What is a HELOC (home equity line of credit)?

If you need to finance a home project, pay for college tuition or cover another large expense, a home equity line of credit (HELOC) may be a good option. It gives you the ability to leverage — that is, borrow against — the ownership stake you’ve built up in your home.

HELOCs generally come with lower rates than home equity loans and personal loans, making them a smart choice for cost-conscious borrowers. They also provide flexible financing, as you can choose to borrow what you need over a draw period, which is typically 10 years.

If you need money and are considering a HELOC, here’s everything you need to know.

What is a HELOC and how does it work?

A HELOC is a revolving form of credit with a variable interest rate, similar to a credit card. It allows you to borrow and repay funds on an as-needed basis during a specified period of time. After that, you 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.

So, how does a HELOC work, specifically? When you’re approved for a HELOC, you’ll be given a credit limit based on your available home equity. Typically, you can borrow up to 85 percent of your home’s value, minus outstanding mortgage balances.

During the draw period, you can use funds from the HELOC using dedicated checks or a draw card. You’ll need to make monthly interest payments on the amount you borrow, but as you pay back your HELOC, the funds are 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 only be on the hook for interest payments during the draw period, you can pay both principal and interest at this time if you choose. This can help keep your payments manageable when you enter the repayment term.

How do you calculate the borrowing limit for a HELOC?

When considering your HELOC application, lenders use your total equity in your house — your ownership stake — to calculate your loan-to-value ratio, or LTV, which factors into how much you can borrow.

Say your home is appraised at $375,000 and your outstanding mortgage balance is $150,000. Your total equity, then, is $225,000 ($375,000 – $150,000). You’d then divide your mortgage balance by the appraised value to determine your LTV. In this example, your LTV would be 40 percent and your total equity would be 60 percent.

With a HELOC, you can usually borrow up to 85 to 90 percent of your combined LTV, meaning your LTV minus the amount still owed on your mortgage and the total credit line of the HELOC you’re seeking.

To calculate your maximum HELOC balance, you can multiply your home’s value by the percentage of equity you’re tapping and subtract your outstanding mortgage debt. Or as a math equation:

(Your home’s value x the percentage of equity you’re tapping) – how much you owe on your mortgage = your maximum HELOC balance

Say your bank allows you to draw up to 85 percent of your home’s equity, and your house is worth $460,000. You still owe $250,000 on your mortgage. That means you could get a HELOC of $141,000 maximum ([$460,000 x 0.85] – $250,000 = $141,000).

Of course, this is a generic example. Factors such as your credit score, financial situation and bank policies could also affect the maximum limit the lender sets for your HELOC.

What are the pros and cons of a HELOC?

The pros and cons of a HELOC include:

Pros of HELOCs

• Flexibility: While you’ll be approved for a maximum HELOC amount, you don’t need to use all of it. This makes HELOCs an attractive option for paying for ongoing expenses, as well as a “nice to have” for unforeseen emergencies.
• Interest-only payments: During the draw period (the first 10 years), you’re only required to pay interest on what you use from the line of credit. This keeps your payments low, freeing up cash for other expenses or goals.
• Lower rates: HELOCs are backed by the equity in your home, which acts as collateral for the debt (in contrast to unsecured debt instruments, like credit cards or some personal loans, which aren’t backed by anything). The presence of collateral makes a loan less risky to a lender. Because of this lower risk, HELOCs and home equity loans tend to have lower rates than these other types of financing.
• Potential tax deduction: If you use the funds from a HELOC to make home improvements, you might be able to deduct the interest on your tax return.

Cons of HELOCs

• Variable rates: HELOCs have a variable interest rate, which means the rate can go up or down depending on the economy and prevailing market rates. If your rate goes up significantly, you might no longer be able to manage the payments.
• Secured by your home: A HELOC is tied to the equity in your home, so if you default on your payments, it could be foreclosed on by your lender.
• Sudden repayment shock: You might be able to afford your HELOC payments during the interest-only period, but once the repayment term kicks in, the new monthly amount you owe, a combination of principal and interest payments, could squeeze your budget.
• Sensitive to the real estate market: A significant decline in home values could cause your lender to reduce or freeze your credit line (during the draw period).

Why HELOCs are popular now

Home equity-based financing is having a moment. According to TransUnion’s latest “Home Equity Trends Report,” HELOC originations are up 7 percent year over year, from Q2 2022 to Q2 2023. Their fixed-rate cousins, home equity loans, are up even more — 24 percent in the same period.

Why? It’s mainly the rise in interest rates that began in mid-2022 — particularly mortgage rates, which have doubled since their mid-pandemic lows. For many, the rapid rise has decimated the advantage of a cash-out refinance, once the go-to way to tap a homeownership stake. Hence, the appeal of home equity loans and HELOCs; while their rates have risen too, they remain cheaper than other forms of debt, like credit cards.

