Understanding Home Equity Line of Credit (HELOC) Approval and Interest Rates

Home Equity Line of Credit (HELOC) can be a powerful financial tool for homeowners, allowing them to access home equity at relatively low interest rates. However, banks and lenders carefully evaluate several factors before approving a HELOC and determining its interest rate. This article explores the key considerations, including home appraisals, the borrower's debt-to-income ratio, and how interest rates are calculated.

Home Value Appraisal and CLTV

The process of securing a HELOC begins with a home appraisal to determine the property's value. Unlike a traditional home mortgage appraisal, which is typically more comprehensive, HELOC appraisals can be more limited. Many lenders use drive-by appraisals or automated valuation models (AVMs), which compare your home to recent sales of similar properties.

For example, the Zillow Zestimate is a popular AVM, but it often lacks the precision needed for HELOC approval. Banks rely on more reliable methods, such as drive-by appraisals, which are quicker and less expensive, or AVMs, which are cost-effective and speed up the loan process.

Once the home's appraised value is known, the lender applies the maximum Combined Loan To Value (CLTV) ratio to determine the maximum HELOC amount. If the home is valued at $500,000 and there is an existing loan balance of $300,000, and the bank’s maximum CLTV is 80%, the largest HELOC they will approve is calculated as follows:

$500,000 * 0.80 $400,000 - $300,000 $100,000

Debt-to-Income (DTI) Ratio

Just as with a first mortgage, lenders also assess the borrower's debt-to-income (DTI) ratio. The DTI ratio is calculated by adding up all housing expenses, including both loans, taxes, insurance, and HOA fees if applicable, and dividing the total by the borrower’s gross monthly income. A typical cap on this ratio is around 45%, meaning the sum of housing expenses cannot exceed 45% of the borrower's monthly income.

Interest Rate Calculation

The interest rate for a HELOC is primarily based on the Prime Rate, which is published in the Wall Street Journal. As of May 3, 2022, the Prime Rate is 3.50%. However, the Federal Reserve may increase the Federal Funds rate, leading to a rise in the Prime Rate, as they did earlier in the month when the rate was increased by 0.50%.

Lenders add a margin to the Prime Rate to determine the final interest rate. This margin can range from 0% for the most creditworthy borrowers to more than 2% for those with lower credit scores. For instance, a HELOC with a 0.50% margin will have an interest rate of 4.00% once the Federal Reserve increases the Federal Funds Rate to 4.00%.

Bonus Facts about HELOCs

HELOCs come with two distinct periods:

Draw Period

During the draw period, typically lasting around ten years, borrowers can write checks against the HELOC. They receive monthly statements showing the outstanding balance and interest earned for the previous month. Interest payments can be made in full, or only the interest can be paid, depending on the borrower's financial situation.

Repayment Period

After the draw period, the HELOC enters the repayment period, lasting typically 20 years. During this period, borrowers no longer have access to the credit line and must repay the loan in full. The interest rate continues to adjust based on the Prime Rate.

HELOCs offer a cost-effective way to access home equity, but it's essential to understand the implications. Using a HELOC for a fancy vacation, for example, should be approached with caution, as the funds must still be repaid as any other debt.

I hope this information is helpful in understanding HELOCs and their nuances.