A home equity line of credit, also known as a HELOC, is a mortgage that allows a homeowner to access the equity in their home via a credit line. Think of a HELOC like a credit card that is attached to a home’s equity; the loan balance can be repeatedly charged up and then paid off on a monthly basis.
A HELOC is typically a second lien mortgage, has a variable interest rate, a variable loan balance, and a variable monthly payment. Each month the mortgage payment is based off the balance owed and the interest rate at that time.
Home Equity Line of Credit (HELOC) Overview
A HELOC allows a homeowner to take out cash on their home via “draws” for a certain period of the loan’s life. There are many types of refinances and a home equity line of credit is great way to get cash out of a home.
HELOCs are often second liens. This means that there is a primary mortgage on a home and the HELOC “sits” behind the existing loan.
Most states allow a HELOC to used to purchase a home (but not Texas).
The primary features of a home equity line of credit are:
- ability to increase or decrease a loan amount,
- interest-only payments for first 10 years,
- variable interest rates,
- low closing costs.
HELOCs offer tremendous flexibility; however, they may not be right for everyone. This article will first cover the feature of a home equity line, then address the pros and cons of a HELOC, and finally, provide a detailed example.
This is portion is a shameless plug. We can close a non-Texas HELOC within a few days because our fully automated online process. By comparison, other lenders will require the normal mortgage loan process which can take 30 to 90 days to close.
Our fully automated process is both a benefit and a drawback. The obvious benefit is that a homeowner can access their equity quickly. There is no human involvement in the approval process; however, that is also the downfall. The Mortgage Mark Team can not overturn any issues relating to property value, credit evaluation, or erroneous information.
Nonetheless, our HELOCs allow fast cash for any homeowner (and home) that fits “inside the box.” Here’s how to apply online and close quickly: HELOC application.
At this time, the Mortgage Mark Team does not offer home equity lines of credit in Texas due to the unique cash out laws that are only applicable to Texas. We can, however, recommend a few bankers that do a great job for clients.
For that reason, the last segment of this article outlines the unique features specific to Texas HELOCs. Please also visit Texas home equity cash out loans for additional information about Texas equity laws.
How HELOCs Work
To understand home equity lines of credit, it’s important to understand three things:
- credit lines,
- interest only payments,
- the prime interest rate
Line of Credit & Draw Period
Home equity lines of credit are generally 20–year mortgages. What makes HELOCs unique is that they “feel” like two different loans. The credit line feature is open for the first 10 years of the loan’s life, but then closed for second 10 years.
HELOCs have a line-of-credit feature for the first 10 years of the mortgage. This means the loan balance can change month to month. It can go up or down based on what the homeowner chooses to draw.
The amount of the existing loan balance determines the monthly mortgage payments. Each month the payment is based on the current amount borrowed. As a result, the monthly mortgage payments may change each month. (More on this later.)
Example: Line of Credit
For this example, let’s assume Joe Homeowner has home equity line of credit with a $100,000 credit line. Joe’s current loan balance is $30,000. This means Joe has access to $70,000 of cash should he want it.
Next month Joe chooses to draw another $10,000 of cash out from the home. The loan balance then increases to $40,000, and Joe gets $10,000 cash put in his bank account.
The following month Joe gets a $30,000 bonus from work. Joe decides to use that money and pay down the mortgage balance. The new balance is then $10,000 ($40,000 current balance minus the $30,000 bonus).
After the initial 10-year draw period the credit line will “close”. On year 11, the loan balance will become fixed and the line is no longer available.
The loan balance owed at the start of year 11 determines the fixed monthly payments for the remaining ten years. The monthly payments will become fully amortized (i.e. principal and interest payments) from year 11 through 20.
The monthly mortgage payment of a home equity line of credit can change each month for the first 10 years of the loan. Payments are interest only for the first 10 years. The loan balance and interest rate determine the payment each month.
The monthly payments of a HELOC are interest only payments for the first 10 years of the loan. Afterwards, the monthly payments become fully amortized (i.e. principal and interest payments) for the remaining 10 years.
Interest-only payments are lower than “normal” fully-amortized payments. The reason why interest-only payments are lower than amortized payments is because only interest is being paid on the loan (i.e. zero principal is being applied to the loan).
Here’s how to calculate the monthly payment of an interest-only loan:
- take the current loan balance,
- multiply the loan balance by the current interest rate,
- and then divide that amount by 12 months.
Example: Interest Only
A $20,000 loan amount with a 6% interest rate has a monthly interest only payment of $100 per month. ($20,000 multiplied by .06 and then divided by 12).
The $100 monthly payment covers only the interest on the loan. This means the loan balance the next month is still the same $20,000.
