How Does a HELOC Work?

Owning a home comes with quite a few benefits. You don’t need to worry about anyone raising your rent. As you pay down your mortgage, you build home equity. And if you’re ever in need of some cash, you could tap into that equity with a home equity line of credit, or HELOC for short.

A HELOC is a revolving line of credit. That means you can borrow from it multiple times, similar to a credit card. Your home is the collateral on a HELOC.

Under the right circumstances, a HELOC can be a good way to use your home's equity as a tool to reach financial goals. You could get one to cover a large expense, such as a remodel, or consolidate high-interest debts as a form of debt relief. For the best results, it’s important to understand how a HELOC works before you borrow.

How HELOCs Work

Here’s how a HELOC works from start to finish:

1. You apply with a HELOC lender.

2. If approved, the lender sets a credit limit.

3. You can borrow repeatedly during the draw period.

4. You repay your HELOC during the repayment period.

That’s the general idea. Now, let’s take a closer look at each step in the HELOC process.

Application process

HELOC applications normally ask for your personal information, including your name, date of birth, and Social Security number, and employment information. Be prepared to provide your income, employment status, and proof of income.

Most HELOC lenders will also check the following during the application process:

• Credit score: Since you’re applying for a loan, there’s normally a credit check. Credit score minimums for a HELOC vary from lender to lender, but a 620 minimum is fairly common.

• Home value: Lenders typically conduct an appraisal of your home to check your home equity—how much the home is worth compared to how much you owe.

• Debt-to-income (DTI) ratio: Your DTI ratio is your monthly debt payments divided by your income. For example, if you have $2,000 in debt payments and $5,000 in income, your DTI ratio is 40% ($2,000 divided by $5,000). You may need to reduce your DTI ratio if you already have high debt payments for your income.

HELOC limits

When it comes to how much you can borrow with home equity, lenders generally let you borrow up to about 80% to 85% of your home’s value. That limit includes your original mortgage and your HELOC.

Say you have a home worth $300,000 and your mortgage balance is $200,000. Since 80% of your home’s value is $240,000, you may be able to borrow up to $40,000 with a HELOC.

Draw period

A HELOC draw period is the first phase, usually lasting five to 10 years. The draw period is when you can borrow money from your HELOC. You can borrow up to the maximum credit line, and as you pay down your balance, you can borrow more.

HELOC withdrawal options depend on the lender but may include:

• ACH transfers to your bank account

• Convenience checks you can use that are linked to your HELOC account

• A debit card linked to your HELOC account

• Wire transfers to your bank account (these are normally faster than ACH transfers but often have an extra fee)

Many lenders allow interest-only payments during the draw period. Others require full payments of the interest and loan principal (the amount you borrowed) from the beginning.

Repayment period

A HELOC repayment period is the second phase, usually lasting five to 20 years depending on the lender and term. You can’t make any more withdrawals during the repayment period.

You’ll also need to make full interest-and-principal payments, meaning payments go toward interest charges and the principal that you originally borrowed. If you were making interest-only payments before, then your monthly payment amount will likely increase.

How HELOC Interest Rates Work

Most HELOCs have variable interest rates. A variable rate can increase or decrease during the life of the loan. If interest rates in the U.S. go up, then the rate and monthly payment on a variable-rate HELOC could also increase.

While uncommon, there are also HELOCs with fixed interest rates. A fixed-rate HELOC has the same interest rate from start to finish.

Pros and Cons of HELOCs

Here are the biggest benefits of HELOCs:

• A flexible way to borrow: HELOCs normally allow you to borrow up to the credit limit as needed. This flexibility is helpful if you need to borrow for ongoing expenses, such as a home improvement project.

• Competitive interest rates: Since HELOCs are secured by your home, interest rates tend to be lower than with personal loans and credit cards.

• May have high credit limits: If you have enough home equity, you could qualify for a large HELOC.

• Payment flexibility: With many HELOC lenders, you only need to pay interest charges during the draw period.

HELOCs also have a few notable drawbacks:

• Use your home as collateral: If you default on a HELOC, the lender could pursue foreclosure. Only get a HELOC if you’re 100% confident you can pay it back.

• Closing costs: You typically need to pay about 2% to 5% of the total HELOC amount in closing costs.

• Variable-rate HELOCs can get more expensive: Make sure you can easily afford your HELOC payments in case rates increase. Or, opt for a fixed-rate HELOC so your rate stays the same the entire time.

• Could lead to more debt: The tradeoff to a HELOC’s flexibility is that you could end up borrowing more overall, since you can reuse your HELOC as you pay down the balance. If you think you’d do better with a fixed loan and payment amount, consider a home equity loan instead.

Should You Get a HELOC?

A HELOC could be right for you if you want to borrow a large amount of money at a reasonable interest rate. Some of the most common ways to use a HELOC are debt consolidation, home remodels or repairs, college tuition, and medical bills.

If you have enough home equity and the credit to qualify for a HELOC, it may be your best option. Just make sure you have a plan for how you’ll use and repay the money. That way, you can get the most out of your HELOC and get it paid off on schedule.