Homebuyers

How Does a HELOC Work?

For homeowners who have built up equity, the difference between what their home is worth and what they still owe on their mortgage, there are several ways to turn a portion of it into cash.

A home equity line of credit, or HELOC, allows homeowners to borrow against their equity while keeping their existing mortgage intact. Homeowners can use the funds as needed, much like a credit card. However, a HELOC is secured by the home, which means failure to repay the debt could put the property at risk.

“Think of a HELOC as a credit card secured by your house, but with a timer on it,” said Marcel Miu, founder and lead wealth planner at Simplify Wealth Planning in Austin, Texas.

Here’s what homeowners need to know about how a HELOC works, how it compares with other borrowing options, and the potential costs and risks.

How does a HELOC work?

A HELOC is a revolving line of credit with a borrowing limit based largely on the home’s appraised value, the outstanding mortgage balance, and the lender’s maximum combined loan-to-value ratio.

“For a set period of time, called the draw period, you may borrow whatever amount you want, pay it back, and draw again,” said Alan Atchley, owner of Better Homes and Gardens Real Estate Atchley Properties in Sarasota, Fla.

The draw period typically lasts about 10 years. Some HELOCs allow interest-only payments during the draw period, though borrowers can usually pay toward the principal as well.

Once the draw period ends, new borrowing generally stops and the repayment period begins. The homeowner must repay the remaining principal and interest over a set number of years. Payments may increase substantially at this point, especially if the homeowner made interest-only payments during the draw period.

How are HELOC rates determined?

HELOCs typically have variable interest rates tied to a benchmark, such as the prime rate, plus a margin established by the lender.

Rate changes can make monthly HELOC payments less predictable than those on a fixed-rate home equity loan. Some lenders may offer an introductory rate or allow borrowers to convert part of the balance to a fixed rate. Homeowners should review the full terms before applying.

Interest isn’t the only possible cost. Depending on the lender, homeowners may also pay appraisal, application, closing, annual, inactivity, or account-maintenance fees.

How to qualify for a HELOC

Lenders generally consider the homeowner’s equity, income, existing debts, credit history, and ability to repay when reviewing a HELOC application.

Many lenders require homeowners to maintain about 15% to 20% equity after borrowing and may look for a debt-to-income ratio below roughly 40%, said Miu. Credit requirements can begin around 620, though homeowners with scores above 750 may qualify for more favorable pricing. Requirements vary by lender.

The lender may require an appraisal or another form of property valuation to determine the home’s current market value.

Approval doesn’t guarantee that the full credit line will remain available throughout the draw period. Under certain circumstances, a lender may freeze or reduce the line, including after a significant decline in the home’s value or a material change in the homeowner’s financial circumstances.

HELOC vs. home equity loan and cash-out refinance

The primary difference between a HELOC and a home equity loan is how the homeowner receives and repays the money.

A home equity loan provides a lump sum upfront and typically comes with a fixed interest rate and predictable monthly payments. It may be a better fit for a known, one-time expense, such as a major home repair.

A HELOC provides a reusable credit line during the draw period. Homeowners generally pay interest only on the amount they borrow, making it useful for expenses that arise in stages or have uncertain final costs.

Both options use the home as collateral.

A cash-out refinance replaces the existing mortgage with a new, larger mortgage, and the homeowner receives the difference in cash. A HELOC leaves the original mortgage in place and adds a separate debt secured by the home.

Keeping the first mortgage can be especially valuable for homeowners whose existing rate is lower than the rate available on a new mortgage. With a HELOC, they retain that rate and borrow only the amount they need from the credit line.

HELOC vs. credit cards and personal loans

HELOCs may offer lower interest rates than credit cards and personal loans because the debt is secured by the home. Credit cards and personal loans are generally unsecured and may provide faster access to funds, particularly when the amount needed is relatively small. Failure to repay a HELOC could result in foreclosure.

Personal loans typically carry higher interest rates than HELOCs but can be funded quickly, according to Miu. For someone who needs a modest sum right away, the added speed may justify the higher borrowing cost.

The best option depends on how much money is needed, how quickly it is needed, how long the homeowner expects to carry the debt, and whether they are comfortable borrowing against their home.

Is a HELOC a good idea?

Whether a HELOC is a good idea depends largely on how the homeowner plans to use the money and whether the payments will remain affordable if the interest rate rises.

Major repairs may be difficult to cover from savings or other available funds.

“A HELOC should be used for some predetermined purpose like replacement of the roof, plumbing, or other things that will increase the value of your home and cannot be done in any other way,” said Atchley.

“If it’s a one-time need, take the lump-sum, fixed-rate route,” said Miu. “If the cash need is uncertain or arriving in waves, like a renovation budget that keeps moving, the HELOC might be best. When speed is the constraint, a personal loan might be the winner.”

A HELOC can provide flexible access to home equity without replacing the existing mortgage. Before applying, homeowners should compare rates and fees, estimate future payments, and consider the risks of using their home as collateral.