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What is a HELOC, and how does it work?

Your equity can get you a revolving line of credit

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Written by Jennifer Schurman
Edited by Cassidy McCants
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Building equity is how you turn your home into an investment. Home equity is calculated by taking the difference between your home’s current appraised value and your outstanding mortgage balance.

With enough equity, you can use it as collateral to borrow money for things like home improvements, consolidating debt or paying for emergency expenses. A home equity line of credit (HELOC) is one of several products that can help you use the equity you've built in your home.

Key insights

  • HELOCs are popular for home improvement projects, but they can go toward all kinds of expenses.
  • You need a minimum of 15% to 20% equity in your home to qualify for a HELOC.
  • Your home is the collateral for a HELOC, which means you could lose it if you aren’t able to pay back what you’ve borrowed.
  • Most HELOCs have variable interest rates, meaning your payment could rise in the future.

What is a home equity line of credit?

A home equity line of credit (HELOC) is a type of revolving credit you can access using the equity in your home. This type of financing works best for ongoing expenses, especially when you don’t know what the total costs will be. With a HELOC, you can borrow cash up to your credit limit and pay back the money over an extended period.

How does a HELOC work?

A HELOC lets you borrow against a portion of the equity in your home and uses your house as collateral to secure the loan. You can choose to make regular withdrawals from a HELOC or keep it open and available for use at a later time. As you pay back what you’ve borrowed from the line of credit, the total amount you can borrow (called a credit limit) is replenished.

With a HELOC, you won’t be able to borrow all of your equity — lenders use a loan-to-value (LTV) ratio to determine how much of that equity you can use. This LTV is usually between 60% to 85%, which means you can borrow 60% to 85% of the available equity.

Your HELOC credit limit depends on the loan-to-value ratio.

Here’s how lenders use the LTV ratio to determine your credit limit: Say your home recently appraised for $300,000, and the outstanding balance on your mortgage loan is $220,000. The LTV ratio your lender offers is 80%, so you may be able to borrow 80% of $300,000 less the $220,000 you still owe on your mortgage loan. The potential credit limit could equal $20,000 in this case.

HELOCs are different from other forms of credit because there’s a specified spending period (called the draw period) that ends after a certain amount of time. Most draw periods range from five to ten years. You’ll make minimum monthly payments throughout the draw period, though you won’t really begin repaying principal until the repayment period begins.

After the draw period ends, the repayment period starts. Repayment periods are typically longer than draw periods, so a HELOC with a 5-year draw period could have a 10-year repayment period. During the repayment period, you’ll make monthly payments of principal and interest until the balance is paid off.

It’s important to note that some HELOCs require a balloon payment at the end of the draw period rather than an extended repayment period. A balloon payment is a large lump-sum payment of both principal and interest. Keep this in mind as you compare HELOC options — one alternative may be better for your budget and goals than the other, depending on how you plan to use the HELOC.

What can you use a HELOC for?

You can use a HELOC for a number of objectives, like consolidating credit card debt, funding a home renovation project, paying for medical expenses or even starting a business. It’s pretty much up to the borrower.

According to Micheal C. Borman, vice president and chief lending officer at Jetstream Federal Credit Union in Miami Lakes, Florida, “The most popular uses of a HELOC are for home improvements, debt consolidation, college tuition and as a backup emergency fund in case of unexpected expenses. Sometimes, individuals utilize the HELOC to purchase another property, such as a vacation or rental property.”

However you decide to use a HELOC, it’s important to remember that your HELOC payment requirement could vary in the future. “A typical HELOC has a variable interest rate, which causes concern for consumers. … The interest you pay on the balance owed can rise and fall based on market conditions,” Borman said.

If you’re worried about rising payments, keep in mind that you don’t have to withdraw up to your limit if it’s not necessary. You can use as little of it as you like, which could help prevent unmanageable debt. You can also make principal payments early (during the draw period) to keep interest costs down and get a head start on repayment.

A typical HELOC has a variable interest rate, which causes concern for consumers.  … The interest you pay on the balance owed can rise and fall based on market conditions.”
— Michael C. Borman, VP and CLO of Jetstream Federal Credit Union

Risks of using a HELOC

A HELOC places an additional lien on the property, making it a type of second mortgage. Using your house as collateral can be risky, especially if there’s a chance you may not be able to pay back what you’ve borrowed. Defaulting gives the lender a right to foreclose on your property and sell it to get its money back. In this case, you would lose any equity you had in the property.

Keep this in mind as you plan how you’ll use the HELOC. It may be best to use it to help you achieve your long-term financial goals. For example, using the money to consolidate high-interest credit card bills may help you get out of debt faster. You can also use a HELOC to make improvements that could increase your home’s value in the long run.

HELOC requirements

If you’re applying for a HELOC, you typically need about 15% to 20% equity in your home and a credit score of at least 680.

