What is a HELOC?

What is a HELOC?

A HELOC (home equity line of credit) is a revolving form of credit with a variable interest rate, similar to a credit card. The line of credit is tied to the equity in your home. It allows you to borrow and repay funds on an as-needed basis during a specified period of time. After that, you’ll pay back the amount you borrowed in installments.

Your home is the collateral for the line of credit, which means falling behind on payments puts your home at risk of foreclosure.

HELOC variable and fixed interest rates 

The interest rate on a HELOCs is variable — that is, it changes periodically, moving up or down in accordance with general interest rate trends. The HELOC’s rate is usually tied to an index of interest rates that fluctuates. The interest rate on your variable HELOC will reflect the performance of this index — plus an additional markup of several percentage points that your lender tacks on. 

The variable interest rate means the minimum required payment on your HELOC can change from month to month. Some lenders, however, allow borrowers to convert a portion of the outstanding variable-rate balance on a HELOC to a fixed interest rate. As a result, you can lock in a rate so that your payments will no longer vary and instead you’ll have stable, predictable amounts to repay. This can typically be done any time during the HELOC’s draw period. 

In addition, it’s also possible to obtain a fixed-rate HELOC, meaning the interest rate you pay on money borrowed remains the same for the life of the draw period and during the repayment period as well.

How does a HELOC work?

When you’re approved for a HELOC, you’ll be given a credit limit based on your available equity in your home. Borrowers can usually tap up to 80 percent of their home’s value (sometimes as much as 85 or 90 percent, depending on lender policy and if they’re very well-qualified), minus outstanding mortgage balances.

During an initial draw period, you can spend the funds using dedicated checks, a draw debit card or online transfer. You’ll need to make monthly interest payments on the amount you borrow, but as you pay back your HELOC, the funds will be replenished. This draw period typically lasts 10 years.

After that, you’ll enter a repayment period, during which you’ll no longer be able to access funds and instead need to repay the principal and any outstanding interest. Most HELOC plans allow you to repay the remaining balance over a period of 10 years to 20 years.

While you’ll often only be on the hook for interest payments during the draw period, you can pay both principal and interest during this phase if you choose. This can help keep your payments manageable when you enter the repayment period.

“Maximize your HELOC by reviewing your balance during the draw period to make sure you aren’t overspending,” says Linda Bell, senior writer on Bankrate’s Home Lending team. “To manage payments effectively, you can explore options such as interest-only payments or fixed-rate conversions. By incorporating HELOC payments into your long-term financial plan, you can protect your financial well-being and keep your home safe from potential risks.”

Why HELOCs are popular in 2024

Approximately 1.3 million HELOCs were originated in 2023, and then half a million through the second quarter of 2024, according to the Federal Reserve Bank of New k York. These numbers are comparable to pre-pandemic levels. But what’s really interesting is that, after nearly 13  years of decline, HELOC balances have begun to rebound, gaining 20 percent since bottoming out in 2021.

A lot of the appeal lies in their flexibility – HELOC funds can be tapped on an as-needed basis, providing homeowners a cushion against unexpected expenses. Borrowers appreciate the option to take out only what they require and pay interest only on what they use.

Also adding to their appeal of late: They’ve gotten less expensive. Rates began retreating at the start of 2024 and as of October have plunged to their lowest levels in more than a year – spurred on by the Federal Reserve cutting its benchmark interest rate in September.

HELOCs remain less expensive than other forms of consumer debt, like credit cards and personal loans. And, unlike a cash-out refinance — the old go-to way to tap a homeownership stake — HELOCs allow a homeowner to hang onto a mortgage with a low interest rate.

Thanks to rising residential real estate values, homeowners interested in making the most of the lower rates have plenty of equity to tap into. As of August 2024, 32 million mortgage holders have at least $100,000 in tappable equity, while some 4.6 million have at least $500,000 in equity. In addition, nearly 1.2 million have $1 million or more, according to data analyst ICE Mortgage Technology.

HELOC requirements

There’s no one-size-fits all set of requirements to qualify for a HELOC. That said, the criteria commonly include:

• Amount of home equity: Lenders typically require homeowners to have at least 15 percent to 20 percent equity in the home.
• Credit score: Homeowners generally need a credit score in the mid-600s — at least — to qualify for a HELOC. If you’re approved with a lower credit score, you’ll likely have a higher interest rate.
• DTI ratio: Many lenders want to see a debt-to-income (DTI) ratio of 43 percent or less. However, certain lenders might approve you with a DTI ratio of up to 50 percent.

How to apply for a HELOC

• Review and strengthen your credit. A strong credit score, ideally in the 700s, will get you the most favorable rate and terms. To improve your credit, make all payments on time — catching up on any past-due ones — and try to settle or at least pay down any outstanding balances. Review your credit report to correct any errors. Do all this several months before you actually apply.
• Find a HELOC lender. Shop around and compare offers. Even a small difference in interest rate can save you thousands in the long run. Learn whether the HELOC lender charges annual maintenance or early closure fees.
• Apply for the HELOC. Depending on your lender, you can do this in several ways: in person, over the phone or online. However you apply, you’ll need to provide your residence history and income and employment information. You’ll also need to verify your identity and give permission for the lender to pull your credit reports.
• Hurry up and wait. The lender will order an appraisal of your home to determine its current value. The appraiser’s assessment of overall home worth determines how much equity you have available, which in turn helps set the size of your line of credit. Your lender might get back to you with a preapproval or an initial decision within days; others require you to wait until the whole underwriting process is done.

