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

Updated 8 min read

Thanks to elevated home prices, many homeowners have found themselves with an unexpected boost in their home equity. That creates an opportunity to borrow with a home equity loan or home equity line of credit (HELOC). Whether you'll be approved for a HELOC will depend on your income, debt-to-income ratio, employment record, and credit history, as well as how much equity you have in your home.

A second mortgage is a big commitment, but as a credit line, a HELOC offers a lot of flexibility. In fact, you don't even have to borrow any money immediately after you get a HELOC; you can just keep the line open until you're ready to tap it. When you do borrow, you'll have a lot of options for how to use and repay those funds.

Dig deeper: How to buy a second home

A HELOC is a type of second mortgage that is a revolving credit line secured by your home equity. Your home equity is the portion of your home's value that exceeds the combined balances for your original mortgage and any home equity loan or HELOC that you have.

Unlike a home equity loan, a HELOC doesn't give you an up-front lump sum of cash. Instead, you can borrow as much or as little as you want, up to your credit limit, and then repay — and reborrow — those amounts when you choose. A HELOC works more like a credit card than a traditional loan.

Most HELOCs have a variable interest rate, which can go up or down depending on various economic factors.

One advantage of a HELOC compared with a home equity loan is that with a HELOC, you'll only be charged interest on the amounts you borrow. That doesn't necessarily mean a HELOC that you open but never use will be free of charges. You might have to pay closing costs and a variety of other fees as well as interest.

Tip: Although HELOCS typically have adjustable rates, some HELOCs allow you to lock in a fixed interest rate for all or a portion of your balance during your draw period. With this option, you can set up a repayment schedule and eliminate the risk of a higher rate on that portion of your debt while you continue to have access to draw any remaining funds up to your credit limit.

Learn more: What is an adjustable mortgage rate?

Most HELOCs have a "draw" period, during which you can borrow and, if you choose to, repay and re-borrow the same funds repeatedly. Borrowing may be as easy as writing a check or swiping a credit card linked to your HELOC. You might also be able to request a cash advance or transfer funds from your HELOC to a checking or savings account.

The draw period is typically 10 years. At the end of your draw period, you may be able to renew your HELOC with a new draw period or by refinancing your HELOC into another type of loan.

If you don't renew or refinance, you'll have to pay off your remaining balance, including principal and interest charges, during the “repayment” period. Repayment may be due immediately or over a fixed repayment term, depending on the terms of your HELOC agreement.

If you sell your home during either your draw or repayment period, you'll probably have to pay off your HELOC with the home sale proceeds.

By tapping into your home equity with a HELOC, you are taking out a second mortgage. There are several factors to consider before taking this step.

  • Tap into your home equity without affecting your original mortgage term or rate

  • Use the money however you see fit, from home improvements to paying off student loans or credit card debt

  • A line of credit gives you the option not to borrow the full amount you're approved for (and you don't pay interest on the money you don't borrow)

  • A variable interest rate means your rate could fall if market rates decrease

  • You'll usually only make interest-only payments during the draw period

  • Interest payments may be tax-deductible

  • You'll have two monthly home loan payments, not just one

  • A variable interest rate means your rate could rise if market rates increase

  • Your home is collateral for paying off your HELOC, which means there is a risk of foreclosure if you don't make payments

  • Monthly payments will increase during the repayment period, when you switch from interest-only payments to also paying off the principal

Before you apply for a HELOC, you should consider these questions:

  • Is your credit score high enough? Many lenders expect HELOC borrowers to have a very good or excellent credit score.

  • Do you have enough equity in your home? Most lenders expect HELOC borrowers to have at least 15% to 20% equity in their home. The lender may require an appraisal of the value of your home to determine how much equity you have.

  • Is your debt level too high? Lenders use your debt-to-income (DTI) ratio to assess whether your income is adequate for managing your debt. While these ratios differ by lender, if your DTI is higher than 43%, you may need to increase your income or pay off some other debt you owe to qualify for a HELOC.

  • Can you prove stable income and a strong history of on-time payments? You'll need to provide copies of your recent pay stubs, IRS Form W-2s, income tax returns, or other documents to demonstrate how much you earn.

  • Do you need access to extra cash from time to time to make home improvements or repairs, consolidate debt, or for other purposes?

  • Are you confident you can afford the monthly payments? If interest rates go up, your monthly payment may be significantly higher than you expected. Even if rates don’t rise, you’ll need to be able to pay interest charges and other fees.

  • How comfortable are you with risk? If your financial situation changes or your home's value decreases, your lender may lower your credit limit or curtail your ability to draw additional funds, not to mention the risk of losing your home if you fail to make payments.

To get a HELOC, choose a mortgage lender and provide all the necessary documents for an application, such as bank statements and tax returns. You can use the same lender that gave you the original mortgage loan, but you don't have to.

You'll need to schedule a home appraisal so the lender knows how much your house is worth, and thus the amount of equity you have to borrow from. When you close on the HELOC with your lender, you'll start the draw period.

If you're curious about alternatives to a HELOC, you may want a cash-out refinance, home equity loan, personal loan or personal line of credit, or home equity conversion mortgage, among other options.

A cash-out refinance replaces your current home mortgage with a new mortgage that has a higher balance. A portion of your new loan is used to pay off your existing loan. The remainder, after closing costs are paid, is provided to you in a lump sum.

Read more: Cash-out refinance vs. HELOC

A home equity loan is a second mortgage with a fixed loan amount and repayment term. This type of loan typically has a fixed rate and fixed monthly payment.

Dig deeper: HELOC vs. home equity loan

A personal loan or line of credit is a loan that's not secured by your home or a car, though it may be secured by other assets that you own. This type of loan typically has a higher interest rate, a fixed term for the loan, and an adjustable rate for the line.

A home equity conversion mortgage (HECM), also called a "reverse mortgage," allows older homeowners to borrow against their equity. This type of loan generally doesn't require repayment until the borrower dies, moves out of their home, or sells their home.

If a HELOC sounds like a good choice for your needs, you may be ready to talk with a mortgage lender about applying for this type of credit line.

Yes, HELOC stands for home equity line of credit.

The biggest disadvantage of a home equity line of credit (HELOC) is probably that many lenders only offer HELOCs with adjustable rates, not fixed rates. This means your rate could increase later if market rates are trending upward overall.

It's relatively easy to get a HELOC, as long as you have enough equity in your home to qualify.

Yes, you pay back a HELOC, since it is a type of second mortgage. Once your draw period is over and you cannot borrow money anymore, you'll enter the repayment period, which can be as long as 20 years. You'll pay interest on your HELOC along with the principal.

HELOC interest may be tax-deductible if you use the money for specific expenses, such as a home renovation.

A HELOC term can last between five and 30 years. HELOC rates depend on your term length and financial profile, but you can expect to pay around 8.50% to 9.50% right now.

Yes, there is no limitation on how you can use the money from your HELOC. Just remember that the interest paid on a HELOC is only tax-deductible if it's used for specific expenses like home improvements.