What is a home equity line of credit (HELOC)?
July 19, 2022 5 min read
Home equity is the value a homeowner might build in their home over time. It’s defined by the difference between the current market value of a residence and what’s still owed on a mortgage.
One way to tap into that value is with a home equity line of credit (HELOC). Here’s a closer look at what a home equity line of credit is, how it works and what it can be used for.
- A HELOC is a line of credit that lets you borrow against the value of your home.
- HELOCs are a form of revolving credit.
- HELOCs are a form of secured debt.
- Falling behind on HELOC payments could result in losing a home.
What is a HELOC?
A home equity line of credit, also known as a HELOC, is a revolving line of credit that allows people to borrow against the equity in their homes. In some ways, HELOCs function a lot like credit cards.
HELOCs are also a form of secured debt, with the home acting as collateral. That means borrowers who default are at risk of losing their home.
Most HELOCs have variable interest rates, which can go up or down based on the prime rate.
How does a HELOC work?
If you apply for a home equity line of credit, the lender will start by determining the current value of your home through an appraisal. Lenders will limit the amount you can borrow to a certain percentage of this appraised value minus what you still owe on the home.
For example, let’s say a home with $60,000 remaining on its mortgage appraises for $200,000. If the lender agrees to lend 75% of the appraised value, that equals $150,000. After subtracting the $60,000 still owed, the bank might approve a HELOC for $90,000.
However, lenders may also look at other qualifying factors to determine exactly how much credit to extend. These might include credit scores, credit history and debt-to-income ratios. These factors could also influence the interest rate offered on a HELOC.
Using a HELOC
Once a HELOC is approved, borrowers are typically issued special checks or a card to access funds. The time when the money is accessible is known as the draw period. And draw periods usually last for a fixed amount of time, such as 10 years.
During draw periods, money can be borrowed and then repaid to restore how much credit is available. Depending on the terms of the HELOC, there might be minimum amounts required to make withdrawals.
But it’s helpful to be aware of potential fees that come with using a HELOC. Fees can vary by lender, but there could be prepayment penalties, annual fees or fees for inactivity.
Repaying a HELOC
The repayment terms of HELOCs may differ from lender to lender. Some HELOCs require borrowers to repay part of the principal each month. Other HELOC plans may have an interest-only draw period. This means that, during draw periods, borrowers may only be required to make interest payments on the money they take out.
At the end of the draw period comes the repayment period. Lenders may require borrowers to pay back the outstanding balance plus interest during this time. It may be in a balloon payment, where everything must be paid at once. Or repayment periods could stretch over many years. There may also be opportunities to renew the line of credit.
If someone who has a HELOC decides to sell their home, they’ll probably be required to pay back the HELOC and interest before the sale can take place.
What can you use a home equity line of credit for?
Many homeowners use a home equity line of credit to make home improvements, using their home’s own equity to further boost its value. One reason this is a popular choice is that the interest paid on these upgrades is tax deductible up to a certain amount when funded using a HELOC.
People may also use HELOCs for other reasons. A few examples:
- Debt consolidation
- Medical expenses
- Business expenses
- Wedding expenses
- Tuition costs
HELOC vs. home equity loan
A home equity line of credit and a home equity loan both let people borrow against the value of their homes. But they’re not the same. Here’s a breakdown of some possible differences between the two:
Home equity line of credit
- Funds can be borrowed as needed.
- May have a variable interest rate.
- Monthly payments may vary based on how the HELOC is used.
- Draw period might include interest-only payments.
Home equity loan
- Loan amount disbursed upfront in one lump sum.
- May have a fixed interest rate.
- Installment payments are typically the same every month.
- Repayment begins as soon as the funds are disbursed.
Pros and cons of a home equity line of credit
A HELOC can be a great option if you’re unsure how much money you need to borrow, but it also comes with some drawbacks. Take a closer look at the pros and cons of taking out a home equity line of credit:
- You can withdraw money as needed.
- May have a lower interest rate than other types of credit, thanks to collateral.
- You may only be required to pay interest on the amount of money you use, not the full credit line amount.
- Variable rates can lead to increased interest payments over time.
- May include additional fees, such as cancellation fees, annual fees, application fees, appraisal fees and closing costs.
- If you don’t make the payments, you risk losing your home.
HELOCs in a nutshell
A home equity line of credit gives you a flexible way to borrow against the equity built in your home, but it also carries certain risks. If you’re considering shopping for a home equity line of credit, be sure to read your lending agreement carefully to ensure you understand the costs of establishing the plan and the terms of repayment.
If you’re unsure whether a HELOC is the right product for you, check out our guide to the different types of revolving credit to see if there’s another borrowing option that better suits your needs.