What is a HELOC?
A Home Equity Line of Credit (HELOC) is a secured loan, where the borrowing capacity is set based on a percentage of the borrower’s home equity.
The lender provides the borrower of the loan with the option to draw funds from the HELOC on a need basis, akin to a consumer credit card or corporate revolving credit facility (i.e. “revolver”).
How Does an HELOC Work?
HELOC stands for “Home Equity Line of Credit” and refers to an open credit line secured by the borrower’s home equity.
The home equity line of credit (HELOC) is a form of secured debt, as the home’s equity collateralizes the security.
Since collateral backs the loan, an HELOC is perceived as a less riskier form of debt financing from the perspective of the lender.
The mechanics of an HELOC loan, stated in simple terms, are borrowing against home equity.
- Home Fair Market Value (FMV) → The fair market value (FMV) of a home is the price at which the property can be sold on the present date.
- Mortgage Balance → The mortgage balance refers to the outstanding amount of funds borrowed from the line of credit (and still owed to the lender). If the borrower has not drawn from the credit line, the balance is zero.
What are the Characteristics of HELOC Loans?
A home equity line of credit (HELOC) is borrowing against the equity of a home. Therefore, the credit limit – i.e. the size of the credit line extended to the borrower – is determined as a predefined percentage of the home equity.
In the event of default, where the borrower misses a scheduled payment on the loan or is unable to repay the principal in full at maturity, the lender possesses the right to seize the property pledged as collateral.
Unique to HELOCs, the principal paydown replenishes the available credit to draw from, assuming the credit line is currently active.
In contrast, the amortization – i.e. the repayment of the principal – on other types of debt securities is retained by the lender.
Unlike traditional debt securities, such as consumer loans or corporate bonds, a home equity line of credit (HELOC) offers the borrower the option to draw funds as needed.
- HELOC Lender → Once the loan agreement is signed by both parties to formally commit to the financing arrangement, the HELOC lender is contractually obligated to provide funds to the borrower if requested. But until the borrower decides to draw from the line of credit, the funds remain in the lender’s possession.
- HELOC Borrower → The borrower, on the other hand, must meet periodic interest payments on the outstanding debt balance across the loan term. The outstanding balance of the HELOC at maturity must also be zero, i.e. the borrower repaid any borrowed funds in full. If the remaining balance of the HELOC loan is not zero, the borrower is at risk of property foreclosure.
What is the HELOC Interest Rate Structure?
The interest owed on a home equity line of credit by the borrower depends on the credit limit set by the lender, which is the maximum amount that can be borrowed.
The credit limit is often based on a percentage of the home’s appraised fair value, minus the amount owed on the existing mortgage.
However, interest is only paid on the outstanding balance of the HELOC, rather than the total credit extended to the borrower by the lender. Thus, the interest paid is based on the drawn amount, instead of the size of the credit line, inclusive of the undrawn amount.
The standard interest rate pricing structure on HELOC loans is a variable interest rate, otherwise known as a “floating” interest rate.
The interest payments on the borrowing fluctuate based on changes in the credit markets and economic conditions, which are unpredictable variables that can favor either the lender or borrower.
The relationship between the prime rate (i.e. the benchmark interest rate) and the interest payments are as follows.
- Rising Prime Rate → If the prime rate increases, interest costs rise in tandem.
- Falling Prime Rate → If the prime rate decreases, interest costs decline.
What is the HELOC Draw Period?
The home equity line of credit (HELOC) amortization schedule consists of two stages: 1) the draw period and 2) the repayment period.
- Draw Period (Interest-Only) → The first stage, the draw period, is the initial phase of a HELOC in which the borrower can draw from the revolving line of credit up to the maximum limit. In most cases, the draw period lasts between five and ten years, and the borrower is only required to pay interest on the amount borrowed.
- Repayment Period (Interest + Principal) → The second stage, the repayment period, follows the draw period. The borrower is no longer able to draw from the credit line, and there are mandatory principal repayments charged to the borrower, as well as payments related to accrued interest if applicable to the financing scenario. The repayment period usually ranges between 10 and 20 years.
Combined, the draw period and repayment period last around 25 to 30 years on average.
What are the HELOC Qualification Requirements?
Upon submission of the initial application process and receipt of approval of a home equity line (HELOC) from a lender, the lender must perform further diligence on various risk factors to determine the terms of the requested financing.
First and foremost, one of the requirements to obtain a HELOC is that the current market value of the home equity must exceed the outstanding balance on the existing mortgage on the home.
The common factors considered for approval of HELOC financing and the determinants of the lending terms, such as the interest rate, are the following:
- Home Equity (Current Market Value of Home Exceeds Mortgage Balance)
- Minimum Equity Stake Requirement in Home (15% to 20%)
- Strong Credit Score (Minimum 620+ while Preferred 700+)
- Sub-40% Debt-to-Income Ratio (DTI)
- Proof of Income (Employment Documentation)
- Evidence of Stable Income (Paystubs, Tax Returns)
- Property Insurance
The credit score requirements are specific to the lender, as some can be more lenient because of the home equity collateral, while others are more risk-averse.
