How to Use a HELOC Loan for a Down Payment on a Home

Buying a home is an exciting milestone in life. However, saving up enough money for a down payment can be challenging for many homebuyers. If you don’t have enough cash on hand, using a home equity line of credit (HELOC) to fund your down payment is an option worth considering.

In this comprehensive guide, I’ll explain what a HELOC is, how it works, and the pros and cons of using it to cover your down payment. I’ll also share tips on qualifying for a HELOC, calculating how much you can borrow, and comparing it to other financing options.

What is a HELOC?

A home equity line of credit, or HELOC, is a type of revolving credit line that allows homeowners to borrow against the equity in their home. It works similarly to a credit card in that you have access to a set credit limit and can draw money as needed up to that limit.

With a HELOC you will only pay interest on the amount you actually borrow. The interest rate is usually variable, meaning it can fluctuate over time. HELOCs typically have a 10 to 20 year draw period where you can access the funds followed by a 10 to 20 year repayment period where no new funds can be withdrawn.

How Does a HELOC Work?

When you take out a HELOC the lender appraises your home to determine how much equity you have built up. Equity is calculated by taking the current market value of your home and subtracting any outstanding mortgage debt.

For example:

• Your home is worth $300,000
• You owe $180,000 on your mortgage
• So your equity is $300,000 – $180,000 = $120,000

The lender will then offer you a line of credit up to a certain percentage of your equity, usually between 75-85%. Using the example above you might qualify for a HELOC up to $102,000 (85% of $120,000).

Once approved, you can withdraw as much or as little of the HELOC funds as you need. You will be required to make monthly interest payments on the outstanding balance. When the draw period ends, you enter the repayment phase where you must pay down the principal balance over the specified timeframe.

Your home serves as collateral for the HELOC. This means if you fail to make payments, the lender can foreclose on your home.

Pros of Using a HELOC for a Down Payment

• Access funds quickly: HELOCs provide faster access to cash compared to cash-out refinancing which can take 30-60 days to close.

• Pay interest only at first: You only pay interest on the amount withdrawn during the draw period, keeping payments low.

• Variable rate: Interest rates on HELOCs are often lower than fixed rate alternatives.

• Reusable funds: You can pay down your balance and withdraw more funds up to your limit.

• Interest may be tax deductible: Consult your tax advisor, but HELOC interest can potentially be tax deductible.

Cons of Using a HELOC for a Down Payment

• Closing costs: You’ll pay closing costs of 2-5% of your loan amount.

• Risk losing your home: Your home secures the HELOC, so failure to repay could lead to foreclosure.

• Payments increase: Once the draw period ends, payments on principal and interest increase.

• Variable rate: Your interest rate can go up over time increasing payments.

• Shorter repayment term: HELOCs usually have 10-20 year repayment periods.

• Debt-to-income ratio: Additional debt from a HELOC may impact loan qualification.

Tips for Qualifying for a HELOC

While HELOCs can be easier to obtain than other types of loans, lenders will evaluate your finances to ensure you can manage the additional debt. Here are some tips for qualifying:

• Have 20%+ equity: Most lenders require at least 20% equity in your home to approve a HELOC.

• Good credit score: Minimum scores are often around 620, but 720+ is ideal for the best rates.

• Low debt-to-income ratio: Lenders look for a total DTI below 43%. Reduce other debts if possible.

• Sufficient income: Expect to provide W-2s, paystubs, and tax returns to verify your income.

• Home appraisal: The lender will appraise your home to determine available equity and collateral.

How Much Can You Borrow with a HELOC?

The amount you can borrow with a HELOC depends on how much equity you have, as well as factors like your income, credit score, and existing debts. Here is an example calculation:

• Home Value: $500,000
• Existing Mortgage: $300,000
• Home Equity: $500,000 – $300,000 = $200,000
• Max HELOC @ 85% of equity: $200,000 x 0.85 = $170,000

So in this scenario, you might qualify for a HELOC up to $170,000. The lender will look at your income, credit, and debts to determine if you can manage that size of a loan.

Keep in mind, you don’t have to withdraw the entire amount. You can use just what you need for the down payment and associated home buying costs.

HELOC vs. Other Down Payment Options

Beyond a HELOC, here are a few other common ways to finance a down payment:

• Cash-out refinance: Refinance your mortgage for more than what you owe and take the difference in cash.

• Home equity loan: Get a fixed amount loan using your equity as collateral.

• Personal loan: Unsecured loan based on creditworthiness, shorter terms than a HELOC.

• Family gift: Receive gift funds from a family member. No repayment needed.

• Down payment assistance: Government and nonprofit programs provide grants for down payments.

• Sell assets: Cash from selling stocks, bonds, a car, or other assets.

Compare interest rates, costs, repayment terms, and risks to choose the best option for your situation. Many homebuyers combine a couple sources, like a HELOC for part of their down payment along with some gifted funds.

Step-by-Step Process to Use a HELOC for a Down Payment

If you’ve decided a HELOC is the right financing choice for your down payment, here is a step-by-step overview of the process:

1. Research HELOC lenders and compare interest rates and terms. Credit unions often offer competitive rates.

2. Determine your home equity by checking home values on Zillow or getting an appraisal.

3. Apply for a HELOC. The lender will review your credit, income, debts, and home value. This takes 1-2 weeks.

4. Get an appraisal to confirm your home equity if approved. The lender pays for this.

5. Finalize HELOC paperwork. This takes 2-6 weeks. There may be closing costs of 2-5%.

6. Shop for a home and make an offer once your HELOC funds are available.

7. Withdraw funds from your HELOC to cover down payment and closing costs.

8. Finalize the home purchase and start making HELOC payments.

Be sure to build payments for both your HELOC and new mortgage into your budget. Also set a plan to repay the HELOC within the allotted timeframe.

Risks to Understand Before Using a HELOC

While a HELOC can be a viable way to finance your down payment, there are some key risks to consider:

• Payment shock: Once the draw period ends, your payment could increase significantly.

• Equity erosion: Drawing equity reduces the cushion protecting you if home values decline.

• Interest rate hikes: Your variable HELOC rate could rise making payments unaffordable.

• Difficulty qualifying for refinancing: The HELOC balance could impact future refinancing.

• Foreclosure: If you default on payments, you could lose your home.

Have a solid repayment plan and emergency fund in case any of these scenarios occur down the road.

Alternatives If You Don’t Qualify for a HELOC

Given the risks, a HELOC may not always be the best solution. Here are a few options if you don’t qualify:

• Save for a larger down payment to avoid financing.

• Look into down payment assistance programs in your state.

• Ask a family member for a down payment gift.

• Reduce debts and improve your credit score, then reapply.

• Explore government guaranteed loan programs which offer lower down payments.

• Consider buying a lower priced home.

The Bottom Line

Tapping into your home’s equity via a HELOC can be an affordable and convenient way to finance the down payment on your next home. It provides fast access to funds and the flexibility of only making interest payments initially.