Everything you need to know about home equity lines of credit (HELOCs)

If the value of your home is significantly higher than your mortgage balance, you may be able to use the difference between the two — your home equity — to fund major expenses, such as home renovations.  A home equity line of credit (HELOC) is a common choice — the Federal Reserve Bank of New York reported that HELOC balances increased by $16 billion in the first quarter of this year. Before you decide to borrow against your home’s equity, learn how a HELOC works, how you can use the money, how to qualify, and what your alternatives are.

What is a HELOC and how does it work?

A HELOC is a revolving line of credit secured by your home. If you’ve ever had a credit card, then you’ve seen how revolving credit works. 

You have a credit limit, which is the maximum you can borrow. You’re required to make minimum monthly payments. As long as you’re below your limit, you can always borrow more. As you pay down your balance, you replenish your credit line, making more money available for future borrowing. You can use the money for any purpose, such as home improvements, debt consolidation, or supplementing your cash flow.

Another similarity between a HELOC and a credit card is that both require you to qualify with a lender and pay interest on the money you borrow. However, a credit card is typically unsecured, whereas a HELOC is secured by your home. Since your home is collateral that the lender can seize if you don’t repay your loan, a HELOC will typically have a lower long-term interest rate than a credit card. Both also have variable interest rates.

HELOC interest rates

Also similar to a credit card, a HELOC’s variable interest rate is based on an index (such as the prime rate) plus a margin (which represents the lender’s profit and doesn’t change during your loan term). The prime rate is what banks and financial institutions base their interest rates on, and it typically mimics the federal funds rate. Going back to 1983, the prime rate has changed sometimes as monthly, other times once a year or so. During uncertain economic times, such as an unusual stretch from December 2008 through December 2015, the rate might not change at all. A typical rate adjustment is 0.25 or 0.50 percentage points (6.5% to 6.0%, for example).

HELOC draw period and repayment period 

While a credit card allows you to borrow and make payments indefinitely (as long as your balance is below your limit), a HELOC has a draw period and a repayment period.

Draw period

The draw period typically lasts up to 10 years at the beginning of your HELOC term. During this time, you can borrow against your credit line as described above. 

Some heloc lenders allow borrowers to make interest-only payments during the first few years, sometimes for the same length of time as the draw period. 

Repayment period

The repayment period begins when the draw period ends. It typically lasts up to 20 years, and during this time, you can no longer borrow against your HELOC. Instead, you’ll need to make fully amortized monthly payments of principal and interest. 

These payments are similar to the ones you make on any other mortgage, and they’re designed to zero out your loan balance by the end of a term — unlike a credit card, which you could use and repay indefinitely. 

Some people postpone the repayment period by refinancing their HELOCs, but there’s no guarantee that your home value, your income, market conditions, or your credit will make this option available to you.

Are HELOCs beneficial? Exploring the pros and cons

HELOCs may be more beneficial for some homeowners than others. Think about how these factors apply to your situation:

HELOC versus home equity loan: What’s the difference? 

Another way to borrow against your home’s value is with a home equity loan. This table can help you understand the key differences between these two options.

Depending on how much money you need, and whether interest rates have dropped since you took out your primary mortgage, you may also consider a cash-out refinance. 

Qualification requirements

To get approved for a HELOC, you’ll need to meet a lender’s credit qualifications and have enough home equity. Here’s what to expect:

Credit score and income requirements

Lenders usually want to see a credit score of at least 620 to extend a HELOC. Depending on the lender and market conditions, the minimum could be higher — 660, for example. Many lenders also want to make sure you don’t have any mortgage payments that were more than 30 days late over the last six to 12 months.

They also want to see that you have a stable and reliable income to make HELOC payments and that you won’t be overextended when you add the new payment to your existing debt payments. This means having a debt-to-income ratio of 43% or less, though you may be able to go as high as 50%.

The higher your credit score and the less equity you borrow, the lower your interest rate will be. In some cases, establishing a larger credit line may also lower your rate. Having a checking account with the same financial institution that issues your HELOC could also decrease your rate.