Plus, people have plenty of equity to tap, thanks to the record-setting rise in home prices since 2020. When property values rise, so does the worth of your ownership stake. The average mortgage holder now has  according to Black Knight, a real estate data analysis firm Black Knight, the average American mortgage-holder possesses $199,000 in equity, up from $185,000 in Q1 2023.

When is it a good idea to get a HELOC?

A HELOC can make a lot of sense if you have a solid purpose for the funds. Some of those purposes may include:

• Use the money to pay off high-interest credit card debt
• Tackle home improvements (and get a tax deduction perk, too)
• Pay for education
• Fund emergency expenses (e.g., car repairs, medical bills)

Ultimately, there are several use cases where a home equity line of credit can make financial sense. Just remember that your home serves as collateral, so it isn’t worth taking out the HELOC if you’re not confident you’ll be able to repay what you borrow.

How do you qualify for a HELOC?

Applying for a HELOC is a lot like applying for a traditional mortgage and 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 (the portion of your home you own outright).
• Credit score: Homeowners generally need a credit score in the mid-600s 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

What is a home equity line of credit’s application process? To qualify for and get a home equity line of credit, you’ll need to:

1. Review and strengthen your credit. A strong credit score, ideally in the 700s, will allow you to qualify for the most favorable rates and terms. To improve your credit, make all payments on time — catching up 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 for anything.
2. Find a HELOC lender. Make sure you shop around and compare offers. Even a small difference in interest rates can save you thousands in the long run. You should also learn whether your loan will include annual maintenance fees or early closure fees.
3. Apply for the HELOC. Nowadays, you can do this in several ways: in person, by mail, over the phone or online. However you apply, you’ll need documentation — lots of documentation. Lenders will assess your financial life thoroughly. Be prepared to provide your residence history, income and employment information with printed proof: W-2s, tax returns, bank/brokerage statements, to name just a few. You’ll need to verify your identity and give permission for the lender to access your credit reports, as well.
4. Hurry up and wait. Some lenders may get back to you with pre-approval or an initial decision within days; others require you to wait until the whole underwriting process is done. They may ask for additional info. At some point, they will do an appraisal of your home, to determine its current value (they may want to arrange for an in-person visit for this). The appraiser’s assessment determines how much equity you have available, which in turn sets the size of your HELOC balance.
5. Close on the loan. After the appraisal, you’ll receive final approval. The lender will arrange a closing date with you. You’ll be sent more paperwork to sign, finalizing the financing and officially opening the HELOC. You generally have access to the HELOC funds starting on the fourth day after closing.

How do HELOC interest rates work?

You’ll almost always encounter variable interest rates with HELOCs, but a few lenders also offer fixed-rate versions.

Variable interest rates

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).

Because market conditions can cause the prime rate to fluctuate, your HELOC interest rate can also increase or decrease over time. As a result, your monthly payment can change. However, your lender will generally cap how much your rate can increase over the HELOC’s lifetime.

Fixed interest rates

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 or decreasing with market fluctuations.

Typically, you’ll repay that portion of the loan over a period of five to 30 years, though the balance must be repaid by the end of your normal HELOC repayment period. If you’re interested in this option, look for lenders advertising “hybrid HELOCs” or fixed-rate locks.

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

Let’s say you take out a HELOC with a $50,000 limit and draw the full amount. Because it’s a revolving line of credit, you have options to repay as much as you want during the draw period.

If you wanted to repay that full $50,000 over the next decade or less, you could make consistent monthly payments to knock down that balance. To give you an idea of how this could work — on a HELOC with a 7.62 percent APR and an annual fee of $35, allowing for $100 a month of extra charges  — let’s break this down. To pay off that $50,000, you could make:

If you want to explore a scenario of your own, you can use our HELOC payoff calculator.

HELOC vs. other equity loan options

A HELOC isn’t your only option for turning the equity you have in your house into cash. You can also explore:

HELOCs vs. home equity loans

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.

HELOCs vs. cash-out refinance

A cash-out refinance means replacing your current mortgage with a new, bigger one — and pocketing the difference. The amount of extra ready money you can take is based on the value of the tappable equity you have in your home.

HELOC FAQs

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

  It depends on your purpose. 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 — say, to pay a contractor in installments for a major home renovation. The line-of-credit arrangement offers the ability to only pay interest on the amount you borrow. 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.
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  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 may 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.
  
  But paying down your HELOC over time could help you build credit. Doing so will establish a positive payment history, which may boost your credit score.
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  What is the typical length of a HELOC?

  HELOC draw periods are generally 10 years, though this may vary by lender. Repayment periods can be as long as 30 years, though certain lenders may offer HELOCs with shorter repayment terms as well. Some may also provide the option to renew or refinance your HELOC once the repayment term ends.