HELOC Loan: What are the Advantages and Disadvantages?
Benefits of Home Equity Line of Credit (HELOC)
- Lower Interest Rate → Compared to traditional consumer credit cards and personal consumer loans, the interest rate pricing of a home equity line of credit (HELOC) tends to be lower. The relatively low interest rate pricing is due to the collateralization of the loan, since the home equity is pledged as collateral to obtain the line of credit.
- Flexibility → The undrawn portion of a HELOC loan represents a “source” of financing, rather than outstanding debt that must be repaid. Therefore, the decision to draw funds from the line of credit is at the discretion of the borrower, not the lender. An urgent need for financing can occur at random, so securing a line of credit to pull funds from can act like a “safety net” in anticipation of an unexpected event.
- Capital Source → The HELOC can be a convenient capital source to finance property improvements and home renovations, or debt consolidation in certain cases, i.e. renegotiate the terms of outstanding debt tranches to simplify and combine them into a single debt tranche with more favorable terms.
- Interest Expense → The borrower only pays interest on the outstanding portion of the loan, as opposed to the entire credit line, inclusive of the unused funds available to the borrower.
- Tax Deductible Interest → The interest paid on a HELOC is tax-deductible per the IRS if certain conditions are met, namely the home must be pledged as collateral to protect the interests of the lender. The borrowed funds must be utilized to renovate and improve the value of the home, i.e. the underlying collateral that secures the home. However, the tax policies around HELOCs are a complex topic and beyond the scope of the post (and subject to change), so it is recommended to speak with a certified accountant or tax advisor.
Drawbacks of Home Equity Line of Credit (HELOC)
- Default Risk → Like all forms of debt financing with an interest schedule and mandatory return of principal at maturity, there is the inherent risk that the borrower might default on the loan from unexpected circumstances.
- Property Foreclosure → The borrower of a HELOC formally agreed to pledge home equity as collateral to receive the line of credit. Therefore, the most probable outcome in the event of default (i.e. unable to repay the loan) is property foreclosure.
- Lump Sum Payment (“Balloon”) → Most HELOCs are structured in two parts, i.e. the draw period and repayment period. The latter phase, which comprises a lump sum payment of the HELOC principal after the draw period, is where most defaults occur from unexpected financial circumstances or drastic changes in economic conditions.
- Variable Interest Rate: Most HELOCs are priced using a variable interest rate structure, which means the interest cost can increase if the prime rate rises.
- Fees and Closing Costs: Obtaining a HELOC loan comes with various fees, including the origination fee (i.e. processing of the application fee), appraisal fees, annual lender fees, and closing costs, which are costs that a borrower must consider, as such costs add to the total financing cost.
The formula to estimate the maximum credit line that a borrower could obtain as part of a home equity line of credit (HELOC) financing is as follows.
- Maximum Loan-to-Value Ratio (LTV) → The maximum loan-to-value ratio (LTV) is the percentage of a home’s appraised fair value that a lender is willing to lend. The standard maximum LTV ratio set among lenders is 85% of the fair value of the home, but other factors to evaluate the creditworthiness of a borrower are embedded into the ratio.
- Appraised Fair Value of Home → The appraised value of a home is the fair market value (FMV) of the property, which is estimated by an independent appraiser. Common factors that can impact a fair value are the location of the home, the state of the home (i.e. damage), etc.
- Outstanding Mortgage Balance → The outstanding mortgage balance is the remaining amount still owed on a mortgage used to finance the purchase of the home.
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Home Value and Loan to Value Ratio (LTV) Assumptions
Suppose a lender is estimating the maximum line of credit (LOC) that could be extended to a potential borrower as part of the HELOC underwriting process.
The appraised fair value of the borrower’s home is $600k, and the lender’s maximum loan to value ratio (LTV) is 85%.
- Appraised Fair Value of Home = $600k
- Maximum Loan to Value Ratio (LTV) = 85.0%
The unadjusted maximum line of credit (LOC) is $510k, which was determined by multiplying the home’s appraised value by the maximum LTV ratio.
- Unadjusted Maximum Line of Credit = $600k × 85% = $510k
2. HELOC Maximum Line of Credit Qualification Calculation Example
In the next step, the $510k credit limit must be adjusted by deducting the outstanding mortgage balance, which we’ll assume is currently $250k.
- Outstanding Mortgage Balance = $250k
In conclusion, the maximum line of credit that the lender can provide is implied to be $260k. The actual credit limit, however, can be lower based on other risk factors, which is at the discretion of the lender.
- Maximum Line of Credit, HELOC = $510k – $250k = $260k