What is a HELOC, or Home Equity Line of Credit

Author  Joe Chappius

Editor  Sam Onelia

Last updated: July 28, 2024

A Home Equity Line of Credit (HELOC) is a revolving credit that allows homeowners to borrow against the equity they have built up in their homes.

Equity is the difference between the current market value of your home and the outstanding balance on your mortgage. For example, if your home is worth $500,000 and you owe $300,000 on your mortgage, you have $200,000 in equity.

HELOCs function similarly to credit cards, providing a predetermined credit limit that you can draw from as needed. Unlike a traditional home equity loan, which provides a lump sum payment, a HELOC allows you to borrow funds incrementally, only paying interest on the amount you actually use.

One of the most attractive features of a HELOC is its flexibility. Funds can be used for a wide range of purposes, including:

• Home improvements and renovations
• Debt consolidation
• College tuition
• Medical expenses
• Business investments
• Emergency funds

How Does a HELOC Work?

Typically, HELOCs have two distinct phases:

1. The draw period
2. The repayment period.

During the draw period, which usually lasts 5-10 years, you can access funds up to your credit limit and are only required to make minimum payments, often covering only the interest.

In this phase, you can withdraw funds using methods such as:

• Writing checks
• Using a credit card tied to your HELOC account
• Transferring funds to your bank account

Once the draw period ends, the repayment period begins, usually lasting 10-20 years. During this time, you can no longer access additional funds and must repay the principal balance plus interest.

It’s important to note that HELOCs are secured by your home, meaning your property serves as collateral for the loan. This arrangement allows lenders to offer lower interest rates compared to unsecured loans, but it also means that your home is at risk if you default on your payments.

A HELOC operates as a revolving line of credit, allowing you to borrow funds as needed up to a predetermined credit limit. This limit is based on a percentage of your home’s value, typically ranging from 60% to 85%, minus any outstanding mortgage balance.

For instance, if your home is valued at $400,000 and you owe $200,000 on your mortgage, with an 80% HELOC, you could access up to $120,000 in credit ($400,000 x 0.8 – $200,000).

Interest rates for HELOCs are usually variable, meaning they can fluctuate based on market conditions. Most lenders use the prime rate as a benchmark, adding a margin to determine your individual rate. Your credit score, debt-to-income ratio, and loan-to-value ratio can all impact the margin and, consequently, your interest rate.

Determining Your HELOC Amount

The amount you can borrow through a HELOC depends on several factors, including:

1. Your home’s value
2. Your mortgage balance
3. Your credit score and history
4. Your debt-to-income ratio
5. Your lender’s HELOC limits

To determine your home’s value, lenders will typically request an appraisal. This assessment will consider factors such as your property’s size, condition, location, and recent sales of comparable homes in your area.

Your credit score is a critical factor in determining your HELOC amount and interest rate. Higher credit scores generally qualify for larger credit lines and more favorable interest rates. Lenders will also review your credit history to assess your ability to manage credit responsibly.

Your debt-to-income ratio (DTI) is another key factor lenders consider. This ratio compares your monthly debt obligations to your monthly income. A lower DTI demonstrates that you have sufficient income to manage your existing debts and the potential HELOC payments, making you a more attractive borrower.

Lenders also have their own limits on HELOC amounts, which can vary based on their risk tolerance and business strategies. Some lenders may cap HELOCs at a specific dollar amount, while others may limit the percentage of home equity you can access.

Types of HELOCs

There are several types of HELOCs designed to cater to different borrower needs and preferences:

1. Standard HELOC: This is the most common type of HELOC, offering a revolving line of credit with a variable interest rate and a set draw and repayment period.
2. Fixed-Rate HELOC: Some lenders offer the option to convert a portion of your HELOC balance to a fixed interest rate, providing more predictable monthly payments. This can be advantageous if you anticipate rising interest rates in the future.
3. Interest-Only HELOC: During the draw period, some lenders allow you to make interest-only payments, keeping your monthly obligations lower. However, this option can result in higher payments during the repayment period, as you’ll need to pay off the principal balance as well.
4. Balloon HELOC: This type of HELOC requires you to pay off the entire balance in a lump sum at the end of the draw period. While this option may offer lower monthly payments during the draw period, it’s essential to plan for the significant payment due at the end of the term.
5. Convertible HELOC: Some lenders provide the option to convert your HELOC to a fixed-rate home equity loan at the end of the draw period, offering more stable monthly payments during the repayment phase.

When choosing a HELOC, it’s crucial to consider your financial goals, risk tolerance, and long-term plans. Assessing the various types of HELOCs available can help you select the option that best aligns with your needs and budget.

