Money Research Collective’s editorial team solely created this content. Opinions are their own, but compensation and in-depth research determine where and how companies may appear. Many featured companies advertise with us. How we make money.
What is a HELOC?
By Cassidy Horton MONEY RESEARCH COLLECTIVE
A home equity line of credit (HELOC) lets you tap into your home’s equity to pay for pretty much anything — home improvement projects, real estate investments, debt consolidation, unexpected expenses, and more.
But HELOCs are just one of many ways to access your home’s equity — and they’re not without risk. Understanding how HELOCs work can help you decide if they’re right for you. Here’s what you need to know.
Table of contents
- What is a home equity line of credit?
- Difference between a home equity line of credit and a home equity loan
- What to know when applying for a home equity line of credit
- Alternatives to HELOCs
- HELOC FAQ
- Home Equity line of credit bottom line
What is a home equity line of credit?
A home equity line of credit is a revolving line of credit that uses your home’s equity as collateral. In short, equity is the difference between your home’s appraised value and the amount of money you owe on it.
For example, if you own a house that’s worth $250,000 and you have a $100,000 mortgage balance, the equity in your property is $150,000. This equity can be used as collateral for loans or lines of credit and can provide a safety net in case of financial hardship.
How does a HELOC work?
HELOCs have credit limits, much like credit cards. This is the maximum amount you can borrow against your home’s equity.
You can use as much or as little of your credit limit as you want, and you only pay interest on the amount you borrow. So if your credit limit is $50,000 and you take out $10,000, that’s the amount you’ll pay back with interest.
HELOC phases
HELOCs are broken down into two phases: a draw period and a repayment period.
The draw period starts first and can last anywhere from five to 10 years. This is when you can borrow money from your HELOC as much as you want. In most cases, you’re required to make interest-only payments during this time. However, you can pay back more if you’d like.
Once the draw period ends, the repayment period kicks in.
The repayment period is when you have to start paying back your loan’s principal (i.e., the money you borrowed), plus interest. This phase usually lasts 10 to 20 years. You’re not allowed to withdraw any money from your HELOC during this time.
Fair warning: some lenders have minimum draw requirements, where you’re required to have $10,000 or more outstanding when your HELOC enters its repayment period. Not all lenders do this — but you’ll want to check before you sign your contract.
HELOC term lengths
While term lengths vary by lender, you can expect to have a five- to 10-year draw period, followed by a 20-year repayment period.
How much can be borrowed with a HELOC?
Most HELOC lenders will let you borrow up to 85% of your home’s value, minus your mortgage balance. So if your home is worth $300,000 and you owe $200,000 on your mortgage, you could borrow up to $85,000 ($100,000 x 0.85). Your actual HELOC cap could be higher or lower depending on your financial situation.
What is a HELOC used for?
You can use a HELOC for almost anything, including:
Home improvements
HELOCs are often used for home improvement projects because they usually come with lower interest rates than other types of loans. You can also pull from the line of credit periodically as you move through different phases of your home remodel.
The interest is also usually tax-deductible if you use your HELOC for home improvements. (It’s not tax-deductible for anything else.)
Medical expenses
Many people tap into their home’s equity if they have substantial medical bills to pay or need ongoing treatment for a chronic or terminal illness.
Large purchases
While it’s never wise to go hog-wild with your HELOC, you can actually use it for any large purchase you want to make — taking a vacation, investing in real estate, covering unexpected car repairs, paying for a funeral, or anything else.
Tuition or education costs
If you’re worried about how you’ll cover education costs for yourself or your kids, HELOCs can provide some peace of mind. Many people use them to cover tuition and expenses of all kinds — from kindergarten all the way through graduate school.
Debt consolidation
If you have a lot of high-interest debt or student loans, you could consolidate them all into one loan using a HELOC. Not only could this potentially save you money on interest, but it could also lower your monthly payment.
Benefits to HELOCs
There are several pros to getting a HELOC.
- Flexible line of credit that you can tap into when needed
- You only pay interest on the amount you borrow
- Can make interest-only payments during the draw period
- Interest rates are generally lower than that of credit cards or other unsecured loans
- Interest may be tax-deductible if used for home improvement projects.
Downsides to HELOCs
But there are also some risks to consider before taking out a HELOC.
- HELOC rates are usually variable, so if interest rates rise, your monthly payments will go up too
- If you don’t make your payments, you could lose your home to foreclosure
- Your line of credit could be frozen or reduced if your home’s value decreases
Difference between a home equity line of credit and a home equity loan
A home equity line of credit is similar to a home equity loan, but the two have some major differences.
First, a HELOC is a revolving line of credit where you can borrow money, pay it back, and then borrow it again. You only pay interest on the money you withdraw.
With a home equity loan, or second mortgage, you get a lump sum of cash all at once and pay it back in fixed monthly installments. You pay interest on the full amount — even if it sits in your savings account for the first few months.
HELOCs are generally best if you have frequent, recurring expenses you need to cover. A home equity loan is best for large one-time expenses.
What to know when applying for a HELOC
HELOCs have a handful of terms and conditions you need to know about. These include:
Different interest types
HELOCs have two different types of interest rates: variable and fixed.
