What is a home equity line of credit (HELOC) and how does it work?

A home equity line of credit (HELOC) allows you to tap into your home equity and withdraw the money for different purposes. It acts as a revolving line of credit, giving you the flexibility to borrow what you need, when you need it, up to a set limit. 

HELOCs use your house as collateral to secure the loan. And because they are secured this way, HELOCs typically have lower interest rates than personal loans or credit cards. 

How does a HELOC work?

A HELOC is structured as a revolving line of credit with a maximum limit, similar to a credit card. You withdraw money as needed, and pay it off. As you pay down the balance, the credit becomes available again, and you can continue spending.

HELOCs have variable interest rates, meaning your payments can change based on market conditions. The amount of your payments will also depend on which phase of the HELOC you’re in — the draw period or the repayment period.

The draw period

The first phase of a HELOC is called the draw period. It usually lasts for 10 years. 

Home equity is the difference between your home’s current market value and the amount you still owe on your mortgage. During the draw period, you can borrow money against this equity and typically only pay interest on the amount you use. HELOC payments tend to be much lower in this initial phase.

The repayment period

The second phase is called the repayment period. It could last up to 20 years. 

In the repayment period, you’re no longer able to withdraw money, and you’re required to make monthly payments that cover both the principal and interest.

HELOC requirements: How to qualify

While many homeowners can get a HELOC, not everyone qualifies. You must meet certain requirements. Here’s what lenders look for when you apply for a HELOC:

• Home equity: Typically, borrowers need at least 15% to 20% equity in their home to get a home equity line of credit.
• Credit score: Every lender has different minimum credit score requirements for HELOCs. But homeowners with higher credit scores (700 or above) can usually qualify for the lowest interest rates.
• Debt-to-income (DTI) ratio: DTI ratio is how much money you earn compared to your debt payments. A lower DTI ratio is better because it indicates that you’re not overextended and will be able to afford the HELOC payments.
• Combined loan-to-value (CLTV) ratio: Most lenders look for a CLTV ratio of 80% to 85%. This figure is calculated based on the total debt on your home (first mortgage and HELOC), divided by the home’s appraised value. 

Pros and cons of a home equity line of credit

Home equity lines of credit can be a great solution for homeowners who need to access cash, but they also have downsides. Before you choose this option, it’s important to consider the pros and cons. 

Pros

• Lower interest rates: Home equity line of credit rates tend to be lower than credit card interest rates, which can help you save money. In certain situations, interest is even tax deductible.
• Flexible borrowing: HELOCs allow you to withdraw money as you need it, rather than getting the money in a lump sum upfront.
• Only pay interest on what you borrow: When you borrow money against your home’s equity, you only pay interest on what you take out. 

Cons

• Variable rates can increase: HELOCs have variable interest rates. If interest rates rise during your repayment period, your HELOC payments will also go up. 
• Requires closing costs: Home equity lines of credit come with closing costs and other fees. 
• Risk of foreclosure if payments aren't made: Because your home is used as collateral to secure the HELOC, foreclosure is possible if you can’t pay the loan back.

What can you use a HELOC for?

One of the biggest advantages of a home equity line of credit is the freedom to use the money how you want. While you can typically use a HELOC for any purpose, it’s often used to fund major expenses. Here are some common situations where a HELOC could be a good option.

Home improvements and repairs

Many borrowers turn to home equity lines of credit for home improvements or repairs. For instance, the money could be used to replace an aging roof, renovate a kitchen, or finish a basement. An added benefit, if you use the loan to make home improvements, the interest payments are often tax deductible. 

Debt consolidation

Many homeowners use a HELOC to consolidate high-interest debt (like outstanding credit card balances) and lock in a lower interest rate. However, before making this move it’s important to remember, your house serves as collateral for the HELOC. Failing to make payments could result in losing your home in foreclosure.

Education and major life events

HELOCs can also be used to pay for a major life event — think college tuition, a wedding, or the down payment on an investment property. Because HELOCs have lower interest rates than personal loans and credit cards, it could be a more cost-friendly option. 

Emergency fund backup

When structured the right way, a HELOC can serve as an emergency fund. In this case, you would take out a HELOC but not spend any of the money. That way, you would have access to the full amount if a significant, unexpected expense were to pop up, like an emergency home repair or a medical bill.

When is HELOC interest tax deductible?

In certain situations, homeowners are allowed to deduct HELOC interest on their taxes. According to the IRS, interest payments are only deductible if the money is used to "buy, build, or substantially improve" the home that is collateral for the loan. This tax write-off requires you to itemize your deductions, so it’s a good idea to consult a tax professional.

Alternatives to a HELOC

Home equity lines of credit can help you get money quickly, but they’re not the best option for everyone. Here are some alternatives to consider:

• Home equity loan: A home equity loan is similar to a HELOC, but it provides a lump sum payment upfront, instead of a revolving line of credit. It comes with a fixed interest rate, so your payments won’t fluctuate. 
• Cash-out refinance: This replaces your current mortgage with a new, larger loan. You pay off your old mortgage and keep the extra amount as a lump sum of cash. A cash out refinance usually comes with a fixed interest rate that is often lower than HELOC rates.
• Personal loan: A personal loan provides a lump sum of money upfront. They’re unsecured, so you don’t have to worry about losing your home to foreclosure. However, they usually have higher interest rates than HELOCs.
• Credit card: Credit cards can be used to cover emergency expenses, but they have much higher interest rates than HELOCs. If you can’t get a HELOC, consider a credit card with 0% introductory APR so you can pay off the balance before higher interest rates set in.

HELOC vs. home equity loan: Which is right for you?

Although similar in some ways, HELOCs and home equity loans are not the same. The table below shows a side-by-side comparison of HELOCs vs. home equity loans.

Frequently asked questions

How much can I borrow with a HELOC?

The amount you can borrow with a HELOC depends on the amount of equity you have in your home, and the lender’s LTV limits. In general, most lenders allow homeowners to borrow between 80% and 85% of the home’s value, minus the mortgage balance. 

Does a HELOC affect my credit score?

Yes, taking out a HELOC can affect your credit score. When you apply, the lender will run a hard credit inquiry, which can cause a temporary dip in your score. Your credit utilization can also affect your score. Like a credit card, high balances can negatively impact your credit, which is why it’s important to pay off what you spend as soon as you’re able. 

Can I get a HELOC on a second home or investment property?

It’s possible to get a home equity line of credit on a second home or investment property, but there could be stricter HELOC requirements. For example, the lender might require a higher credit score, higher home equity percentages, or lower LTV ratios.  

What are the typical closing costs for a HELOC?

HELOCs have closing costs, which may include appraisal fees, application fees, and title search fees. HELOC closing costs are usually around 2% to 5% of the total loan amount. Some closing costs can be financed into the loan, which can reduce your out-of-pocket spending.