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What is a Home Equity Line of Credit (HELOC)?

Key takeaways

  1. A HELOC is a revolving credit line secured by your home equity, often allowing you to borrow up to roughly 75% to 90% of available equity.

  2. You draw funds for about 10 years, sometimes with interest-only payments, then repay principal and interest over 10-20 years with no new borrowing.

  3. HELOCs can provide flexible, lower-cost borrowing for things like home renovations, emergencies, or consolidating high-interest debt.

A home equity line of credit (HELOC) is a revolving line of credit that lets you borrow against home equity, which is the difference between your home’s market value and what you owe on your mortgage. With a HELOC, you can typically borrow up to a certain percentage of your home’s equity—often around 75% to 90%.

This article will explain how HELOCs work, what the benefits and risks are, and whether a HELOC might be right for you.

How does a HELOC work?

In some ways, a HELOC works like a credit card. One big difference is that a HELOC operates in two phases: the draw period and the repayment period. Different lenders offer different terms on their HELOCs.

What is a HELOC draw period?

During the initial HELOC draw period, you can access your funds using checks or a debit card. The typical draw period is 10 years, after which funds can no longer be borrowed.

During the draw period, you can

  • Borrow money as needed. It can used for a wide range of purposes, including debt consolidation, home renovation financing, emergency expenses, and big purchases
  • Make payments. These could be interest only payments or interest plus principal, depending on the loan
  • Borrow funds again. As you repay what you've borrowed, you rebuild the total amount available to borrow

What is a HELOC repayment period?

After the draw period ends, your HELOC enters the repayment period, which typically lasts 10 to 20 years. During this time:

  • You can no longer borrow
  • Payments include principal and interest
  • Monthly payments could increase significantly

What are the benefits of a HELOC?

A home equity line of credit could provide significant benefits.

1. Flexible access to funds

You can use as much of the line of credit, up to the maximum, or as little as you need. Some lenders, however, require a minimum initial draw, from as little as $500 to as much as $10,000, depending on the size of the loan.

2. Lower interest rates than credit cards

The average annual percentage rate (APR) on credit cards tends to be higher than the interest rates charged for HELOCs.

3. Pay interest only on what you borrow

You can borrow only what you need, so interest is charged only on the amount you're using. This differs from fixed-term loans in which you borrow a set amount and begin paying interest immediately based on that amount.

4. Potential tax benefits

Under tax law changes made in 2017, HELOC interest is tax deductible if the funds are used to buy, build or substantially improve a primary residence. 

What factors should I consider when looking at a HELOC?

If you're considering taking advantage of a HELOC's benefits, there are several factors to keep in mind.

1. Variable interest rate HELOCs

HELOCs tend to have variable interest rates, which means you could eventually face higher monthly payments and pay more in interest than you expected. Some lenders offer fixed-rate options, which could protect you from increased market rates but don't benefit you if interest rates fall.

2. Risk of overspending

Ease of access and low upfront costs are among the attractions of HELOCs. Some borrowers may be tempted to spend more than they can afford.

3. Your home is the collateral

Because your home services as collateral for a HELOC, you could risk foreclosure if you fall behind on payments or can't make the required payments. 

4. Payment shock after the draw period ends

HELOC borrowers sometimes are surprised at how much monthly payments increase when the draw period ends, especially if they have just been making interest-only payments. Some HELOCs require a "balloon payment" to pay off the remainder of the loan at the end of the repayment period. However, lenders might allow you to refinance the balloon payment. A HELOC calculator can help you estimate monthly payments, amortization, and a payoff timeline based on a variety of factors. 

What are the best uses for a HELOC?

Experts recommend that home renovation financing is one of the best uses for a HELOC because it will increase the value of your home, which is the collateral for the loan. This can include additions and the construction of an accessory dwelling unit (ADU), such as an in-law suite or rental.

Other uses include: 

  1. Emergency fund. Having a HELOC in your pocket is a hedge against unanticipated expenses. Avoid lenders who require minimum initial draws or impose fees for inactivity

  2. Debt consolidation. High-interest credit cards can be paid off with a HELOC, but this is only useful if you don't go back to using those cards

  3. College expenses. A HELOC can cover costs not covered by grants, scholarships, and loans. The interest may be tax deductible if funds are used for qualified educational expenses

  4. Major purchases with planned repayment. If you're looking to purchase something that doesn't qualify for conventional financing, a HELOC may help. As always, it's prudent to have a repayment plan in place

How does a HELOC compare to a home equity loan?

There are two home equity borrowing options, and you might benefit by comparing a HELOC vs. a home equity loan. Here are some features of each. 

HELOC

A HELOC taps the equity you've built up in your home with a revolving line of credit, much like a credit card.

A HELOC taps the equity you've built up in your home with a revolving line of credit, much like a credit card.

  1. Revolving credit. As you pay back the principal, you can re-borrow it

  2. Variable rates. HELOCs tend to have variable interest rates that fluctuate based on the prime rate. These rates tend to be lower than credit card interest rates

  3. Interest-only payments during the draw period. HELOC interest-only payments keep monthly payments low and provide significant cash flow flexibility during the initial years of the loan

  4. Flexible withdrawals. As the name says, a HELOC is a line of credit that you can tap when you need to for the amount you need. Funds are accessible with checks and debit cards

Home equity loan

A home equity loan (HELOAN) also lets you tap your home's value, but it's more like a personal loan than a credit card. 

  1. Lump sum amount. You borrow a fixed amount that is based on your home equity and credit history

  2. Fixed rate. Home equity loan interest rates fluctuate with the bond market, but your interest rate will remain the same for the life of your loan

  3. Predictable monthly payments. The fixed rate means payments stay the same, so you know what your payment will be each month

  4. Useful for large, one-time expenses. A home equity loan is a good choice if you have a specific project with a known cost, such as a $20,000 kitchen renovation

Are you ready for a HELOC?

The lender will evaluate whether you meet its HELOC credit requirements. Lenders have different criteria for loan approval, but they might include:

  •  Home equity of at least 20% based on your existing mortgage
  • A credit score at least in the mid-600s and solid credit history, with an acceptable debt-to-income ratio and steady income
  • The capacity to manage variable payments each month

FAQs

Experts say that the best use for a HELOC is to improve the value of your home with renovations, upgrades, and additions, which can significantly raise your equity. HELOCs can also be used as a source of funds for emergencies, debt consolidation, college expenses, and major purchases.

HELOC interest might be deductible if the loan is used for qualifying home improvements. Interest paid on funds used for qualifying college expenses may also be deductible. Be sure to consult a tax professional.

You can typically borrow up to 75% to 90% of your home equity based on the existing mortgage and the HELOC's requirements. Home equity is the difference between the market value of your home and what you owe on an existing mortgage.

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