Variable interest rate
Most HELOCs have variable interest rates, meaning your monthly payment can go up or down over time. This interest rate is pegged to a prime lending rate, which is the rate that banks charge their best customers.
For instance, if the prime lending rate is 3% and your HELOC has a margin of 2%, then your interest rate would be 5%. If the prime rate goes up to 4% due to inflation, then your interest rate would go up to 6%.
Most states prohibit lenders from raising HELOC rates above 18%.
Fixed interest rate
Although not as common, some lenders offer fixed-rate HELOCs where your interest rate never changes. Other lenders may let you lock in a fixed rate for a portion of your HELOC’s term. This could be a good idea if you suspect interest rates are about to rise.
Types of common fees
The biggest fee to watch out for with HELOCs is closing costs. Just as with your primary mortgage, you can expect to pay anywhere from 2% to 5% when you sign for your loan.
In addition to closing costs, here are a few more HELOC fees to watch out for:
Appraisal fees
You may have to pay this fee if a professional needs to come out to your house to evaluate its market value.
Application fees
An application fee is a one-time fee you may pay when you apply for the loan.
Attorney’s fees
In most cases, you may not need an attorney to get a HELOC. However, it could be a good idea to hire one to review your loan documents if you’re not sure what some of the fine print means.
Title search fees
A title search is when a professional searches for any liens or other claims against your home.
Mortgage preparation and filing
This fee is typically charged to help cover the cost of processing and filing your HELOC paperwork.
Annual fees
Some lenders charge annual fees for HELOCs (just as some credit cards have annual fees). These fees can add up over the life of a 20-year loan, so evaluate them carefully when shopping around.
Transaction fees
Some lenders may also charge transaction fees each time you withdraw money from your HELOC.
Prepayment penalties
Believe it or not, you could be penalized if you pay off your HELOC before your repayment period ends. So if you think you might want to pay off your HELOC early, try to find a lender that doesn’t charge this fee.
The three-day cancellation rule
Federal law gives you three days from the time you finalize your HELOC to cancel it if you change your mind. This rule is also called the “Right of Rescission.”
More specifically, your three-day clock doesn’t start until these three events happen:
- You sign your HELOC documents.
- You receive your Truth in Lending disclosure.
- You get two copies of a document that explains your right to rescind your HELOC.
So if you sign your HELOC on a Wednesday and don’t receive your final documents until that Friday, you have until the following Tuesday at midnight (i.e., late Monday night) to back out.
If your lender never supplies you with the right documents, you may have up to three years to rescind your loan. You can learn more on the Consumer Financial Protection Bureau’s website.
Qualification requirements
The exact requirements vary by lender. But in general, homeowners need to meet these qualifications to get approved for a HELOC.
Minimum credit score
Most lenders require a minimum credit score of 620 to get approved for a HELOC, although some may be willing to approve you with a lower score if the rest of your qualifications are above average.
Reliable income
You’ll also need to show proof of reliable income via pay stubs and tax documents. This will help verify that you have enough steady income to make your HELOC payments.
15% to 20% home equity
You’ll also need to have 15% to 20% equity built up in your home to qualify for a HELOC. So if your home is appraised at $200,000 and you have a mortgage balance of $150,000, you have $50,000, or 25% equity.
Low debt-to-income ratio
Ideally, your debt-to-income ratio should be below 43% to qualify for a HELOC. In other words, your monthly debts should be no more than 43% of your gross monthly income. Gross monthly income is what you make before tax.
History of responsible payments
Finally, HELOC lenders like to see that you have a strong history of paying your debt payments on time and in full. They’ll often look at your credit report for this information.
Beware of these harmful practices
As you shop around for the best HELOC rates, keep in mind that you’re never obligated to sign for a loan just because you’ve applied for one. Be wary of dishonest lenders that use any of these harmful practices:
High-pressure tactics
The Federal Trade Commission (FTC) recommends avoiding any HELOC lenders that:
- Use high-pressure sales tactics
- Make false promises
- Try to get you to borrow more money than you need
- Ask you to sign blank forms
- Don’t give you time to read the financial disclosures
- Encourage you to take out monthly payments that are more than you can afford
If you’re feeling pressure from a lender, take a step back and consider if the loan is right for you. Predatory lenders exist, and one way to weed them out is by looking up their NMLS number.
The NMLS is a national registry that helps track and monitor lenders’ activities. This allows the government to ensure that lenders are following the proper guidelines and regulations. It also allows consumers to check on the lender’s history to see if there have been any complaints or problems in the past.
Loan flipping
Loan flipping is when a lender gets you to refinance your loan multiple times in a short period of time. They might do this by promising a lower interest rate or monthly payment.
But each time you refinance, you have to pay fees. And with each new loan, you end up owing more money than you did before.
Insurance packing
Insurance packing is when a lender pushes unnecessary insurance products on you as a requirement for refinancing. For instance, they may require you to get “credit insurance” or some other product that may only benefit them.
Bait and switch
Bait and switch is when a lender says you qualify for a low-interest rate loan. But when you go to sign the loan documents, they might try to get you to sign for a HELOC with a higher interest rate or different terms.
