What is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is a form of revolving credit that allows you to borrow money against the equity you have in your home as you need it. A HELOC can come in handy with all the changes that come with being a homeowner, like making landscaping improvements or purchasing new appliances for your kitchen. We’ll explain how a HELOC works so you can decide if it’s right for you.

What is a HELOC?

A HELOC is a line of credit that allows you to borrow money against the equity of your home. Equity is the value of your home minus what you owe on your mortgage. A HELOC is a secured loan, meaning your home serves as collateral (something valuable you own) in order to obtain the loan. The HELOC is debt in addition to your primary mortgage, which means you’ll have a separate balance and payment each month. If you cannot make payments, the lender has the right to foreclose on your home to recoup their losses.

Once approved for a HELOC, you’ll receive a line of credit — say $50,000, for example — but you don’t have to borrow the full amount. Instead, you can withdraw money as needed, up to that limit, over a period of time known as the draw period.

The draw period

The first phase of a HELOC is the “draw period,” when you can withdraw money up to your approved limit. The draw period usually lasts 10 to 15 years, and during this time, you can typically access the funds with a bank card, online transfer or paper checks.¹

During the draw period, you’ll only pay the interest (the cost of borrowing) on the amount you withdraw. For example, if you only draw $20,000, your interest payments will be based on that $20,000 — not the full $50,000 line of credit you were approved for. You’ll start paying back the balance, which becomes the principal amount, and any remaining interest during the repayment period.

The repayment period

The repayment period is the next phase of the HELOC, which can last 10 or 20 years.² During this time, you’ll repay the balance of what you took out during the draw period — the principal — plus any remaining interest on the loan. You won’t be able to withdraw any more funds during this time, so it’s important to plan your borrowing carefully during the draw period.

Your monthly payments will increase in the repayment period because you’re paying back the principal and interest rather than just the interest. How much you owe each month will depend on how much of the credit line you use, your interest rate, and the length of your repayment term.

A HELOC typically comes with a variable (changing) interest rate, but some lenders offer what’s called a conversion option that allows you to convert all or part of your balance into a fixed rate (a rate that stays the same). Converting to this option can make your payments more predictable during the repayment period. However, your lender may charge a fee and a higher interest rate for the fixed-rate option.³

How much can I borrow with a HELOC?

The lender multiplies the total value of your home by your maximum draw rate, which is the highest percentage of your home’s value that you can access for the HELOC. This equation calculates the amount the lender would allow you to borrow. It would look like this:

[Total Home Value] X [Max Draw Rate] - [Outstanding Mortgage Balance] = [Maximum HELOC Credit Line]

For example, if your home is worth $300,000 and the lender allows you to borrow 80% of that value, you’d start at $240,000. Then, if you still owe $150,000 on your mortgage, you could qualify for up to $90,000 in a HELOC if you meet the lender’s qualifications. Here’s the equation to break this down:

[$300,000] X [0.80] – [$150,000] = [$90,000]

Item	Amount	Explanation
Home value	$300,000	The current market value of your home
Max draw rate	80%	The lender limits how much you can borrow against your home’s value.
Total debt allowed	$240,000	$300,000 X 0.80
Outstanding mortgage balance	$150,000	What you still owe on your mortgage
Maximum HELOC amount	$90,000	$240,000 - $150,000

What are the eligibility requirements for a HELOC?

It’s important to understand the eligibility requirements for a HELOC as you decide if this type of credit is right for you. These can include sufficient home equity, a minimum debt-to-income ratio and an adequate credit score.

Sufficient home equity

Equity is the difference between the value of your home and how much you owe on your mortgage. So for example, if your home is valued at $300,000, and you still owe $150,000 on your mortgage, that means you’ve paid 50% of the current value of your home, which means you have 50% equity in your home.

Most lenders require you to maintain at least 20% equity in your home to approve a HELOC.⁴ The minimum required equity threshold could help protect you from negative changes in the housing market. If your home were to lose value in the future, you could owe more on your home than it’s worth. This is called negative equity. Plus, the minimum amount of equity helps reduce the lender’s risk.