Pros and Cons of a HELOC

When Does a HELOC Make Sense?

A HELOC can be a useful financial tool in various situations:

1. Home improvements and renovations: If you’re planning to make upgrades to your home that will increase its value, a HELOC can provide the necessary funds while potentially offering tax deductions on the interest paid.
2. Debt consolidation: If you have high-interest debts, such as credit card balances, using a HELOC to consolidate these debts can save you money on interest charges and simplify your monthly payments.
3. Emergency funds: A HELOC can serve as a backup source of funds for unexpected expenses, such as medical bills or home repairs. However, it’s essential to use this option sparingly and repay the borrowed amount as quickly as possible.
4. Education expenses: If you or your children are pursuing higher education, a HELOC can help cover tuition, books, and other related costs.
5. Business investments: For small business owners, a HELOC can provide access to funds for equipment purchases, inventory, or expansion projects.

Before deciding to take out a HELOC, it’s essential to assess your financial situation, long-term goals, and risk tolerance. Consider consulting with a financial advisor to determine if a HELOC is the right choice for your unique circumstances.

Eligibility and Qualifications for HELOCs

To qualify for a HELOC, lenders typically consider several factors:

1. Home equity: Lenders generally require borrowers to have a minimum of 15-20% equity in their homes. For example, if your home is worth $500,000 and you owe $300,000 on your mortgage, you have 40% equity ($200,000 / $500,000).
2. Credit score: A good credit score is essential for HELOC approval. Most lenders require a minimum credit score of 620, but a score of 700 or higher will likely qualify you for better interest rates and terms.
3. Debt-to-income ratio (DTI): Lenders prefer borrowers with a DTI of 43% or lower. To calculate your DTI, divide your total monthly debt payments by your gross monthly income.
4. Income and employment: Lenders will assess your income and employment stability to ensure you can repay the HELOC. Most lenders require a minimum of two years of stable employment history.
5. Property type: HELOCs are typically available for primary residences and, in some cases, second homes or vacation properties. Investment properties may not qualify for a HELOC.

Meeting these qualifications doesn’t guarantee HELOC approval, as lenders may have additional requirements or restrictions based on their specific policies.

Understanding the Fine Print of HELOCs

Before signing on the dotted line, it’s crucial to understand the fine print of your HELOC agreement:

1. Interest rates: Be aware that most HELOCs have variable interest rates that can change over time based on market conditions. Some lenders may offer an introductory fixed rate for a limited time, after which the rate will become variable.
2. Draw and repayment periods: Understand the length of your draw and repayment periods, as well as any restrictions on accessing funds during the draw period.
3. Minimum withdrawal and balance requirements: Some HELOCs may have minimum withdrawal amounts or require you to maintain a minimum balance to keep the line of credit open.
4. Fees: Be aware of any fees associated with your HELOC, such as annual fees, transaction fees, or early closure fees. These costs can add up over time and impact the overall cost of borrowing.
5. Balloon payments: Some HELOCs may require a balloon payment at the end of the draw period, which means you’ll need to pay off the entire balance in one lump sum. Make sure you understand your repayment obligations and plan accordingly.
6. Collateral: Remember that your home serves as collateral for the HELOC. If you default on your payments, you risk losing your home to foreclosure.

By carefully reviewing and understanding the terms and conditions of your HELOC, you can make informed decisions and avoid potential pitfalls down the road.

HELOC vs. Home Equity Loan

While HELOCs and home equity loans both allow homeowners to borrow against their home equity, there are some key differences between the two:

1. Funding: A home equity loan provides a lump sum payment, while a HELOC allows you to draw funds as needed up to a predetermined credit limit.
2. Interest rates: Home equity loans typically have fixed interest rates, offering predictable monthly payments. HELOCs, on the other hand, usually have variable interest rates that can change over time based on market conditions.
3. Repayment: Home equity loans have fixed repayment terms, with equal monthly payments over a set period. HELOCs have two phases: a draw period, during which you can access funds and make minimum payments, and a repayment period, when you must repay the borrowed amount plus interest.
4. Flexibility: HELOCs offer more flexibility, as you can borrow only what you need when you need it. Home equity loans are better suited for one-time expenses or debt consolidation.
5. Fees: Both options may have fees, such as origination fees, appraisal fees, and closing costs. However, HELOCs may also have additional fees, such as annual fees or transaction fees.

Choosing between a HELOC and a home equity loan depends on your financial needs, preferences, and long-term goals. Consider consulting with a financial advisor to determine which option best aligns with your unique circumstances.