How does a HELOC loan work?

With home values near generational highs, homeowners have significant home equity. However, many homeowners are locked in mortgage rates that are far below today’s interest rates. One way to access your home equity without impacting your mortgage is through a home equity line of credit (HELOC). But how does a HELOC loan work? Learn how they work, the pros and cons of using a HELOC, and alternative financing options to consider.

How does a HELOC loan work?

A home equity line of credit (HELOC) loan is a way for homeowners to access their home equity without impacting their current mortgage. It provides a line of credit with a maximum loan amount based on what your home is worth, your current mortgage balance, and the bank’s maximum LTV (loan-to-value) ratio.

This type of financing works like a credit card that you can withdraw cash from as often as you like. The money can be used however you want, but common uses include paying off credit cards, home repairs, college tuition, and unexpected expenses. In most cases, you can withdraw any amount, but some banks may have a minimum withdrawal amount. As you repay your balance, you free up available credit that can be used at a later date.

HELOCs have a variable interest rate based on the U.S. Prime Rate. This means that your interest rate can fluctuate as economic conditions change. Your payments are based on the current interest rate and your monthly balance. During the draw phase, HELOC monthly payments are interest-only, which means that your balance will not go down if you don’t pay extra. When your balance is zero, no payments are due.

Some lenders charge an annual fee, while others have no annual fee or will waive it based on your borrowing. Additionally, some lenders waive closing costs for HELOCs as long as the account is open for a few years.

Some HELOCs allow borrowers to convert a portion of their balance to a fixed rate and term. This locks in the current interest rates and puts homeowners on a path to pay off their balance by a certain date. Depending on the lender, you may be able to do additional conversions without having to pay off the first loan.

The draw period typically lasts for 10 years. After that, the remaining balance converts into a term loan like a traditional mortgage or a home equity loan. At conversion, the HELOC automatically locks in the current rates to set your monthly payments over a 20-year repayment period.

HELOC pros and cons

HELOC loans have a lot to offer homeowners, but there are pros and cons you need to know before submitting an application.

Pros

• Doesn’t impact the current mortgage. As a second mortgage, the interest rate, balance, and loan term of your first mortgage don’t change. For the more than 80% of homeowners with mortgage interest rates under 6%, this is a huge benefit.
• Affordable payments. HELOC payments are interest-only based on the amount you borrow. These payments are easier to handle for most homeowners.
• Re-useable credit limit. You receive a maximum credit limit that you can use over and over. As you pay down your balance, you increase the available credit to borrow in the future.

Cons

• Variable interest rate. Unlike a traditional mortgage or home equity loan, your interest rate is variable. As interest rates rise, your payments will increase and may become harder to budget for.
• Your home is at risk. HELOCs are secured by the equity in your home. If you fail to make payments, the lender could foreclose on your home, even if your primary mortgage payments are current.
• Not required to pay the principal. While interest-only payments are more affordable, your HELOC loan balance doesn’t go down unless you pay extra. This can lead to prolonged debt that doesn’t get paid off. This can also lead to borrowing more than you can comfortably repay, creating financial strain when it’s time to pay the loan back.

Alternatives to HELOC loans

HELOCs are an excellent choice for many homeowners, but they aren’t the best way to access home equity in every situation. Before applying for a HELOC, consider these alternatives to determine if they are a better fit for your financial situation.

Home equity loans

A home equity loan acts like a HELOC because it allows you to access your home equity without impacting your first mortgage interest rate or term. It’s a second mortgage that provides a lump sum of cash upon approval. You’ll receive a fixed interest rate with a consistent monthly payment of principal and interest. For this reason, home equity loans typically have higher payments than HELOCS.

Loan terms vary by lender, but borrowers can typically choose terms that range from 5 to 30 years. As long as you’ve made all payments on time, your loan will be paid off when the term expires. However, you can make extra payments or pay off the loan early without incurring any penalties.

