What Is a Home Equity Line of Credit (HELOC)?

When applying for a home equity loan, the lender will determine your home’s value, review your outstanding mortgage payments, assess your monthly income and debts and review your credit score and credit report.

In most cases, a borrower can typically borrow up to 80 to 90 percent of their home’s value minus their outstanding mortgage balance, based on the loan to value ratio. A good benchmark is to have at least 15%–20% of equity in your home to qualify for the loan.

Many lenders require a minimum FICO score of 640 or higher to qualify for a HELOC. A good credit history and solid credit score indicate that you’re a responsible, active borrower who can keep up with monthly interest payments.

If the lender approves your application, they’ll set a credit limit on how much you can borrow. They’ll then set a draw period (usually 10 to 15 years) during which your home equity line of credit works somewhat like a credit card. You’ll be able to access funds with a dedicated debit card, special check or online transfer through mobile banking.

During the draw period, you only make monthly interest payments on the money borrowed, not the entire credit line. Every time you repay your HELOC, your available credit renews, allowing you to borrow additional funds throughout this period.

One key aspect of a home equity line of credit is that you only make monthly payments on the amount you’ve borrowed rather than the entire credit amount. This flexibility allows you to manage your monthly budget effectively.

When the draw period ends, the HELOC changes over to a repayment period. In most cases, the repayment period lasts 10 to 20 years. Your payments will be set up in fixed installments against principal and interest. At this point, you can no longer borrow money against your home equity.

Your home equity line of credit may come with minimum withdrawal requirements across the draw period, much like when retirees withdraw funds from their retirement accounts.

You may also request to make larger payments against your principal during the draw period rather than interest-only payments, which is the norm.

Remember that, like a mortgage, a HELOC may come with annual fees, closing costs, application fees, appraisal fees and possibly an early closure fee if you pay off the loan early.

Begin by completing an application, which can often be done online, by phone or in person. You’ll need to provide personal information and details about your income, debts and current mortgage.

Lenders typically request documents such as proof of income, recent bank statements and mortgage statements to verify your financial situation.a

The lender will order an appraisal to determine your home’s current market value. This appraisal helps establish how much equity you have available to borrow.d

Your credit report, credit score and debt-to-income ratio will be reviewed to assess your creditworthiness and ability to repay the loan.

Based on the appraisal and financial review, the lender will set your credit limit and inform you of the draw period, repayment terms, interest rates and any fees.

Once you agree to the terms, the HELOC is finalized and you gain access to your credit line. Prompt communication and providing any additional requested information can help speed up this process.

A variable interest rate is the most common type of rate for a home equity line of credit. It correlates to a certain financial index (most often the Prime Rate) plus specific margins defined by the lender. Your HELOC interest rate will fluctuate as the Prime Rate changes.

Most of the time, variable interest rates begin at lower points than fixed rates. This structure might work well for you if you feel confident that the Prime Rate won’t fluctuate too much over the draw period.

However, stability is never a given. In times of economic flux, the variable interest rate may increase, affecting your repayment plan and monthly budget. On the other hand, if the Prime Rate drops, you may benefit from lower HELOC rates and more affordable monthly payments.

You might also choose a HELOC with a fixed interest rate, which is locked in for the entirety of the draw period, regardless of how the Prime Rate moves. This structure makes monthly repayments on the interest more predictable and easier to manage.

Fixed rates are typically higher than variable rates initially. They are also relatively inflexible, which runs counter to one of the main benefits of a home equity line of credit. Additionally, your lender may impose limits on how much you borrow during the draw period to account for potential increases in rates.

The annual percentage rate (APR) reflects the true yearly cost of borrowing, including interest and fees. Understanding the APR helps you compare HELOC offers and know what to expect for your monthly payments.

• Flexibility: Since it’s essentially a revolving line of credit, a HELOC is easy to work with. You only pay for interest on the amount you actually borrow rather than the entire mortgage amount.
• Lower interest rates: You might enjoy a lower interest rate than you would for credit cards or other unsecured loans, especially if you get a HELOC with a variable interest rate. This is particularly helpful during the draw period, when you only pay interest on the amount you borrow.
• Tax benefits: If you use a HELOC to pay for approved expenses like home improvements, there’s a good chance that the cost of those expenses is tax-deductible. A tax advisor can help identify what kinds of costs you can write off.
• Better liquidity: You can use your HELOC to access cash for emergencies or sudden large expenses quickly.
• Debt consolidation: You may be able to use your HELOC to manage other higher-interest loans you owe, consolidating them into a single payment with lower interest. This strategy could save you considerable money.

• Risk of overspending: A HELOC gives you quick access to large amounts of credit — which could lead to spending too much. This, of course, is also a common drawback of credit cards.
• Uncertainty with variable rates: Most HELOCs have variable interest rates, which are unpredictable by nature. When they go higher, the rates will increase your monthly payment schedule and strain your budget.
• Potential home foreclosure: Since your home is used as collateral in a HELOC, the lender can seize or put liens on your house if you don’t honor the terms of your loan agreement.
• Fees: Like most real estate deals, a HELOC can present a lot of unexpected expenses, including closing costs, transaction costs, annual fees and early closure fees.
• Possible depreciation: If your home loses value, you may find yourself underwater if the value is less than you owe. Such a situation creates negative equity, which could make selling or refinancing your home more difficult.