Debt-to-income ratio

In order to approve your application, the lender wants to make sure you can afford to repay the HELOC along with your other obligations. Among other factors, they’ll assess your debt-to-income ratio (DTI). Your DTI is your monthly debt payments compared to your monthly gross income. For example, if you earn $4,000 a month and you currently owe $1,000 per month in debt, your DTI ratio would be 25%. Most lenders typically want to see a debt-to-income ratio of under 43% to approve a HELOC.⁵

Credit score

Your credit score tells lenders how responsible you have been and are with credit. Having a more favorable credit score could increase your chances of qualifying for a HELOC with reasonable terms, such as a lower interest rate.⁶

Fees associated with a HELOC

Different fees are associated with a HELOC, depending on the lender. Some examples include:

• Application fees: These are fees to start your application and can vary in amount depending on the lender.
• Annual fees: You pay a recurring fee each year after your account is open.
• Cancellation fee: This is a charge you may have to pay if you close your HELOC early, typically within the first two or three years.⁷
• Conversion fee: You may be charged a fee if you convert a portion of your HELOC balance from a variable interest rate to a fixed interest rate
• Transaction fees: When you draw from your HELOC, lenders typically charge you a small flat fee, like an ATM surcharge.
• Inactivity fee: Some lenders may charge you an inactivity fee if you don’t use your HELOC for an extended period.

Pros and cons of a HELOC

Like with most major financial decisions, getting a HELOC has both benefits and disadvantages. You should carefully weigh the potential outcomes before moving forward.

Pros

• Flexible borrowing: Since a HELOC is a revolving line of credit, you can take out money as needed.
• Lower interest rate: A HELOC may have a lower interest rate than a credit card, which might make it a nice alternative – but read below to find a few cons to consider.⁸
• Interest-only payments: During the draw period, you pay interest on the amount you draw, leaving the principal for later.
• Tax deduction: You may be able to deduct interest paid on a HELOC if you use it to make home improvements — but check with a tax advisor to be sure.⁹

Cons

• Variable rate: A HELOC usually comes with a variable interest rate, which means the APR for your loan could change over time. Since HELOCs often span years, the interest rate can fluctuate significantly over that period, making future borrowing costs harder to predict.
• Risk of foreclosure: Your HELOC is tied to the title of your home, like a mortgage or a lien, so if you default on it, the lender has the right to take possession of the collateral to recover the amount owed.
• Potential for overspending: A HELOC usually gives you access to larger borrowing amounts, as the typical withdrawable amount starts at $10,000.¹⁰ The actual amount you can draw depends on how much equity you’ve built in your home. You might be tempted to draw more than you need because the funds are available, but this could lead to unmanageable debt.

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Make the right move for your goals

Applying for a HELOC is a big decision, and you may or may not be in the right place to pursue one. If you bought a fixer-upper and have just started to build equity by paying down your mortgage or your home has increased in value, a HELOC might be a great way to finance new additions to your home. Or if you are interested in making home improvements but a HELOC feels like it's too big of a swing, you might consider a personal loan instead.

If you don’t have quite enough home equity for a HELOC, or your current expenses outweigh the potential benefits, then a HELOC might not be the best route for you. Consider all your options, discuss them with a professional tax and/or financial advisor, and make the best decision to grow toward your goals.

Sources:

1. https://www.rocketmortgage.com/learn/how-much-heloc-can-i-get
2. https://www.consumerfinance.gov/ask-cfpb/what-is-a-home-equity-line-of-credit-heloc-en-107/
3. https://www.bankrate.com/home-equity/heloc-with-fixed-rate-option/
4. https://www.bankrate.com/home-equity/requirements-to-borrow-from-home-equity/
5. https://www.bankrate.com/home-equity/requirements-to-borrow-from-home-equity/
6. https://www.bankrate.com/home-equity/requirements-to-borrow-from-home-equity/
7. https://www.consumerfinance.gov/ask-cfpb/what-fees-can-my-lender-charge-if-i-take-out-a-heloc-en-249/
8. https://www.bankrate.com/home-equity/pros-cons-of-home-equity-lines/#heloc-pros
9. https://www.bankrate.com/home-equity/pros-cons-of-home-equity-lines/#heloc-pros
10. https://www.bankrate.com/home-equity/pros-cons-of-home-equity-lines/