing to offer 100 percent or even 125 percent of the appraised value*. This can be a risky option that could result in borrowers owing more than the home is actually worth. For homeowners interested in making upgrades or repairs, the HELOC offers solid benefits. Lenders have a variety of products with differing rates, fees, and payment options. It may be worth shopping around to select the best HELOC for your goals and finances.

The HELOC Process

Now that you understand the basics of a HELOC, the next step is to go through the detailed application process. Although the procedure varies between lenders**, the following HELOC step-by-step guideline generally applies.

1. Review Your Credit Records

Take a moment to check on your current credit records and score. You can check your credit records for free. In most cases, lenders prefer applicants with a minimum credit score of 620 or higher. In some cases, HELOCs may be available for homeowners with scores in the 500s. You should try to tidy up loose credit ends to improve your score before you apply.

2. Calculate Your DTI Ratio

Credit scores are one factor that lenders look at, but debt-to-income ratios are also important. A debt-to-income (DTI) ratio is the sum of your monthly debts divided by the sum of your monthly income. Even if your credit score isn't impressive, having a low DTI ratio can help. In general, a DTI below 45% (including the proposed HELOC payment) is optimal. Add up your total annual income and divide that number by 12. Next, add up your monthly debts and divide that number by your monthly income. This is how you calculate your DTI. If your DTI is higher than 45% you should consider making changes to your debt load before you apply for the HELOC.

3. The Physical HELOC Application

Living in the technology age has undoubtedly changed the way everyday people apply for loans and lines of credit. You can still walk into a brick-and-mortar bank and sit down with a Mortgage Advisor. Other options include filling out the HELOC application online or via telephone and then submitting the necessary supporting documents electronically. Applicants can expect to submit documents that include the following:
  • Employment Records
  • Existing Debt Documents
  • Permission for a Credit Report to be Pulled
  • Income Information
  • Mortgage Balance and Monthly Payment
  • Property Tax and Insurance Expenses
With these items in place, a potential borrower requests a HELOC amount. The Mortgage Advisor follows up on issues such as income verification and may request additional documents. These may include W-2s, pay stubs, tax returns, award letters, or other documents.

4. Patiently Wait for a Decision

The most challenging part of the HELOC process may be waiting to find out if you are approved and for how much. Fortunately, most applications are processed within a few business days, so you shouldn't have to wait too long. Borrowers generally receive a HELOC approval from the lender that recaps credit history, DTI ratio, and an estimated market value of your property. Once you get a green light, a professional appraisal of the home is the next step.

5. Home Appraisal

It's important to understand that the lender's willingness to offer you a HELOC is also dependent upon the actual value of the property. Usually, this involves paying for an impartial home appraisal to determine the current value. The appraiser typically makes an appointment to do a walk-thru of the home. The appraiser will also do a cursory inspection of the home's exterior. The appraiser's final number may negatively or positively impact the size of the HELOC. Additionally, the appraisal may be subject to necessary restorations and repairs which affect the home's value.

6. Final HELOC Considerations

Once the review process is complete, the lender sets a closing date to sign off on the home equity line of credit documents. For a loan on a primary residence, borrowers have three business days to review the agreement and can generally back out with no obligation. On the fourth day, it's time to celebrate because your HELOC should be ready to access.

Do you have questions about how a HELOC might work for you?

Fill out the form below or contact us today!

*The interest on the portion of credit extension that is greater than the fair market value of the dwelling is not tax-deductible for Federal Income Tax purposes. Consumers should consult a tax adviser for further information regarding the deductibility of interest and charges
**This product is offered via a lender partner/broker channel. Subject to the terms and conditions of that lender, not Pacific Residential Mortgage, LLC. Not all applicants will qualify. This is not a commitment to lend, terms and conditions can change without notice.
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