What is a Home Equity Line of Credit (HELOC)? Is it Right for You?

What is a home equity line of credit (HELOC)?

A home equity line of credit, or HELOC, provides you with a line of credit that you can draw from as needed — similar to a credit card. You borrow against the equity in your home and your home serves as collateral for the loan. HELOCs typically have much lower interest rates than credit cards, making them an attractive option to homeowners.

A HELOC is secured by your home or another residential property you own. It allows you to borrow against the equity you have in your home and use the funds to pay for home improvements, consolidate debt, or even just cover monthly bills.

Here’s how a HELOC works

Unlike other home loans, a HELOC doesn’t give you a lump sum upfront. Instead, you’ll receive a line of credit that you can use for things like home renovation projects, debt consolidation, or any other major expenses.

You can borrow as many times as you want, up to your credit limit, during the loan’s draw period. Once the draw period ends, you’ll enter the repayment period to pay off your balance. HELOCs can have draw periods of up to 10 years and repayment periods of up to 20 years.

The amount you can borrow on a HELOC varies based on how much equity you have in your home and other factors. Generally, most lenders offer credit lines around 75% to 85% of your home’s appraised value, minus any outstanding loan balance you have on your first or second mortgage.

Let’s say your home is valued at $250,000:

$250,000 x 75% = $187,500

And you owe $120,000 on your first mortgage:

$187,500 - $120,000 = $67,500

In this scenario, assuming your lender caps the maximum loan-to-value ratio of 75%, you could potentially qualify for a HELOC with a maximum credit line of $67,500.

Read on: Best Home Equity Line of Credit (HELOC) Lenders of 2024

HELOC vs. home equity loan

HELOCs and home equity loans both let you borrow cash against your equity, and they both use your home to secure the loan. In addition, both are examples of second mortgages.

The primary difference between a HELOC and a home equity loan is the way you receive the cash and repay the loan.

As mentioned earlier, HELOCs give you a line of credit you can draw from as needed throughout the draw period. Depending on the loan, you might be able to make interest-only payments during the draw period.

A home equity loan gives you an upfront lump sum. You make payments on the entire amount beginning the month after you take out the loan. Unlike HELOCs, which typically have variable interest rates, home equity loans come with fixed interest rates, so your payment will stay the same for the life of the loan.

Fixed-Rate HELOCS: A Cross Between HELOCs and Home Equity Loans

HELOC requirements

Even though you’re borrowing against your own equity, you’ll still have to qualify for the loan. Here are some common HELOC requirements:

• Sufficient equity for the amount you want to borrow
• A debt-to-income ratio within the lender’s limits, usually 43% or less, although some lenders allow as high as 50%
• A credit score of 620 or higher, depending on the lender, and a positive credit history

HELOC pros and cons

Understanding the pros and cons of HELOCs will help you make an informed decision.

Pros

• Borrow only what you need, as you need it
• Make payments only on the amount you withdraw
• Typically come with higher credit limits and lower interest rates than credit cards
• Interest might be tax-deductible

Cons

• Closing costs are similar to those of a first mortgage
• Transaction and membership fees, in some cases
• Generally have variable rates, which means payments can increase
• Defaulting on the loan may result in foreclosure

How you can use HELOCs

You don’t have to use your line of credit for any specific type of expense. Many homeowners use it for renovations or repairs, while others use it as a way to pay off high-interest debt (like credit cards).

A HELOC can also be helpful for homeowners facing financial hardship — though it does come with some risks.

Keep Reading: Using a Home Equity Loan or HELOC to Pay Off Your Mortgage

Is a home equity line of credit right for you?

HELOCs aren’t right for everyone. For instance, they put your home at risk. Should you be unable to repay your balance once the draw period comes to a close, your lender could foreclose on the property.

HELOCs also come with upfront costs, including an application fee, costs for appraisals and title searches, and more.

Additionally, a HELOC might affect your credit for better or worse. It can reduce your score by adding to your debt, but it can also raise your score by diversifying the types of accounts you have and increasing the total amount of credit you have available.

Ultimately, here are some scenarios when you might want to consider a HELOC — and when you’d want to steer clear:

HELOCs are best when:

• You want to renovate or make repairs. Using a home equity line of credit toward home improvements comes with unique tax benefits. If you use your HELOC funds to increase your home’s value, you might be able to write off any interest you pay on your annual taxes. You should always consult with a tax professional, however.
• You’re buying another property. HELOCs can ease the homebuying process if you’re purchasing a second home, vacation property, or some other real estate investment. Use the funds from your HELOC toward the down payment and closing costs for the second home, and only pay interest on what you borrow.
• You can afford the costs. HELOCs don’t come for free. There are both upfront costs and, in many cases, maintenance, membership, and per-transaction costs. Make sure you’ll have the income necessary to meet your obligations both at closing and over the course of your draw period.

Think twice before getting a HELOC if:

• You’re prone to flippant spending. Just like credit cards, HELOCs come with temptation. If you can’t trust yourself with a large line of credit, you might want to avoid one altogether.
• You don’t need much cash. If you’re only looking for a small amount of money, keep in mind that the origination charges on a HELOC might exceed how much you're planning to borrow. If that’s the case, a credit card might be a better option — especially if you can find one with a zero- or low-interest promotional period.
• You’re unsure about your future earnings. If there’s any uncertainty about whether you can meet your payment obligations down the line, avoid taking out a HELOC secured by your home. It could put you at risk of foreclosure.
• Home values are declining around you. If your home loses value, it cuts down on how much equity you have. If it falls too much, you might end up owing more money on the loans secured by your home than your home’s worth.

How to get a HELOC

If a HELOC is a good fit for your personal situation, your first step is to determine how much equity you have. To do this, just subtract your mortgage balance from your home’s appraised value.

If the difference is more than 15% to 25% of your home’s appraised value, you could qualify for a HELOC. Your best bet for determining the appraised value is to use the appraisal from when you purchased the house or the last time you refinanced the property — whichever is most recent.

If you have enough equity in your home to warrant a HELOC, you can follow these steps to apply:

1. Shop around for a lender. As with any loan product, rates and terms on HELOCs vary, so comparing your options is key if you want the best deal.
2. Gather your documentation. You’ll need bank statements, pay stubs, and other financial paperwork.
3. Fill out the application. Complete your chosen lender’s application. Many lenders offer fully online processes these days.
4. Work with your loan officer. Your loan officer will guide you through the rest of the process. They might ask for more documentation or order an appraisal of your property.
5. Close on your loan. Finally, sign your closing documents, pay any fees owed, and open your line of credit.

HELOC alternatives

If you’re not sure a HELOC is right for you, consider these alternatives:

Credit card

Using a credit card makes more sense than a HELOC if the amount you want to borrow doesn’t justify the closing costs plus any fees the lender might charge.

Although credit card rates are typically much higher than HELOC rates, a card with a 0% introductory promotional rate could give you as much as 18 months interest-free.

Home equity loan

For large, one-time expenses like debt consolidation or a major home repair, a home equity loan might be a better choice than a HELOC. You can also get a shorter loan term with a home equity loan, which could save you money on interest. Plus, the fixed payments make budgeting easier.

Cash-out refinance

A cash-out refinance can be a good option if you get a lower interest rate than with your current mortgage. Even if the interest rate on your new loan is higher than your existing mortgage, a cash-out mortgage refinance might make sense if you need funds to pay off other debt or fund a home improvement project. Always compare offers first, so you can find the right loan for your situation.