How Do HELOCs Work?

HELOCs let you borrow funds from your home equity. Learn how HELOCs work and why they can be a cost-effective way to finance home improvement projects.

By Megan Doyle | American Express Credit Intel Freelance Contributor

8 Min Read | February 1, 2022 in Money

 

At-A-Glance

A HELOC is a revolving line of credit that lets you borrow a portion of your home equity for a set period of time, to be paid back with interest.

If you have high home equity and are considered creditworthy by lenders, HELOCs can be a useful alternative to loans or credit cards because interest rates are typically lower.

With a HELOC, your home is collateral. This means that missing payments will risk foreclosure. 

You may be able to refinance a HELOC to get lower interest rates once the borrowing period ends and repayment period begins.  

If you’re looking for a way to finance a home improvement project or big-ticket purchase that can help increase the value of your home, it may be worth considering a home equity line of credit (HELOC). HELOCs come with a number of advantages, such as historically lower interest rates than other lending options, borrowing and repayment flexibility, and tax benefits. But like all forms of debt, HELOCs come with particular risks, too: You’re essentially borrowing funds from the value of your home, but every penny you use must be repaid with interest.

 
Learning how HELOCs work can help you decide whether they’re the right lending option for your financial needs.

 

What Is a HELOC?

A HELOC is a form of revolving credit that lets you borrow money against the equity of your house. HELOCs work similarly to credit cards in the sense that you receive a predetermined credit limit that you can tap into and repay in monthly bills. You can use as little or as much of the credit limit as you like as long as you don’t exceed it, and interest is charged on the amount you borrow.


But there are a few key differences that set HELOCs apart from credit cards. For HELOCs:

  • Your available credit limit is primarily based on how much home equity you have – not your credit history and debt-to-income ratio. You can’t get a HELOC unless you own equity in a home.
  • You’ll typically receive lower interest rates. Historically, HELOCs have had lower interest rates, averaging 1.99% to 7.24%1 – compared to credit cards, whose annual percentage rates (APRs) are averaging approximately 16% in 2022 and can sometimes have interest rates higher than 20%.
  • You can only withdraw during the draw period. This is the amount of time your credit line is available for withdrawal, usually 10 years. When you repay any withdrawals before your draw period is up, the balance will return to your revolving credit line and can be borrowed again – similar to a credit card’s revolving balance. Some HELOCs let you make interest-only payments during the draw period, but this means you may get large bills with bigger interest charges once the draw period ends and repayment period begins.
  • You’ll enter a repayment period after the draw period ends. The repayment period is the time you have to repay any outstanding balance on your HELOC, usually 10 to 20 years after the end of the draw period. You can no longer make withdrawals during this period and your payments will include principal and interest charges. During the repayment period, a typical HELOC looks and feels like a regular mortgage.

 

What Is Home Equity?

You can’t open a HELOC if you don’t have home equity, which is the portion of your home’s value that you own versus what you owe the mortgage holder. Here’s a simplified example: If you bought a $100,000 home, paid $20,000 as a down payment and $10,000 in mortgage payments, you would have $30,000 in equity, or 30%.


In most cases, lenders will require you to own at least 20% equity before qualifying for a HELOC. Your equity is then used to determine what your credit limit will be. Your credit limit is then fixed unless you apply – and are approved – for an extension if your equity increases.

 

How to Qualify for a HELOC

In addition to having at least 20% equity on your home, lenders will also look at other factors to determine whether you’re eligible for a HELOC:

  • Your credit score and credit history.
  • Monthly debt-to-income ratio.
  • Proof of employment.

All of the above will help the lender decide your creditworthiness and whether you will be able to repay the HELOC. Depending on your personal financial situation, you may be able to borrow up to 85% of your total equity minus how much you owe on your mortgage.2 Put simply, the more equity you have in your home, the more you will be able to take out in a HELOC.

 

How HELOCs Work: Key Factors to Consider

Before applying for a HELOC, it’s a good idea to keep the following in mind.


You’re putting your home up for collateral. If you don’t repay your HELOC, your home could end up in foreclosure. Failing to pay credit card debt, on the other hand, could put a big dent on your credit score – and you may have to file for bankruptcy – but the chances of losing your home are significantly smaller.


