What is a home equity line of credit and how does it work?

In a nutshell

A home equity line of credit (HELOC) is a second mortgage that enables you to borrow money from the equity you’ve built in your home. HELOCs generally offer lower interest rates than personal loans and credit cards.

  • A HELOC lender may let you borrow up to 85% of your home’s value, minus the outstanding balance on your mortgage.
  • Interest rates for HELOCs are generally variable, rather than fixed.
  • You can borrow as little or as much as you want, as long as you don’t exceed your credit limit.

How a HELOC works

A HELOC is a revolving line of credit, similar to a credit card. Unlike a credit card, though, a HELOC relies on collateral (your home) to secure the loan.

Related: Secured vs unsecured loans: What’s the difference?

Your home equity is calculated by subtracting any outstanding mortgage balances from your home’s current market value. For example, if your home is now worth $400,000 and you still owe $200,000 on your home loan, you have 50% equity. A HELOC enables you to withdraw a portion of this money for home renovations, consolidating high-interest debts or meeting other financial goals.

When you apply for a HELOC, your lender will determine your line of credit limit based on your home equity amount and your credit and financial history. As with a credit card, you can borrow as little or as much as you need as long as you stay within your credit limit. In most cases, you can access HELOC funds through online bank transfers or with a card that works like a credit or debit card.

How much money can I borrow with a HELOC?

The amount of money you can borrow with a HELOC depends on how much equity you have. Some lenders allow you to borrow up to 85% of your home’s value, minus the current balance on your mortgage.

Here’s an example of how this might work. Let’s say your home is valued at $300,000. If you want to borrow 85% of your home’s value, that comes to $255,000 (300,000 x 0.85 = 255,500). You then need to subtract the outstanding balance of your mortgage. So, if the mortgage balance is $150,000, you’d subtract that from the home’s value (up to 85%) to arrive at $105,500 (255,500 – 150,000 = 105,000). This means you may be able to borrow as much as $105,000.

What can I use a HELOC for?

You can use money borrowed through a HELOC for a number of purposes, including:

  • Consolidating higher-interest debts.
  • Paying for home improvement projects.
  • Covering college tuition.
  • Launching a new business.

If you use a HELOC or home equity loan for purposes other than buying, building or substantially improving the property securing the loan, you won’t be able to deduct the mortgage interest, according to IRS rules.

What is a HELOC draw period?

A lender normally attaches a draw period to a HELOC, such as 10 or 15 years. This is the amount of time you actively borrow from your credit line.

Once the draw period ends, the lender might renew your line of credit. If the HELOC isn’t renewed when the draw period expires, you’ll need to start paying off the amount you borrowed. You can make a one-time payment to clear the entire balance or monthly payments over a repayment period, usually up to 20 years.

Most HELOCs require interest-only payments during the draw period. After the draw period, the payments will include both the principal and interest. In some cases, you may be able to pay off the HELOC during the draw period. However, some lenders may charge a prepayment penalty if you do so.

You also can make payments toward the principal amount during the draw period. If you do this, the amount of money you can borrow from the line of credit goes up.

What is the interest rate for a HELOC?

Most HELOCs charge a variable interest rate, meaning it can increase or decrease over time. Interest accumulates during both the draw period and payoff period. You pay interest only on the amount you borrow, and not the full amount of the line of credit.

Factors that determine the interest rate (known as the annual percentage rate, or APR) include:

  • The amount of home equity you own.
  • Your credit history.
  • Your debt-to-income ratio.
  • Your employment status.

As of May 2024, a number of lenders were promoting HELOC rates as low as roughly 8% to 9%. That’s significantly lower than the typical credit card interest rate of nearly 21.6% in February 2024, according to the Federal Reserve Bank of St. Louis. HELOCs are secured loans because you are using your home as collateral. This means that the interest rate on a HELOC is generally lower than the rates on unsecured loans such as personal loans and credit cards.

