You’ve diligently made your mortgage payments for years, eagerly checking the principal balance on your monthly statements as it continues to shrink. Bottom line? You’ve built up a significant amount of equity in your home, and you want to use it.
Whether you intend to finance a home improvement, pay down high-interest debt, or put a kid through college, the flexibility of a home equity line of credit makes it a useful tool for homeowners.
Of the multiple ways you can access the equity in your home, a HELOC is unique in that it is a revolving line of credit — much like a credit card. You spend the money as you need it, then pay it back with interest. A HELOC differs from credit cards, though, because your home is used as collateral.
When you apply for a HELOC, your lender will approve you for a certain amount, and you withdraw funds as needed — up to your limit — during a specific time frame, called the draw period.
One of the first steps in leveraging a HELOC is to determine how much to borrow. This guide will walk you through how to decide.
First, do you qualify for a HELOC?
Before you decide how much to borrow, you need to make sure you can qualify for a home equity line of credit in the first place. To determine if you qualify for a HELOC, your lender will consider multiple factors.
Equity in your home. The most important criteria for getting approved for a HELOC is the amount of equity in your home. To figure out your equity, you subtract the amount you still owe on your mortgage from the current market value of your home.
For example, if the value of your home is $300,000 and you owe $200,000 on your mortgage, then you have $100,000 in equity. The more equity you have, the more likely you are to qualify.
Credit requirements. Lenders put a lot of weight on your credit history and credit score when approving you for a HELOC. The better your score, the more likely you are to qualify and the lower your interest rate will be.
Some lenders have a minimum credit score requirement or credit history stipulations — for example, Chase Bank requires a score of 680 in most cases. While you may still be approved for a HELOC with a low credit score or blemishes on your credit report, it will come at a much higher rate.
Your debt-to-income ratio. Another essential factor lenders will weigh is how much of your income will be going towards debt, factoring in the future HELOC. They want to ensure that you’ll be able to handle all of your obligations.
To do this, banks calculate your debt-to-income ratio (DTI), which is the total of all of your debt payments — mortgage, student loans, credit cards, car loans, etc. — divided by your monthly pre-tax income.
For example, if your monthly payments including the expected payment on the HELOC total $2,000 and your gross monthly income is $5,000, then your DTI would be 40% ($2,000 ÷ $5,000).
Many lenders look for a DTI of 43% or less, though some will allow a higher DTI when taking into consideration other factors.
Employment. Lenders want to know you have a sufficient and regular source of income to support your payments and will verify your income during the application process, much like when you first applied for a mortgage.
Exact eligibility guidelines including additional requirements vary by lender, so be sure to check the qualification criteria of your bank.
Home Equity Slider
The amount of equity you have in your home is just one piece of the puzzle when it comes to how much you’ll be able to borrow. Most lenders have limits and stipulations in place that determine just how much of your equity you can access.
So before you begin drafting your kitchen remodel plans, you’ll want to familiarize yourself with your lender’s guidelines.
Banks typically have minimum and maximum amounts for their HELOCs. For example, HELOCs at Wells Fargo range from $25,000 to $500,000.
Additionally, banks will use your loan-to-value ratio (LTV), the percentage of your home value that you owe, to determine the maximum amount to lend you. Your LTV is calculated by dividing the amount you owe on your home by the value of your home.
Many lenders want a loan-to-value ratio of 85% or less, including the HELOC you are looking to take out. This varies by lender, as well as by state and type of property: some lenders cap you at 80%, while others allow a higher LTV of 90% or more.
Using our example earlier, if you owe $200,000 on your mortgage and your home is valued at $300,000, then your current LTV is 67% ($200,000 ÷ $300,000).
To determine the amount of HELOC your lender will allow, you would first calculate the total amount you can owe on your home based on the bank’s maximum LTV, and then subtract your current mortgage from it.
If the lender in our example allows a loan-to-value ratio of 85%, then the maximum amount they will let you owe on your home including the first mortgage and the HELOC is $255,000 ($300,000 x .85).
So if you already owe $200,000 on your mortgage, then the most you could take out in a HELOC is $55,000 ($255,000 – $200,000).
Here’s another example. Let’s take the same $300,000 home but let’s say you owe $250,000 and have $50,000 in equity.
