How does a home equity line of credit work? A guide

One of the best things you can do for your finances is to give yourself options so that when things change — and they always do — you can roll with the punches. Many homeowners find that a home equity line of credit, or HELOC, is an excellent way to do that. 

How does a home equity line of credit work, though? It’s similar to credit cards inasmuch as you can borrow money as you need it at a variable interest rate, but that’s where the similarities end. In fact, HELOCs work differently from just about any other financial product. 

If you learn how HELOCs work — and, more importantly, how to use them well — you can better position your family for a successful financial future.

How does a home equity line of credit work?

A HELOC, like other home equity products, uses your home as collateral for the loan. If you were to default, your lender could foreclose on your home to secure repayment for your HELOC. 

In return for that guaranteed payment, lenders typically offer lower interest rates than on unsecured debts, such as personal loans. HELOCs have another added twist, though: they typically charge variable interest rates, which means that your financing costs can fluctuate over time.  

Unlike most lending options, a HELOC is divided into two distinct periods: a draw period and a repayment period. Each one has real implications for how much you’ll spend and what you can borrow. Let’s take a look at how they work. 

Draw phase

After you’re approved for a HELOC, you’ll immediately enter the draw phase. This is when you can borrow funds against your available credit limit (called “taking a draw”) as you need, although some lenders impose certain restrictions. You may be required to take an initial draw after opening the account, for example, or make a minimum withdrawal each time you access funds. Lenders do this to ensure you’re actually using the account. 

The draw phase lasts anywhere from five to 10 years with most lenders. During this time, you’re only required to make interest-only payments, although you can pay extra if you choose. It’s a good idea to do this if possible, as it’ll refresh your available credit limit, reduce your interest costs over the long run, and make repaying the funds easier once you enter the repayment phase. 

Repayment phase

Once you enter the repayment phase of the HELOC, your access to credit stops, and you can no longer borrow additional funds. Instead, your HELOC essentially converts to a loan. Any unpaid loan balance is amortized into principal and interest payments, and you’ll make those payments over the course of a further 10 to 20 years.

Home equity line of credit requirements

HELOCs are very popular among homeowners, but you’ll still need to meet certain HELOC lending requirements in order to get one. Each lender is free to set its own rules, but they often consider the same general factors: 

• Income: Lenders prefer a strong and stable income over smaller and more variable paychecks. 
• Credit score: 620 or higher is required with most lenders.
• Debt-to-income ratio: 43% or less, as measured by the percent of your monthly take-home pay that goes toward minimum debt payments.
• Combined loan-to-value ratio: 85% or less with most lenders, although some will allow you to borrow up to 100%. This is measured as the total debts secured by your home (including your mortgage and new HELOC limit) divided by your home’s value. In other words, you’ll generally need at least 15% equity in your home to qualify. 

Pros and cons of a home equity line of credit

HELOCs can be very powerful tools, but they’re not right for everyone. Check first to see whether this list of pros and cons aligns with your personal financial situation:

Pros

• Peace of mind: Knowing that you have access to credit that you can use instantly in an emergency is very comforting to many people. 
• Flexible funding: You can borrow money as needed during the draw period and use it for almost anything you want.
• Lower interest rates: HELOCs typically charge lower interest rates than similar options, such as personal loans, at least before any potential rate increases take effect. 
• Interest-only payments: While it’s good to pay down your HELOC balance even when it’s not required, sometimes it’s useful to have the option of making interest-only payments, like if your income suddenly drops because of an unexpected job loss. 
• Tax-deductible interest for some uses: If you use HELOC funds for home improvements, you may be able to deduct the interest you pay on your tax return. Speak with an accountant to be sure, though. 

Cons

• Fee-laden structure: In addition to potentially high amounts of interest, some lenders charge annual fees or draw fees each time you tap into your credit line. Plus, you’ll have to pay high closing costs even to open the line of credit, which can range as high as 5%. 
• Foreclosure potential: It’s extra-important to stay on top of your HELOC payments because if you default on the debt, you could face foreclosure on your home. 
• Complicates home sales: Your HELOC will be repaid by proceeds from your home sale if you sell it before paying back the debt, similar to your mortgage. That leaves less money for you to buy a new home, and can add extra wrinkles if your home value drops below what you owe on your home. 
• Changing monthly payments: Lenders tie your HELOC interest rates to an index, like the Wall Street Journal Prime Rate. Your monthly payment will change as the number fluctuates or when you borrow or repay funds. That can make budgeting for your HELOC payments particularly challenging. 

Home equity line of credit alternatives

Homeowners often prefer HELOCs over other types of home equity lending methods, but it’s important to be aware of your other options in case something else works better for you. 

• Home equity loan: This loan offers a lump-sum payout that’s better aligned for specific projects with known costs, like debt consolidation or a home contractor estimate. Choose this option if you don’t want the added borrowing capacity that HELOCs offer, and prefer the payment certainty of a fixed interest rate. 
• Cash-out refinance: If you didn’t get good terms on your primary mortgage, you may be able to refinance it and borrow additional funds in the process, for a larger overall loan. You’ll pay interest for a longer length of time, however, which can increase the overall cost of those extra funds. 
• Home equity investment: This lump-sum funding option doesn’t require any monthly payments and is instead repaid after a 30-year period as a single payment, along with a share of your home’s future equity appreciation (change in value, not total home value). 
• Reverse mortgage: Homeowners 62 and over may be eligible for a reverse mortgage, which allows them to tap into their home equity without having to make any payments. The debt is typically repaid when you no longer need the home. 

Frequently asked questions

Is it a good idea to take out a home equity line of credit?

A HELOC can offer adaptable access to funds that can be used for a wide range of purposes, but it can be hard to manage repayment because the amount due changes over time. If you need more payment certainty, a home equity loan or a home equity investment (HEI) may provide greater payment stability. 

How do payments work on a home equity line of credit?

You’re generally only required to make interest-only payments during the draw phase, but it’s a good idea to pay down your balance, too, if possible. Once you switch to the HELOC repayment phase, you’ll make full interest and principal payments on the debt. 

Is a HELOC a second mortgage?

Yes. A HELOC is considered a type of second mortgage, meaning that it’s attached to your home on top of an already-existing mortgage. Home equity loans are also considered second mortgages for this reason. 

Final thoughts

A HELOC is one of the most valuable financing tools available to homeowners, especially if you want a more open-ended way to borrow money than simply applying for a new loan each time. That said, HELOC repayment can be more difficult to manage because of that flexibility, so it’s important to take an honest look at your ability to handle shifting monthly payments, too. 

Looking for flexible funding without monthly payments or income verification? Point’s HEI lets you tap your home’s equity for what matters most.

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