How do I access funds with a HELOC?

To access HELOC funds with a HELOC, you can typically use checks, a debit card, or make online transfers from one account to another. The specific methods depend on the lender you choose.

When considering how to use your HELOC, there are a few more details to keep in mind:

1. Minimum draw requirements and potential fees: Some HELOCs mandate minimum withdrawals, impose transaction fees each time you access funds or charge an annual maintenance fee. It’s wise to clarify these terms with your lender beforehand.
2. Withdrawals: To manage your finances effectively, withdraw only the amount you need and make timely payments. This helps you minimize interest charges and can positively influence your credit score.
3. Repaying the principal: Many HELOCs allow you to make minimal, interest-only repayments during the draw period. Tempting as that might be, making principal payments — if you’re able to — can reduce the balance you’ll owe in the repayment period.
4. Early payoff penalties: Conversely, if you pay off your entire and close the HELOC early — within the first two or three years after you open it, or ahead of the payment-period schedule — you might incur an early termination or cancellation fee.

How much can you borrow with a HELOC?

The amount you can borrow with a HELOC depends on several factors, including your creditworthiness, the value of your home and of your equity stake, and your loan-to-value ratio (LTV) — the sum total of all your home-based debt vis-à-vis your home’s value. Typically, lenders will allow you to borrow up to 80 to 90 percent of your home equity.

For example, if your home is valued at $300,000 and your mortgage balance is $200,000, you have $100,000 in equity. If the lender demands you keep 20 percent of that stake untapped, you could have a line of credit of $80,000.

You don’t have to use the full amount of your HELOC all at once. You can choose to spend part of your allowable credit, and the remaining amount will still be available for you to use in the future. For instance, if you have $100,000 in available credit and only use $65,000, you’ll still have $35,000 left in your credit line. You’re only required to pay back the portion of credit you use.

How to calculate your HELOC borrowing limit

When considering your HELOC application, lenders look at the equity you have in your home. Equity is the value of your home minus what you still owe on your mortgage.

Say your home appraised at $375,000 and you still owe $150,000 on your mortgage. Your total equity, then, would be $225,000 ($375,000 – $150,000).

You can also determine your level of equity by calculating your loan-to-value ratio (LTV). Simply divide $150,000 by $375,000, then multiply by 100 for a percentage. In this case, you’d have a 40 percent LTV ratio. This means you’d have 60 percent equity (or $225,000) in your home.

With a HELOC, you can usually borrow up to 80 percent of your combined LTV (CLTV). The CLTV takes into account the value of your home and what you owe on your first mortgage, plus the maximum you want to borrow via the HELOC: the combined total of all your home-based debt, in other words.

Say your lender allows up to an 80 percent CLTV. Using the above example:

So, even though your total equity stake is worth $225,000, your HELOC borrowing limit would be $150,000.

What fees do HELOCs have?

The cost of a HELOC can vary depending on a number of factors, including the lender, the terms of the loan, interest rates and the amount borrowed. And then there are any extra expenses, aka closing costs: origination fees, application fees, appraisal fees. Some HELOCs also carry annual fees, a charge for locking in your interest rate, and an early termination penalty, if you close the credit line within a year or two of opening it, or before the repayment period ends.

You can get a sense of these fees’ cumulative costs by comparing a HELOC’s current interest rate with its current annual percentage rate, or APR, when you start looking around. The APR factors in both interest and other charges. Sometimes the difference can be a full percentage point, or even more.

“Comparison-shop with at least three lenders and before choosing one, make sure you consider all of the loan costs, not just one aspect, like the closing costs or interest rate,” says Bell. “Knowing all of the costs upfront can help you plan your budget and avoid any nasty surprises down the road.”

What are the pros and cons of a HELOC?

The pros and cons of a HELOC include:

What should you use a HELOC for?

Some of the best uses for HELOCs include financing home renovations or improvements, paying off or consolidating high-interest debt, starting a business or establishing an emergency fund. But just because you can use a HELOC for most things, it doesn’t mean you should.

“While HELOCs offer flexibility, it is not the best choice if your home is your primary asset or if you want to purchase unnecessary, big ticket items, like a luxury vacation or a fancy car,” says Bell. “Why put your house on the line for things that provide little to no long-term value?”

What should you do if you’re unable to open a HELOC?

If your HELOC application is rejected, the essential first step is to understand why. Common reasons include a low credit score, insufficient income, high debt-to-income ratio, or not enough home equity.

Following your denial, consider these steps:

1. Request a letter of denial: You have the right to receive a written explanation or letter of denial from the lender, which outlines the reason for the rejection. This letter can provide clarity on financial areas to focus on for future applications.