Equity stripping
Equity stripping happens when a lender approves you for a HELOC based on how much equity you have on your home, regardless of your ability to pay. It can be dangerous because you could end up with monthly payments you can’t afford, and your home could be foreclosed on as a result.
Non-traditional products
Be wary of HELOCs with huge balloon payments at the end. These loans often have low monthly payments, which can be tempting. But when the balloon payment comes due, you may not be able to afford it. As a result, you may have to refinance your loan into another HELOC and pay closing costs and fees all over again.
Mortgage servicing abuses
Some lenders might try to take advantage of you if you’re having trouble making your monthly payments. They might do this by refusing to accept partial payments, charging you excessive fees, or not properly disclosing your rights as a borrower.
The “home improvement” loan
This is a type of scam where a contractor pressures you into taking out a home equity line of credit with them in exchange for a good deal on repairs or renovations. The HELOCs attached to these promises often have high fees or interest rates that end up outweighing any discounts you’ll receive in return.
How HELOCs are repaid
HELOCs are typically repaid over a 10- to 20-year period, although some lenders may offer repayment periods of up to 30 years. During the draw period, you’re usually required to make interest-only payments, which means that your monthly payment will only cover the interest that accrues on the loan.
At the end of the draw period, you’ll enter the repayment period, during which you’ll be required to repay the loan’s principal and interest. Because HELOCs are typically adjustable-rate loans, your monthly payments may increase or decrease over time, depending on changes in market interest rates.
To make sure you don’t get caught off guard by a sudden increase in your monthly payments, calculate how much your payment would be if it were the highest advertised interest rate. Use this as your worst-case scenario when deciding on how much equity to take out.
Alternatives to a HELOC
A HELOC isn’t the only type of loan that allows you to borrow against your home equity. So if you think it’s not for you, here are a few alternatives to consider:
Home equity loans
A home equity loan is a second mortgage. You receive a lump sum of cash upfront and then make fixed monthly payments for the life of the loan. Home equity loans are typically ideal for people who need a large amount of cash for a one-time expense, such as a major home repair or medical bills. The downside is that you’re stuck with two mortgage payments.
Cash-out refinance loans
If you need to access a lot of cash and want the security of one fixed monthly payment, you may want to consider a cash-out refinance loan. With this type of loan, you’re refinancing your current mortgage and taking out a new loan for the amount you need, using your home equity as collateral. You then have one monthly payment for both loans
Reverse mortgages
A reverse mortgage is available to those age 62 or older and allows you to tap into your home equity without having to make monthly payments.
A reverse mortgage can give you the financial freedom to enjoy your retirement years, but it’s not for everyone. The loan has to be repaid when you sell your home or when you die. So if you want to leave your home as an inheritance to your kids, a reverse mortgage may not be right for you.
Personal loans
Lastly, a personal loan could be a good alternative to a HELOC depending on your needs. It doesn’t use your home as collateral, so you don’t need equity to qualify.
The best personal loans tend to have shorter terms than HELOCs, which means you’ll pay off the debt faster. But they also typically have higher interest rates because they’re unsecured.
You may want to consider how to get a personal loan if you have good credit and need money for a specific purpose, such as moving costs or an emergency.
HELOC FAQ
What is a HELOC?
How much money can I get with a HELOC?
How long does it take to get a HELOC?
How often can the interest rate change on a HELOC?
If your HELOC has a variable interest rate (as most do), your interest rate can change at any time. And when your interest rate changes, it makes your monthly payment go up or down accordingly.
If your HELOC has a fixed interest rate, it will never change, and neither will your monthly payment.
How to qualify for a HELOC
Homeowners generally need to meet these requirements to qualify for a HELOC:
- • A good credit score: This varies by lender, but you'll typically need a FICO score of 620 or higher.
- • A loan-to-value ratio (LTV) of 80% or less: This means that you'll need to have at least 20% equity in your home.
- • A debt-to-income ratio of 43% or less: This means that your monthly debts — including your mortgage payment, property taxes, and insurance — shouldn't exceed 43% of your monthly income.
- • A steady source of income: This can be in the form of employment, disability benefits, alimony, or child support.
- • A history of making on-time payments: Lenders will pull your credit report to see if you have a history of making timely payments on your debts.
If you don't meet all of the requirements above, you may still be able to qualify for a HELOC if you have a cosigner or if one part of your application is better than average.
Home equity line of credit bottom line
A home equity line of credit is a type of home loan that lets you borrow against the equity in your property. Unlike a traditional loan, a HELOC typically has a variable interest rate and requires only interest payments for the first few years.
However, because the interest rate can change over time, borrowers should be aware of the risks involved. If you can’t make your payments, you could lose your home. For these reasons, carefully consider whether a HELOC is the right choice before taking out a loan.
Cassidy Horton is a finance writer based in Seattle, Washington. With an MBA and a bachelor's in public relations, her work has been published over a thousand times by The Balance, Finder.com, Money Under 30, Clever Girl Finance, and many more. Cassidy is a self-confessed money nerd who’s passionate about helping people find financial freedom. Oh, and she really loves cats.