Be careful where you spend your HELOC money. It can be tempting to use HELOC funds to finance a vacation or a new car, but financial experts strongly recommend using HELOCs to pay for home improvement projects like a kitchen renovation because they can increase the value of your home and therefore the investment might pay for itself over time. Some people also use HELOCs to finance their children’s education since the interest rates can be lower than student loan rates.


Interest rates are variable during the draw period. During your draw period, you might only have to pay interest on what you borrow. This means you may not have to pay off the amount you borrowed until your repayment period begins. But HELOC interest rates are variable, meaning they’re generally tied to the U.S. prime rate and can fluctuate.


You may be able to opt for a fixed-rate interest in the repayment period. Some HELOCs will let you switch to a fixed interest rate on your outstanding balance during your repayment period.


HELOC interest can be tax-deductible. According to the IRS, deducting a HELOC’s interest from your taxes is possible as long as the funds are being used to “buy, build, or substantially improve the taxpayer’s home that secures the loan.”3


HELOCs might have fees. Depending on the lender, you may have to pay closing fees before opening your HELOC. Closing fees might include application fees, credit report fees, home appraisal fees, and attorney fees.

 
You can shop around for HELOCs. You don’t have to get a HELOC from the same lender that holds your mortgage. You can shop around for the best interest rates and plans that work for your financial needs. Some HELOCs may require a minimum initial draw, so be sure you have enough equity to match lender requirements.


HELOCs are subject to underwriting standards. That means that your income, employment, and home value will be taken more seriously than when applying for a credit card, for example. This also means the process may take more time, and you may need to go through extra application steps like getting your home officially appraised.

 

Can You Refinance a HELOC to Take Advantage of a Lower Rate?

Once your HELOC enters the repayment period, you can no longer make withdrawals and must begin paying back any outstanding balance. But if your interest rate is high and market rates turn lower, you may be able to refinance your HELOC to take advantage of those lower rates. For example, you could apply for a second HELOC to pay the outstanding balance on the first.

 
To refinance a HELOC, you’ll need to meet application requirements again, and being approved once before does not guarantee you’ll be eligible to refinance. In case you don’t qualify, there are other options that may help lessen the burden of higher HELOC payments, including:

  • Cash-out refinancing. You may be able to combine your mortgage and HELOC under a cash-out refinance. This leaves you with a single loan and payment structure.
  • Taking out a personal loan. Personal loans have the benefit of a fixed interest rate and usually don’t require collateral, so you can cover your HELOC balance without risking home foreclosure.
  • Converting your current HELOC into a fixed-rate loan. While it won’t change the principal you owe, a fixed interest rate can help you get a set idea of how much you will pay each month so you can create a dedicated financial plan.
  • Getting a home equity loan. If you qualify for a home equity loan at better rates than your HELOC, you may be able to use the lump sum to pay off the HELOC. You may also be able to apply for an extended repayment period.

 No matter what option you choose, it’s important to do careful research and make sure your decision will help improve your financial situation.

 

What’s the Difference Between a HELOC and a Home Equity Loan?

HELOCs aren’t the only way to use your home equity as collateral. You can also take out a home equity loan. But what’s the difference? For home equity loans:

  • Instead of a revolving credit line, you’ll receive a lump sum and make monthly payments towards the outstanding balance.
  • Interest rates are usually fixed. This means you’ll know from the beginning how much you’re going to pay and rates won’t be affected by market conditions. However, rates on home equity loans tend to be slightly higher than HELOCs.
  • The repayment period is usually 10 to 30 years, and there is no draw period because you receive all the money in a lump sum up front.

 

The Takeaway

Getting a HELOC can be a good idea if you’re planning on a big home improvement project or other major purchase that could increase the value of your home. Like all financial decisions, there are pros and cons to opening a HELOC. On one hand, you can get lower interest rates and flexible withdrawal and repayment options. On the other, interest rates can vary and your home is at risk if you’re unable to repay your balance. Before opening a HELOC, it’s a good idea to carefully consider your options.

Megan Doyle

Megan Doyle is a business technology writer and researcher whose work focuses on financial services and cross-cultural diversity and inclusion.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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