In the example above, the monthly payment needs be higher than the minimum amount required in order to pay down the principal balance of the interest only loan.
Had the payment been $600 the loan balance would then change to $19,500. The first $100 covered the interest owed and the next $500 paid down the loan’s balance from $20,000 to $19,500.
HELOC’s Interest Rate
A home equity line of credit has a variable interest rate. This means the interest rate (and payments) can change over time. The HELOC’s interest rate is the sum of two things: the prime interest rate and the bank’s margin.
The Prime Interest Rate
A HELOC’s interest rate is determined by the “prime rate”. The Federal Reserve (i.e. the Fed) indirectly sets the prime interest rate via the fed funds rate. The Wall Street Journal (WSJ) publishes the prime rate monthly.
The Federal Reserve controls the “fed funds rate”. This the interest rate that grabs the attention of the media headlines. When the Fed “raises interest rates” they are increasing the fed funds rate.
The prime rate is typically 3% above the fed funds rate. For example, when the fed funds rate is 3.5%, the prime rate is 6.5% (3.5% plus 3%). Here’s a historical chart of the prime rate since 1991.
This means a HELOC’s interest rate will change whenever the Fed changes their interest rate.
As stated above, a HELOC’s rate is sum of the prime interest rate plus the bank’s margin. The margin is the bank’s profit.
The bank’s margin typically ranges from .5% to 2.0% for a homeowner with good credit. The borrower’s credit score and the loan to value influence the margin.
Example: HELOC’s Rate
Joe Homeowner has a home equity line of credit where the interest rate is prime plus 2%. The 2% is the bank’s margin.
Let’s assume the fed funds rate is 3.5%. This makes the prime interest rate 6.5%. Remember, prime is 3% higher than the fed funds rate.
In sum, Joe’s HELOC rate is 8.5% (as a result of the 3.5% fed funds rate + 3% to get prime + 2% bank’s margin).
Lender’s limit the amount of leverage (i.e. debt) that is allowed to be placed on a home; this limit is determined by the loan-to-value ratio.
The loan-to-value (LTV) ratio is a result of dividing the loan’s balance by the home’s value. A combined LTV (i.e. CLTV) exists when there are two mortgages on a home.
For example, a mortgage that has a $65,000 loan balance on a $100,000 home has an LTV of 65%. When a $15,000 HELOC second mortgage exists on that home, the CLTV is 80%. ($65,000 plus $15,000 totals $80,000; then divide that by the $100,000 value).
In addition to lenders setting the LTV limits, the great state of Texas has a law that limits the CLTV to 80% for home equity loans; other states can go to 90% or 95% CLTV.
Other Need-to-Know Info
There are two other features of HELOCs that are covering. The first relates to HELOCs only offered by Amegy Bank. The second relates to all non-purchase, second lien HELOCs.
A lesser known feature: fix a portion of the balance
As stated above, a HELOC’s available credit line is open for the first 10 years of the loan’s life. This means the balance, payment, and interest rate can change over time…. unless the HELOC is from Amegy Bank.
Amegy Bank, unlike most lenders, will allow a portion (or all) of the loan balance to become fixed at the current interest rate. Doing this would “lock in” the interest rate on that particular portion of the balance.
The homeowner chooses the amount that is to become fixed. That selected portion of the credit line will then become “closed”. The monthly mortgage payments for that portion of the loan are then fully amortized (i.e. no longer interest only).
The fixed portion of the loan can later be “unlocked” and return to the normal line-of-credit terms. There are zero costs associated with this feature.
This feature allows the best of both worlds: a fixed rate on a determined portion of the loan while having credit line on the remaining balance.
Not every bank offers this feature but it’s really cool so ask around. We really like Michelle Kubitz of Amegy Bank. Feel free to reach out to her (at Michelle.Kubitz@AmegyBank.com or 303-887-1197) with any questions about this product.
The Mortgage Mark Team is not associated with Amegy Bank. We do not get any incentives or compensation for this promotion. We just think this is a cool HELOC feature. Feel free to email us any other bank that offers a similar feature and we’ll be happy to promote that bank as well.
Cash Out Interest: No Longer Tax Deductible
President Trump signed the Tax Cut and Job Act on December 14, 2017. That law removed the tax deductible interest benefit on equity loans (for both new and existing equity loans).
In 2026 the law will revert back to the prior limits which allowed interest tax deductions on equity loans up to $100,000.
Closing Costs for HELOC
HELOC closing costs are relatively inexpensive; at least when compared to the closing costs of a “normal” home loan. There are potentially three sets of cost for a HELOC:
- lender fees ($0 to $500)
- appraisal fee ($600 if required)
- title policy (if required)
It is possible to close a home equity line of credit and not incur any fees.