A lender will ask for proof of income to verify that you are able to make monthly payments. You’ll also need to provide a list of debts. The lender will use your income and debts to calculate your debt-to-income ratio (DTI ratio). Most lenders want borrowers to have a DTI ratio of 43% or lower.

HELOC pros and cons

There are several benefits and drawbacks to consider before applying for a HELOC. This financing option isn’t for everyone, even if you meet the minimum borrower requirements.

One of the main benefits of a HELOC is that it lets borrowers access funds as needed rather than borrowing and repaying a large sum of cash. The interest rates on HELOCs are also typically lower than available rates on credit cards or even other types of loans.

For reference, the average interest rate on a personal loan in July 2022 was 10.60%, according to Bankrate. The average credit card rate in the same month was 20.82%, according to LendingTree. However, the average rate on a HELOC during the same time period was 4.87%, Insider reported. Even small interest rate reductions could result in significant cost savings over time.

Also, HELOCs offer something that credit cards do not: a final repayment date. With credit cards, you could keep spending over time and continuously maintain a balance that you’ll pay interest on. However, with a HELOC, the spending period will eventually end and the repayment period begins.

One of the most significant drawbacks to consider is that your home serves as collateral for the HELOC, which means you risk losing your property if you can no longer make payments. You’ll also lose a significant portion of your equity until you pay off the HELOC.

In addition to a loss of equity, the variable interest rates on HELOCs mean your required payment amount could change, making it more difficult to budget for future payments. You’ll also have to pay some closing costs upfront when you start a HELOC (like appraisal and attorney’s fees).

Keep in mind that some lenders require an initial draw on your HELOC, regardless of whether you need cash at that time. Initial draw amounts could be hundreds or thousands of dollars, depending on your lender. If you know you won’t need funds immediately, you may want to consider the timing of starting a HELOC or research other loan options.

HELOC benefits

  • Consistent availability of cash for expenses
  • Lower interest rates compared with credit cards
  • Few restrictions on how you use the funds
  • Set repayment date

HELOC Drawbacks

  • Collateral is your home
  • Variable interest rates
  • Must pay closing costs
  • May have initial draw requirements

HELOC alternatives

HELOCs aren’t the only means to accessing the equity in your home, so consider all your choices for funding before you make your decision. Each alternative will have an impact on your budget, both now and in the future. After researching the costs of these financing options, you may decide it’s better to postpone spending in the present in order to save money for a big purchase in the future.

If you’re looking for a loan that offers access to cash upfront instead of a line of credit, a home equity loan, cash-out refinance or reverse mortgage may be a better alternative, depending on your individual situation. As you weigh these options, consider the interest rate, the repayment plan and the overall costs associated with each.

HELOC vs. home equity loan

A home equity loan provides loan funds upfront in a single payment. You begin making payments on both the principal and interest immediately. While HELOCs typically carry variable interest rates, home equity loans offer fixed rates that won’t change over the life of the loan.

HELOC vs. cash-out refinance

A cash-out refinance is a refinance loan for your remaining principal balance on your primary mortgage plus an additional amount that you receive in cash. You typically need at least 20% equity in your home to get started. With a cash-out refi, you can generally choose between a variable or fixed rate. As with a home equity loan, this option is good for when you need funds all at once.

HELOC vs. reverse mortgage

A reverse mortgage is a loan for senior homeowners (often 62 and older) who want to trade their equity for regular payments or a lump sum. The borrower doesn’t repay the loan as long as they remain in the home and don’t sell it. The funds are repaid to the lender after death or after the borrower sells the home or moves out. To qualify, you have to have paid off your mortgage or have significant equity in your home.

Bottom line

A HELOC is a form of home equity borrowing giving you access to a revolving line of credit. You usually need at least 15% equity to qualify. HELOCs come with a number of risks, including a variable interest rate, which could mean unpredictable payment increases.

A HELOC might be right for you if you're willing to borrow against the equity in your home and need funds for ongoing expenses or want to consolidate debt, but be sure your budget can handle a larger payment if rates rise in the future.

If you have a tendency to overspend, are uncomfortable with interest rates changing or don’t want to put up your home as collateral, you might consider different financial strategies.

ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. To learn more about the content on our site, visit our FAQ page. Specific sources for this article include:
  1. Experian, “What Is a Draw Period on a HELOC?” Accessed Aug. 9, 2022.
  2. LendingTree, “HELOC Balloon Payments: How to Find a Way Out.” Accessed Aug. 9, 2022.
  3. Experian, “What Credit Score Do I Need to Get a Home Equity Loan?” Accessed Aug. 9, 2022.
  4. Insider, “The average HELOC interest rate by loan type, credit score, and state.” Accessed Aug. 9, 2022.
  5. LendingTree, “Average Credit Card Interest Rate in America Today.” Accessed Aug. 9, 2022.
  6. Experian, “How Does a HELOC Affect Your Credit Score?” Accessed Aug. 9, 2022.
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