Equity and appraisal: How to calculate your home’s value for a HELOC

The size of your home equity line of credit will depend on three things:

1. Appraisal: Your home’s fair market value is the starting point for what you might be able to borrow. Let’s say your home is worth $500,000. 
2. Equity requirements: Your lender will require that you still have a certain amount of equity even if you borrow up to your credit limit. Many lenders prefer you leave 20% equity, or $100,000 in this example. That leaves $400,000 that you can potentially borrow.
3. Existing mortgage balance: If you’re still paying down your first mortgage, then your equity is less than $400,000. Let’s say your existing mortgage balance is $250,000. That leaves you with $150,000 in equity to borrow.

How to calculate your potential HELOC payments

It’s important to understand how high or low your HELOC interest rate can go during your loan term, how much your rate can change, and how often. 

Here’s how these factors might play out:

Introductory period

You get approved for a HELOC with a six-month teaser rate of 1 percentage point below prime (the index rate). In other words, if the prime rate is 8.5%, your rate will be 7.5%. If the prime rate changes during the introductory period, your interest rate will change, too. 

The minimum draw to get that rate is $50,000. If you take a lower draw, your rate will be 0.5 percentage points higher. Let’s say your first draw is $20,000. Now your rate is 8.0%. 

The annual interest on $20,000 at 8% is $1,600. Divide that by 12 and you get $133.33. If you’re only required to pay interest, the prime rate doesn’t change, and you don’t borrow any more money, this will be your payment for the next six months. 

After the introductory period

Starting in month 7, the prime rate is still 8.5%, but your teaser rate has expired. You lose your 1 percentage point discount and your rate goes up to 9.0%. You haven’t borrowed anything more, but you also haven’t paid down any principal. Your interest-only payment is now $150 per month. 

Repayment period

Let’s say your interest-only period ends after 10 years. Between month 7 and month 120, you’ve drawn an additional $50,000 from your credit line without repaying any principal. Now you owe $70,000 and you have to start repaying principal along with interest. 

Your HELOC also has a lifetime cap of 18% and a lifetime floor of 4%. This means that no matter how high or low the index rate goes, these are the highest and lowest rates you could end up paying.

In this example, your monthly payment could be as low as $233 if your interest rate is 4% and as high as $1,050 if interest rates are 18%. Most likely, it will fall somewhere in between these extremes. 

What is a HELOC FAQ

Is applying for a HELOC a sound financial decision? 

There’s little harm in applying for a HELOC other than a small drop in your credit score that’s typical whenever you apply for credit. Whether you use the money wisely if you get approved is another story. 

How is a HELOC’s monthly payment calculated?

The monthly payment on a HELOC depends on how much you owe, what your interest rate is, and whether you’re required to make interest-only payments or fully amortized principal and interest payments.

Can a home equity line of credit be fully paid off early? 

Yes, you can pay off a HELOC early. If you completely close your credit line within the first two or three years of opening it, you may have to pay an early closure fee or reimburse your lender for certain closing costs if any were paid on your behalf. If you pay off your HELOC but keep it open, you may pay a small annual fee, such as $50 or $99.

What impact does a HELOC have on your credit score?

The impact of any event on your credit score varies by person based on algorithms closely guarded by credit scoring companies, such as FICO. Generally speaking, though, a HELOC could increase your score if you always make your payments on time and if you borrow a smaller percentage of your credit limit. It could decrease your score if you don’t stay on top of your payments and if you borrow most or all of your credit limit.

How much can you typically borrow against your home's equity?

The percentage of home equity you can borrow will largely depend on the lender and your credit score. If your credit score is good enough, it might be as high as 95% or 100% for your first and second mortgages together, which is called combined loan-to-value (CLTV). Other factors that impact your CLTV include lien position (whether the lender is first or second in line to get paid from a forced home sale if you default) and occupancy (whether the home is a primary residence, second home, or investment property).