2. Address the reason for the denial: Once you understand why you were denied, you can take steps to rectify the situation. For example, if your credit score was a factor, you might focus on improving it by paying bills on time, reducing outstanding balances, or correcting any credit report errors. If insufficient income was the issue, you could look into a side hustle or perhaps a gift or forgivable loan from family.

3. Reevaluate the home: Sometimes the fault, dear borrower, is not in you but in your home. If the appraisal deemed it insufficient to secure the credit line (or as big a line as you wanted), examine it carefully for mistakes (did they get the square footage wrong? Mis-count the number of bedrooms? Use outdated comps?) You could also get a second appraisal, albeit at your own expense.

4. Talk to other lenders: Different lenders have different risk tolerances and qualification standards for HELOCs — there are those that specialize in bad-credit applicants — so taking your business elsewhere might bring you better luck.

5. Examine other options: If a HELOC isn’t possible, there are other financing solutions available, such as:

• Personal loans: These are unsecured loans, so you don’t need collateral, and they can be much easier and faster to get. However, interest rates can be higher than those of HELOCs, and the terms shorter. One particular variety, the home improvement loan, comes with more advantageous rates and can be as big as $100,000.
• Credit cards: One of the most expensive ways to borrow, but they are convenient and relatively easy to qualify for, though an upper five-figure credit line might be hard to come by.
• Home equity loans: These are fixed-sum, fixed-rate loans secured by your home. Though the criteria are similar to HELOCs’, they might be easier to qualify for.
• Cash-out refinances: These refis involve swapping your current mortgage for a new larger one; you take out the difference in ready money, the amount being based on your home equity stake. As mortgages, cash-out refis typically have lower credit score minimums (620-640, vs. 680 and up) and lower interest rates than HELOCs. But the rate might be a lot higher than your original mortgage — depending on when you got it — and the application process might be more onerous.

Remember, each option comes with its own terms, and the choice depends on your individual circumstances and financial needs.

A rule of thumb following a HELOC denial is to wait approximately six months before submitting a new credit application — to the same lender, at least.

Home equity line of credit FAQ

• Is it better to get a HELOC or a home equity loan?

  It depends on your goals. A HELOC could be better than a home equity loan if you want a source of funds you can access on an as-needed basis. The line-of-credit arrangement also means you’ll only pay interest on the amount you borrow, at least initially. With a home equity loan, you’ll be responsible for interest on the entire loan balance, even if you don’t use all the funds. If you’re planning to cover a significant but indeterminate expense in the near future and want to have a pool of cash readily available, a HELOC might also be the better choice. That’s only if you don’t mind a variable interest rate, however (unless the lender offers otherwise), and a fluctuating monthly payment.

• How does a HELOC affect your credit score?

  Your lender will conduct a hard credit check when you apply for a HELOC, which can cause a slight, temporary decrease in your credit score. This type of credit check typically stays on your credit reports for two years, though it might only impact your credit score for up to a year. Apart from that, the way you use and repay your HELOC could impact your score. Borrowing against a HELOC can increase your credit utilization ratio, which factors into your credit score. A higher credit utilization ratio could result in a lower credit score. That said, paying down your HELOC over time could help you build credit.

• What is the typical length of a HELOC?

  The typical length of a HELOC is up to 30 years, with the draw period up to 10 years. Some lenders also provide the option to renew or refinance your HELOC once the repayment term ends.

• How do HELOC interest rates work?

  You’ll almost always encounter variable interest rates with HELOCs, The variable interest rates on HELOCs are partly determined by benchmark indexes, like the U.S. prime rate. The prime rate is set by individual banks and influenced by fluctuations in the federal funds rate (the rate that banks charge other banks for short-term loans). For HELOCs, lenders typically take the benchmark’s interest rate and add several percentage points to it to come up with your credit line’s interest rate.Some lenders offer fixed-rate HELOCs, which allow you to lock in a portion of your HELOC balance with a set, unchanging interest rate. This essentially converts part of your HELOC into a home equity loan. With a fixed rate, you won’t need to worry about your interest rate increasing over time.

• What is the monthly payment on a $50,000 HELOC?

  If you take out a HELOC with a $50,000 limit and draw the full amount, your monthly payment will depend on whether you make interest-only payments or interest and principal payments to start.Say the HELOC has a 9 percent interest rate and you plan to pay it off in 20 years. You’d need to pay $453 per month to reach that goal.If you want to explore a scenario of your own, use our HELOC payoff calculator.

• HELOC vs. other equity loan options

  There are two main alternatives to a HELOC: a home equity loan or cash-out refinancing. While a HELOC works like a credit card — giving you a maximum amount you can borrow with a variable interest rate — a home equity loan works more like your mortgage. You get a lump sum of money, and you repay it on a set schedule with a fixed interest rate. Likewise, a cash-out refinance replaces your current mortgage with a new, bigger one, allowing you to pocket the difference. Both types of loans take your equity into account when determining how much you can tap.

Additional reporting by Mia Taylor