Bank Fees (if required)
Firstly, the lender fees for a home equity line of credit typical costs range from $0 (free) to $500. It’s common for lender’s to not have any fees for HELOCs.
Appraisal Fee (if required)
Secondly, a HELOC lender doesn’t always require an appraisal. Lenders may use an alternative valuation method if the loan’s profile is strong enough.
For example, a loan for a homeowner with great credit, good income, low debt, and a low CLTV may not need an appraisal.
Lenders may use the local CAD (Central Appraisal District) home’s valuation in lieu of an appraisal. The CAD values are often conservative and lower than the home’s current market value.
An appraisal fee is approximately $600 in the event one is required.
Title Policy Fees (if required)
Thirdly, a home equity line of credit mortgage may not require a title policy. Many lenders do not require a title policy unless the loan amount exceeds a particular threshold.
Often times the threshold can be $75,000; however, it’s more common to see the limit be $250,000. In other words, a lender may not require a title policy for a $100,000 HELOC if their threshold is $250,000.
The cost of the title policy varies by state. We like using this title policy calculator from Old Republic Title to estimate the title policy cost.
HELOC Pros & Cons
There are three ways to get cash out of a home. A homeowner can do a:
- “normal” cash out home equity refinance loan,
- fixed-rate second lien cash out, or
In both cases we are assuming that the homeowner has a great first-lien mortgage already in place. In other words, we’re assuming the existing mortgage is so good that refinancing it and getting cash out during that process doesn’t make financial sense.
Cash Out Home Equity Refinance
Doing a “normal” cash out home equity refinance makes sense in these scenarios:
- when the existing first lien has a relatively higher rate,
- when the desired cash out amount is substantial, or
- when a future second lien may be needed.
Fixed-Rate Second Liens
Many banks offer a second lien equity mortgage with a fixed interest rate. These fixed rate second mortgages are great for longer term cash out solutions.
Fixed-rate second mortgages are often done in lieu of HELOC loans because they offer predictable monthly payments. The stable payments allows the homeowner to accurately budget future cash flow.
Fixed-rate mortgages have fully amortized monthly payments. This means the payment includes principal and interest.
Banks typically amortized these fixed-rate second liens for 5 years, 10 years, 15 years, or 20 years. Because of this, the monthly payments are higher than the interest only payments of a HELOC.
The fixed-rate second lien loan balances don’t increase because they are “closed end” loans. This means they are not lines of credit (unlike HELOCs). The loan amount decreases every month when the payment is paid to the lender.
Who may need a HELOC
A home equity line of credit is great for homeowners that:
- wants access to cash for a “safety net”,
- need cash temporarily, or
- wants small cash out loan.
For example, we certainly don’t want to refinance a 3.75% fixed rate loan since there isn’t a financial benefit if current rates are at 5%. Conversely, a homeowner with a 5.5% rate on their first mortgage may do a “normal” cash out refinance loan to lower the overall interest costs. In that case, the Mortgage Mark team can help so call us.
A HELOC is a great tool for short-term money and can be a great “rainy day” fund. Because payments are based off the amount owed someone can open a line, leave the balance at zero, and not have any payments. They then have the peace of mind knowing that they have funds accessible should they need them in the future.
A home equity line is often utilized by anyone that may need quick access to large sums of money. A HELOC may be used by:
- self-employed business owners,
- employees that are 100% commissioned or receive large bonuses,
- and real estate investors.
The aforementioned individuals will often use the HELOC as a financial tool to either capitalize on an opportunity or to have access to funds should cash flow lessens for a period of time.
Another key point of a HELOC is that the loan balance can vary based on the homeowner’s needs. If you don’t need the cash then keep the balance at zero; doing so would mean you don’t have a mortgage payment. If you need $10,000 then write yourself a check for $10,000 using the HELOC. The next month your payment will then be based off a $10k balance.
This means that the payment can be change every month if the loan balance changes.
As stated above, a home equity line of credit allows interest only payments for the first 10 years of the mortgage. With interest-only mortgages the loan balance can stay the same each month if the homeowner chooses not to pay principal towards the loan.
Who shouldn’t get a HELOC
The biggest downfall to home equity lines is that the interest rate is variable. As a result, a HELOC may not be a long-term cash out solution for a homeowner that needs a predicable monthly payment.
Homeowners that need cash for the long-term are not great candidates for a HELOC. It becomes difficult to budget and plan for the long-term financial goals when the amount of interest to be paid can only be estimated.
We typically don’t recommend a HELOC without having a plan (or the ability) to pay off the debt within a few years. The variable interest rate makes it difficult to budget for the future. It often makes more sense to do a fixed-rate second lien equity loan or a “normal” cash out refinance with a fixed interest rate when the money is needed for the foreseeable future.
