What Is a Home Equity Line of Credit?

Home equity lines of credit are convenient ways for homeowners to finance spending or consolidate debt. They offer significantly larger credit limits than regular credit cards, which can give borrowers greater flexibility and spending power. However, a HELOC may not be the right way to borrow against your home. Read more about HELOCs and home equity loans to learn which option is best for your needs.

Below is a breakdown of what a home equity line of credit is, how you can qualify for one and what typical terms look like.

What Is a HELOC?

A home equity line of credit is similar to a second mortgage, in that the homeowner borrows against his existing mortgage. The equity in the home is used as collateral for the new line of credit, and the borrower can borrow from it for the life of the loan or any other predetermined term.

The line of credit is used like a credit card, with a determined credit limit based on the amount of equity in the home, and a variable interest rate that may fluctuate with the market or with the outstanding balance. When you borrow from your line of credit, you are required to make payments based on the loan agreement. As you repay what you borrowed, your available credit revolves, and you can continue to borrow.

A HELOC is different from a home equity loan, which has set terms, a fixed interest rate, and a consistent payment each month. The lump sum is paid off over the term of the home equity loan, and the amount you can borrow is capped at the loan amount, i.e. the credit does not revolve. A HELOC offers much more flexibility than a home equity loan but may also cost more in interest if rates fluctuate.

Related: Is Your Home Equity Line of Credit a Trap?

How to Qualify for a HELOC

Why you are borrowing is a determining factor when choosing between a HELOC and a home equity loan. A home equity line of credit is best for homeowners who know they will need to continually borrow, such as make tuition payments or funding a long-term remodel.

To qualify, you’ll need to meet the specifications set by the bank, credit union or other lender. Typically, lenders are looking for candidates with a low debt-to-income ratio, consistent employment history and other proof of financial stability. Here are some things you’ll need to make it through the approval process:

Substantial Equity

Most lenders will look for borrowers who have at least 80 percent loan-to-value on their home, meaning that at least 20 percent of the mortgage has been paid off or the home value has increased 20 percent since the home was purchased. The credit limit will be based on the amount of equity in the property. Homeowners might be able to borrow up to the 85 percent of the home’s value.

Read: 4 Creative Uses for a Home Equity Line of Credit

Low Debt-to-Income Ratio

Debt-to-income is the ratio between recurring monthly debt payments and monthly income. If the ratio is appropriately low, lenders are confident in the borrower’s ability to afford the HELOC payments. Expenses that will be factored include mortgage payment, potential HELOC payment, loan interest, property taxes, homeowner’s insurance, and mortgage interest, plus other living expenses and financial obligations like alimony and child support, student and car loan payments, and credit card payments. The overall total of expenses should not be higher than 36% of your pre-tax income.

A Good Credit Score

Your credit score is an indication of your payment history and general credibility as a borrower. The higher your credit score, the more trustworthy you are to lenders. The credit score helps lenders determine how much of a risk they are taking by lending to you, and the lower the risk, the more likely you are to benefit from the lowest interest rates and best terms.

Consistent Employment History

Proving a steady employment history will help assure lenders that you will be able to afford payments on the HELOC. You’ll be asked to provide W-2’s and at least one pay stub. If you’ve been employed less than two years with your current employer, you may be asked to provide additional information.

Related: 30 Ways to Spend Your HELOC at Home Depot

Restrictions, Requirements and Downsides

It’s not as easy as it looks. Depending on your terms, there may be different restrictions, requirements and downsides in acquiring a HELOC. You’ll likely pay a pretty penny to secure a HELOC, including appraisal costs, an application fee, closing costs and other fees. Other stipulations:

• You might not be allowed to rent your property as long as the HELOC is open.
• You might have to withdraw within a certain amount of time or meet minimum withdrawal requirements.
• While it’s easy and convenient to access the funds, it can also be easy to borrow too much at once, leaving you with a hefty bill to pay all at once.
• The lender may freeze, reduce or demand full payment of the loan amount.
• Your line of credit may expire with the loan term, which means if you had a large outstanding balance, you may have to pay it.

Not all lenders and loans have the same terms, so be sure to ask questions and compare your options to be sure you’re getting the conditions that work best with your lifestyle and budget.

This article originally appeared on GOBankingRates.com: What Is a Home Equity Line of Credit?

This article by Tess Frame first appeared on GoBankingRates.com and was distributed by the Personal Finance Syndication Network.