What is a HELOC and how does it work?
Homeowners have several options for tapping into their equity for cash. Home equity lines of credit (HELOCs) are one of the most popular choices for this. If you’re considering a HELOC, it’s important to understand how they work, plus the costs and potential risks before you borrow.
Here’s what to know about HELOCs, how they work, and when you might (or might not) want to use one as a homeowner.
What is a HELOC loan?
HELOCs are a type of revolving credit line that allow you to borrow against your home’s equity, which is the portion of the home you actually own. Your home is used as collateral to secure the loan, meaning you risk foreclosure if you can’t make your payments.
Homeowners use HELOCs for a variety of reasons, with home renovations being one of the most common. Many also use HELOCs to consolidate high-interest debt, as home equity products tend to have lower rates than unsecured options like credit cards.
How does a HELOC work?
A HELOC works similarly to a credit card. You can withdraw funds from your credit line up to a certain limit on a repeated basis until the end of your HELOC’s draw period, which can typically last for up to 10 years. During this time, you might be required to make interest-only payments.
After the draw period ends, you’ll enter the repayment period. This is when you’ll start making monthly payments to repay the balance you’ve acquired. This period can last for up to 20 or 30 years, depending on the lender.
How much can you borrow on a HELOC?
The exact amount you can borrow with a HELOC is going to vary based on the lender you choose. Typically, lenders will let you borrow between 80% to 95% of your home’s value, minus your outstanding mortgage balance.
So for example, say your home is valued at $400,000, and you still owe $150,000 on your mortgage. If your lender allows you to borrow up to 80% of your home’s value, your potential HELOC borrowing power would be $320,000 ($400,000 x 80%). Subtracting your $150,000 mortgage balance from this leaves you with a maximum HELOC limit of $170,000.
There are other factors that play a role in what you can borrow, too, such as your credit score, your debt-to-income (DTI) ratio, and more. Lenders will also consider your combined loan-to-value (CLTV) ratio to help determine your loan amount. To calculate this, you’d add your original mortgage balance and the amount you’d like to borrow with a HELOC, then divide this by your home’s appraised value.
HELOC costs
Getting a HELOC isn’t free. You’ll want to consider the borrowing costs — both now and in the long run — before applying for one.
HELOC rates
Interest will likely be the biggest cost you face with a HELOC. And while HELOC interest rates are typically lower compared to those for credit cards and some other types of loans, you could still pay a hefty amount over the long haul.
HELOCs usually have variable rates, which can fluctuate based on the index rate it’s tied to. This means your rate and payments can go up or down, which can make them harder to budget for. Variable rates tend to start out lower than fixed rates on HELOCs; however, your rate could increase later, so savings aren’t guaranteed.
Some lenders also offer fixed-rate HELOC options. With a fixed rate, you’ll have the same rate and payment from Day 1 until you pay your loan off. Fixed rates can start off slightly higher than variable rates due to the consistency they provide.
HELOC closing costs
HELOCs also typically have closing costs, which are the various fees you’ll pay for processing the loan, appraising your house, and other necessary services. These can vary quite a bit, but on average, you’ll pay around 2% to 5% of the HELOC amount. That would be $2,000 to $5,000 for every $100,000 you borrow.
Fees on a HELOC
There can be other fees associated with a HELOC, too, depending on the lender. Additional fees might include the following:
- Annual fee or membership fee for each year you have the HELOC
- Inactivity fee if you don’t use the HELOC
- Conversion fee if you want to convert some of your balance from a variable rate to a fixed one
- Cancellation or prepayment fee if you terminate your HELOC early
HELOC eligibility requirements
Every lender will have its own HELOC requirements. However, you’ll typically need to meet the following guidelines to qualify for a HELOC:
| Criteria | Requirement |
|---|---|
| Maximum DTI ratio | 50% to 55% |
| Minimum credit score | 620 |
| Minimum equity | 10% to 20% |
| LTV ratio | 85% |
You'll also usually need an appraisal to confirm your home’s value, though this isn’t always the case.
How to apply for a HELOC
To apply for a HELOC, you’ll need to:
- Find a lender. Many banks and mortgage companies offer HELOCs, so be sure and shop around for the best deal.
- Fill out an application. Most will let you do this online through a secure platform.
- Upload your documentation. This might include your government ID, proof of residency, pay stubs, W-2s, tax returns, bank statements, retirement and brokerage account statements, and statements for your current mortgage.
- Get your home appraised. The lender will order an appraisal to determine your home’s current value.
- Pay any closing costs. Some HELOCs may come with closing costs, which can include things like application fees, origination fees, appraisal fees, and more.
- Close on your loan. This is when you’ll sign your paperwork and finalize the loan.
HELOC alternatives
If a HELOC doesn’t seem like the right fit for you, there are other options. Here are some alternatives to consider:
- Home equity loan: This is another way to tap into your equity. But instead of getting a credit line as you would with a HELOC, a home equity loan provides a one-time, lump-sum payment that you can use however you’d like. You’ll start repaying the loan immediately after closing, much like a traditional mortgage or personal loan.
- Cash-out refinance: Another equity option, a cash-out refinance pays off your current mortgage with a larger loan and gives you the difference back in cash. Just keep in mind that because it’s a new loan, you’ll have a different interest rate and term, which could be costly if you have a particularly low interest rate on your current loan.
- Personal loan: If you’d rather not use your home as collateral, you could consider a personal loan, which can range from a few hundred dollars up to $100,000, depending on the lender. Most personal loans are unsecured, meaning they don’t require collateral. Because this can be riskier for the lender, personal loan rates tend to be higher than those of HELOCs and other mortgage loans.
Is a HELOC a good idea?
Whether a HELOC is a good idea depends on your personal situation and goals. For example, taking out a HELOC could be ideal if you have plenty of equity and want access to a revolving credit line to cover recurring expenses, such as with ongoing home repairs. A HELOC can also be helpful if you aren’t sure exactly how much you want to borrow. But if you want the funds to pay for unnecessary expenses or have only smaller costs to cover, then a HELOC might not be the best fit.
It’s critical to remember that these loans use your home as collateral, so if you’re not sure you can make the payments, you might want to explore less risky options.
Keep reading: Is a HELOC a good idea?
HELOC FAQs
No. With a HELOC, you'll only pay interest on the amount you actually withdraw from your credit line. You don’t pay interest on any unused credit.
The main drawback of a HELOC is that it uses your home as collateral and puts your home at risk of foreclosure if you don’t make your payments. Another disadvantage is that HELOCs often come with variable interest rates, which can make your payments unpredictable.
It’s only a good idea to borrow from your home equity if you know you can make the payments on the loan. If you can’t, the lender could foreclose on your property.
The interest on a HELOC can be tax-deductible, but only if you use the HELOC funds to buy, build, or substantially improve your home. If you use the money for other purposes, the interest you paid isn’t tax-deductible.