With the lender’s maximum LTV at 85%, the most you can owe on the home is $255,000. Since you already owe $250,000 on your mortgage, the maximum amount you could borrow is $5,000, which may be under the minimum HELOC amount at most lenders.
So it’s important to remember that just because you have some equity in your home, it is not a guarantee that you will be able to borrow against it. Again, be sure you know your lender’s guidelines.
Should I take out the maximum HELOC I qualify for?
The flexibility of a HELOC may tempt you to withdraw the full amount you qualify for, but just because you can take out a large amount of money doesn’t mean you should.
Here’s what to think about when deciding how big of a HELOC to borrow.
During the draw period, some lenders allow interest-only payments, while others require you to pay both principal and interest.
In either case, the amount you borrow along with the interest rate will determine the size of your payments both during the draw period and the repayment period. You’ll need to be sure that your budget can handle the payment in both periods.
Purpose of the funds
“What are you taking the HELOC out for?” asked San Diego-based financial advisor Scott Stevens, who advises clients at California Wealth Transitions. He said the answer to that question plays a significant role in determining the amount you should borrow and whether a HELOC is the best option for you.
If you are funding an expense with a high price, be sure that the amount you are eligible for will cover the cost. On the other hand, if you are looking to borrow just a few thousand dollars to do minor upgrades in your home, Scott advised that other options, like a credit card with a low introductory rate, may be a better way to go.
Impact to your credit score
How much you decide to take out and how much of your HELOC limit you actually use will affect your FICO score. If you max out your HELOC limit, that can hurt your score, but keep in mind that taking out more than you need can be expensive if your lender requires you to make minimum withdrawals.
Out-of-pocket expenses and fees
In most cases, lenders will verify the market value of your home without doing an appraisal. However, the amount you wish to borrow could trigger the need for an appraisal, which would be at your expense, Stevens said. You likely will also pay an annual fee on your HELOC throughout the life of the loan.
One of the long-standing appeals of the HELOC used to be the ability to deduct the interest paid on it during tax season. The tax reform law passed in 2017 has changed that — now, the only part of the HELOC that you can write off is the amount that you use to buy, improve or add on to a primary residence (or potentially a second home), Stevens told MagnifyMoney.
So if you are thinking of borrowing $50,000 with a plan to use $30,000 for home upgrades and $20,000 to pay off credit cards, you will only be able to deduct the interest paid on $30,000, the amount you used to improve your home.
The new law, which is in effect from 2018 through 2026, also places new dollar limits on the combined amount of mortgages that can qualify for the home mortgage interest deduction.
Currently, those amounts are $750,000 or, specifically, $375,000 for married couples filing separately. So if a married couple who files jointly has a mortgage balance of $650,000 and is looking to take out a $200,000 HELOC, only the interest on $100,000 of the HELOC will be tax deductible to stay within the $750,000 limit.
With these tax changes, Stevens said many of his clients are seeking alternatives to borrowing from a home equity line of credit if they plan to use the funds for reasons other than on their homes.
Future home value
No one can guarantee the direction home values will go, but when deciding how much to take out in a HELOC, keep in mind that you are eating into your home’s equity. Depending on how much you borrow, should home values drop significantly in the future you could find yourself owing more than your home is worth.
Having access to more money than you need
“The good thing about a HELOC is it’s revolving credit,” Scott said. “So, just because you open up a $50,000 line doesn’t mean you have to use all $50,000.” With that said, consider whether or not having access to more money than you need may be too much of a temptation for you. If so, you may want to choose an amount close to what you need to spend.
Keep in mind, many lenders will allow you to increase the amount of your HELOC in the future, provided you qualify.
The bottom line
It’s important not to see the equity in your home as free money. While it can be a cheaper way to borrow when compared to other options like personal loans or credit cards, you can potentially put your home in jeopardy should you run into trouble making your payments in the future.
Furthermore, borrowing against the equity of your home means extending the amount of time it will take to pay off your home.
If you do decide to move forward, Stevens stressed the importance of shopping around for the best terms. “Make sure you research a few places,” he said. “If you’re at a big bank, check with a couple credit unions. If you’re at a credit union, check with a couple of big banks.”
Additionally, online lenders may offer some competitive terms. With the multiple options available, spend some time reviewing and comparing lenders. And like with any form of debt, make sure you understand what you are getting into.