Home Equity Line of Credit in Texas
This article is for Texas homeowners. Texas law places restrictions on home equity loans while other states have more liberal guidelines.
Unlike other states, Texas does not allow a home to purchased using a home equity line of credit. A Texas HELOC can only be done as a refinance loan.
Texas HELOC Characteristics
A HELOC mortgage is classified as a Texas home equity A6 cash out loan. Texas law has specific requirements for A6 home loans.
Firstly, the combined loan to value (CLTV) cannot exceed 80%. This means that all mortgages on the property must not total greater than 80% of the home’s value. Each lender will have a method to determine the home’s value.
Secondly, a Texas A6 mortgage cannot be refinanced again until 12 months have passed from closing and funding. This does not prevent the homeowner from paying off the loan or selling the home. There are no prepayment penalties for paying off or closing the HELOC early. The law simply wants to protect Texas homeowners from becoming refi junkies.
Thirdly, a HELOC can’t close before 12 business days have passed from the date a homeowner signs the Texas A6 12-day letter. This typically isn’t an issue since most lending institutions won’t close a loan that fast anyways. In reality, it’s common for banks to take 30 to 90 days to close a Texas HELOC.
Fourthly, HELOCs are for owner occupied homes only. We have yet to find a bank that will offer a HELOC on a vacation home or investment property. Please let us know if you know of a bank that offers these.
Fifthly, most banks will have minimum credit line limit of $10,000 and a maximum credit line of $250,000 or $500,000, depending on the bank.
Finally, the maximum LTV for a HELOC in first lien position is 50%. The LTV cap of 50% is applicable when a free and clear home (i.e. a home with no mortgage) is refinanced with a home equity line of credit.
Big Example Scenario
Joe Homeowner owns a $500,000 home and has a $300,000 mortgage. His fixed 30 year interest rate is 3.75%. Joe wants to get a little cash out of his home.
Texas law limits Joe to 80% combined loan to value. This means Joe can have a total of $400,000 in mortgages ($500,000 x 80%). Since Joe already owes $300,000 on his first mortgage this means he can get as much as $100,000 in cash out ($400,000 – $300,000)
Joe gets a $100k HELOC. After Joe opens the equity line he doesn’t pull anything from the line and leaves the balance at zero. Because the payments are based on the balance Joe won’t have a payment due until he draws money out of the home.
Draws change the loan balance
Now let’s assume months go by and Joe finally pulls out $50,000 when the interest rate is still at 4.5%. The monthly payments will now be $187.50 until the balance or interest rate changes. (Calculation of the interest only payment: $50,000 loan x .045 interest rate / 12 months = $187.50 per month).
Remember, the balance won’t change from $50,000 unless Joe decides to pay more than the $187.50 per month. Interest only payments means that nothing is going towards principal unless additional money is paid.
Interest rate changes
Now let’s say that the $50k balance remains constant for five more month and then the Fed increases rates by .5%. This makes the HELOC’s rate 5% (existing 4.5% + .5% rate increase). Joe’s payments are now $208.33 per month ($50,000 balance x .05 interest rate / 12 months).
10 years later
Let’s just assume that Joe keeps the $50k balance for the remaining time (even though he can pay it down, pay it off, or draw more from it for those first 10 years). At the end of those 10 years the line of credit feature closes.
Let’s assume the interest rate is at 7% when the line closes with that $50,000 balance. The monthly payments then become $580.54 per month for the remaining 10 years since it will be a fully amortizing loan. At the end of the 20 years the balance will then be zero and the HELOC is paid in full and done.
Like all home equity loans in Texas the maximum Combined Loan to Value (CLTV) is limited to 80%. In addition to the 80% CLTV, the maximum Loan to Value (LTV) is limited to 50%. The loan to values are determined by the home’s appraised value or the Central Appraisal District. (More on that below).
Joe Homeowner owns a $500,000 home. and they currently owe $300,000 on the home. If they want to get a HELOC to get some cash out they will be limited to $20,000 because of the $320,000 maximum CLTV. ($400k x 80% =$320,00 max CLTV and then $320k max – $300k current loan = $20k available for the HELOC).
Let’s now assume that the same homeowner with the $400k home has a $100k first lien and wants a HELOC. The maximum amount of the HELOC will now be limited to $200k because the HELOC can’t exceed 50% LTV. ($400k x 50% = $200k max HELOC loan amount). Even though 80% of the $400k is $320k and the $100k first means there should be $220k available for the HELOC, the 50% limitation applies so only $200k of that $220k is accessible for a HELOC.
The information below is applicable for most HELOCs. Please call us with any questions as we’re happy to guide you through the process. Please read this in its entirety and let us know if a bank contradicts what we’ve described.
Loan Officer, NMLS # 729612