Home equity investments

Borrowers who want to access their home equity without adding another monthly bill should consider a home equity investment (HEI). Instead of monthly payments, you share a slice of the home’s appreciation when you decide to exit the partnership, anytime during a flexible 30-year term. The investment is repaid when your home is sold, refinanced, or you decide to use another source of funds to buy back your equity. 

HEIs are an excellent choice for individuals with poor credit or those who struggle to document their income. HELOCs typically require a good credit score and proof of income showing that you can make payments. However, that is not the case with HEIs. There are no income requirements, nor do you need perfect credit.

Reverse mortgage

A reverse mortgage is a loan for seniors that allows them to tap their equity without making payments. There are three main ways to get cash out of your home with a reverse mortgage: a lump sum, monthly deposits, or a line of credit. The existing mortgage is replaced with the reverse mortgage, and as interest accrues, the new mortgage balance grows over time.

Eligible homeowners can live in their homes for the rest of their lives, but the loan must be repaid if the house is sold or refinanced. Additionally, the loan becomes due if they move out for an extended period of time, even if they enter a nursing home or hospice.

To get a reverse mortgage, you must be at least 62 years old and have substantial equity in your primary residence.  Reverse mortgages tend to be more expensive than traditional mortgages. Another downside is that others living in the home may need to move out if the borrower stops living there and is unable to pay off the reverse mortgage balance.

Cash-out refinance

During the refinance process, you replace your existing mortgage with a larger loan to get cash out of your home. Although the loan balance is larger, homeowners often reset the 30-year term to keep payments more affordable. However, you can choose other repayment periods, such as a 10-, 15-, or 20-year mortgage, to pay off the loan more quickly.

Like a traditional refinance, there are numerous costs involved with a cash-out refinance. Refinance costs include appraisals, origination fees, title insurance, and notary fees. Additionally, some lenders charge slightly higher interest rates when pulling cash out of your home. If your existing mortgage has a low interest rate, your new payments could be much higher at today's interest rates.

Frequently asked questions

What are the requirements for HELOCs?

To get a home equity line of credit, you’ll need verifiable income, a good credit score, and equity in your home. You can typically borrow up to 80% to 90% of your home’s appraised value, minus your current mortgage balance. Banks also look at your debt-to-income (DTI) ratio, and your combined DTI should be under 43%, including the new payment. A credit score of 620 is generally considered the minimum preferred. 

How much can you get with a HELOC loan?

The maximum cash you can get from a HELOC loan depends on your home’s value, current mortgage balance, and the bank’s maximum loan-to-value. Technically, there is no limit to the cash you can pull out, but each lender may have its own limits. You can generally get 75% to 90% of your home’s value minus any existing debts tied to the property, like your mortgage. 

How do payments work on a HELOC?

HELOC payments are based on current interest rates and your monthly balance. The minimum payment due is interest-only during the draw period, but you can pay extra to reduce your balance and future interest charges. If your balance is zero for the month, you won’t have a payment. During the repayment period, any remaining balance will convert to a principal-plus-interest loan. 

Is a HELOC a good idea?

A HELOC can be a smart option if you need flexible access to funds for things like home improvements, education costs, or unexpected expenses. It’s especially helpful if you’re confident in your ability to manage variable rates and only borrow what you need. 

That said, if you prefer more predictability, a home equity loan with fixed payments might be a better fit. For homeowners who want to tap into their equity without taking on monthly payments, a home equity investment could be worth exploring. Or, if you're primarily looking to lower your interest rate or consolidate debt, refinancing your mortgage might offer the savings you're after. The best option depends on your financial goals, repayment preferences, and comfort with risk.

Final thoughts

HELOCs are an easy way to get cash out of your home without affecting your current mortgage. You'll only pay for what you use, and your credit limit can be used multiple times as you pay down your balance. HELOC payments are interest-only, but the variable interest rate can make payments unaffordable when rates rise. Consider all of your borrowing options before applying for a HELOC to make sure it is the best loan type for your financial situation.

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