How do you qualify for a HELOC?

Qualifying for a HELOC generally involves having:

  • Home equity of at least 15% to 20%.
  • Low debt-to-income ratio (ideally 43% or less).
  • Good credit score (ideally at least 680) and good credit history.
  • Proof of stable income.
  • Solid employment history.
  • Proof of homeowners insurance.

How to get a home equity line of credit

To get a HELOC, shop around with at least three different lenders to get the best interest rates and terms. Keep in mind that the HELOC with the lowest interest rate might not be the best option for you.

Related: Best home equity loans

The financial institutions that offer HELOCs are:

  • Traditional banks.
  • Online banks.
  • Credit unions.
  • Mortgage lenders.

When you’re considering different lenders for a HELOC, compare these borrowing requirements and items:

  • Home equity requirements.
  • Credit score requirements.
  • APRs.
  • Repayment terms (draw and repayment period lengths).
  • Loan costs such as application fees, appraisal fees and other third-party fees.

Steps to apply for HELOC

Similar to applying for your original home loan, you follow similar steps to apply for a HELOC, including:

  • Check your credit report: Before submitting a HELOC application, review your credit report and credit score to see if there’s any room for improvement. For instance, you might want to pay off some debt to lower your debt-to-income ratio and perhaps score a lower interest rate.
  • Gather financial documents: This may include tax returns, pay stubs, mortgage statements and property tax bills.
  • Fill out a HELOC application: You may be able to do this online, in person or over the phone. Among the pieces of information you’ll need to supply are your name, address, date of birth, Social Security number and a copy of a government-issued ID.
  • Verify your income: A loan specialist will review your application and seek proof of income, such as pay stubs and W-2 forms. You may be required to provide additional documentation if you’re self-employed or earn most of your income through commissions or bonuses.
  • Wait for the lender’s decision: Final approval may take two to six weeks.
  • Close on the loan: If the lender approves your application, it’s time to sign the paperwork and close on the HELOC. Your lender will either provide you with a card to withdraw funds or another form of payment, such as ACH wire transfers.

What are the risks associated with HELOCs?

While HELOCs have some advantages, there are also drawbacks and risks to know. These include:

  • Using your home as collateral: If you fail to make timely loan payments and you default on the mortgage, your lender might try to foreclose on your home.
  • Taking out a loan with a variable interest rate: Most HELOCs come with a variable interest rate, so the cost of your HELOC could go up if rates climb.
  • Reducing your home equity: A HELOC lowers your available home equity. So, if home values in your area fall, the amount you owe could exceed your home’s value, putting you underwater on your loan. If you need to sell your home, you’ll walk away with less net profit.

How does a HELOC differ from a home equity loan?

Home equity loans and HELOCs are both types of second mortgages, but they have two key differences:

  • A home equity loan provides your loan proceeds upfront in one lump sum, while a HELOC lets you borrow as little (or as much) money as needed over time as long as you stay within your credit limit.
  • A home equity loan usually comes with a fixed interest rate, while a HELOC has a variable interest rate.

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A HELOC can be a good way to tap your home equity to pay for a home improvement project, consolidate higher-interest debts or cover education expenses. But relying on your home equity comes at a cost: You’ll pay interest on the amount you borrow and you might have to pay loan fees, in addition to your regular mortgage payments. On top of that, you risk losing your home to foreclosure if you fall behind on payments.

Frequently asked questions (FAQs)

What is the purpose of a home equity line of credit?

A home equity line of credit allows you to borrow a portion of your home’s value to consolidate high-interest debt, pay for home improvements or other financial goals.

What happens if I default on a HELOC?

If you default on or fail to repay a HELOC, the lender could foreclose on your home.

Is it a good idea to have a home equity line of credit?

A HELOC may be worth considering if you have sufficient equity in your home and need access to cash over a period of time at a lower interest rate than you’d typically get with a credit card or personal loan.

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