HELOCs Explained: What Is a Home Equity Line of Credit?

You can benefit from the equity in your home before your mortgage is paid off. With a home equity line of credit (HELOC), you can borrow against the equity you have earned at a lower interest rate than you would with a personal loan or a credit card.

Because your home is used as collateral, you must understand how a HELOC works before you tap into the equity in your home.

• A HELOC is a way to borrow against the value of your home, ideally for home improvements, consolidating high-interest debt, or investing in a second home or property. 
• In most cases, a HELOC lets you borrow up to 85% of your home’s value (minus your existing mortgage balance).
• Your home is the collateral for a HELOC; failure to make payments increases your risk of foreclosure.
• To qualify for a HELOC, you typically need a credit score of 620 and a debt-to-income ratio of less than 40%.

A HELOC is a way to use the equity in your home and access it as cash. Perhaps you need to pay for a new roof or have unexpected medical expenses. If you have equity, meaning that you have paid off a certain amount of your mortgage loan and your home is worth more than the balance on your mortgage, you can use that equity and borrow against it.

A HELOC is an open-ended line of credit you can borrow from when needed. It can be a better option than a personal loan, offering flexibility and potentially lower interest rates.

A home equity line of credit lets you borrow against the money you have invested in your property. It functions like a second mortgage, meaning you’re taking on some additional risk as a borrower. Your home is collateral, and if you cannot make payments you can be at risk of losing your home to foreclosure. 

• Borrowing: You can borrow up to a specific amount of the equity you have in your home, typically 85%, including both the HELOC and your existing mortgage. Like a credit card, you can spend up to your credit limit, and the interest charged is only for the amount you’ve withdrawn or used.
• Payments: Your credit is replenished as you make payments toward your balance. This means you can pay off your HELOC like a credit card and reaccess your available equity if needed. 
• Access to funds: You can typically transfer funds from your HELOC to a checking or savings account at the same lending institution. Your bank might also provide a credit card or specific checks to access your funds. 
• Draw period: This is when you can withdraw funds from your home equity line of credit. It typically lasts for a set period of between five and 15 years. Your minimum monthly payments usually apply to the interest only, and your loan balance is subject to a variable interest rate.
• Repayment Period: After the draw period, you must begin to pay back the borrowed amount (principal) plus interest with fixed repayment terms. Your payments will be higher at this point and may be due over 10 or 20 years. Depending on the terms, you might need to pay back the whole amount you borrowed at the beginning of the repayment period.

The interest you pay on a home equity line of credit may be tax deductible if the funds are used for home improvements, buying a home or building one. The balance of your HELOC and your mortgage must not exceed the loan limits set by the IRS if you want to take a deduction. Consult a tax professional to confirm your eligibility.

Your equity is the portion of your home's value that you own outright. Your down payment is often immediate equity when you buy a home. After that, your equity grows with each payment as funds are allocated toward the principal and interest.

If your property’s value increases over time, you also gain equity, but the opposite happens if your home’s value declines.

To calculate your home equity, get an estimate of your home’s value. You can use a Home Valuation Report as a starting point to see what your property is worth. Then, subtract your mortgage loan balance from that value.

Here’s an example of how your equity grows:

• If you buy a home for $350,000 with a 20% down payment (covering the remaining $280,000 with a mortgage), you'll have equity of $70,000 in the house.
• If the house's market value does not change over the next two years, and $15,000 of mortgage payments are applied to the principal, you would have $85,000 in equity.
• If the home's market value increases by $150,000 over those two years, you would have $235,000 in equity.

As a general rule, a HELOC can be used to borrow up to 85% of the value of your home minus the amount you owe.
Most HELOCs have a variable interest rate, which means your payments will change from month to month. Some banks and credit unions will let you convert some (or all) of your balance from a variable rate to a fixed interest rate. Fixed rates are usually higher than variable rates, but aid in budgeting since you know how much you owe each month.

While a HELOC allows you to tap into the equity in your home, there are a few risks to be aware of. 

• Variable interest rates are common with a home equity line of credit. If rates rise, your monthly payments will also increase.
• Because a HELOC is a second mortgage, your home is used as collateral. You could be at risk of foreclosure if you fail to make payments. 
• Borrowing against the equity in your home can impact your proceeds if you decide to sell. For example, if you use your home equity line to invest in improvements as you prepare your home for sale, any unpaid balance must be settled before closing.  
• If your home value has increased significantly, a HELOC could make it possible to borrow more than you can afford. Consider what your monthly payments will look like before you draw funds so that you’re not at risk of accumulating excessive debt. 

You can apply for a HELOC online. You’ll need to gather the documents the lender will want to see, including:

• Identification, such as a driver's license or passport.
• Income verification, such as pay stubs and bank statements.
• Documents that verify your homeownership, such as tax returns, a property tax bill or mortgage statements.

After you have completed the application, the lender will check your credit score, income, and your home or property’s value. The lender may also conduct an appraisal of your property at this stage.

The lender may specifically require the following:

• A credit score of at least 680 is common, though some lenders may accept a score as low as 620.
• A debt-to-income ratio (DTI) of 40% or less.
•  A consistent track record of income and employment.
• Documentation showing homeowners insurance.

This review stage is the underwriting period, which can take up to 30 days. You'll​​ be asked to sign a loan agreement and pay any closing costs. Then, you'll have access to your HELOC. 

A home equity line of credit differs from a home equity loan, which provides a one-time lump sum payment rather than a revolving credit line.

Another key difference is the interest rates. While a HELOC carries a variable interest rate, most home equity loans have a fixed rate, which may be more appealing if interest rates rise. Speak with your lender to determine if a HELOC or a home equity loan is your best option.  

The attraction of a HELOC is its flexibility. You can use a HELOC for almost anything, including home renovations, real estate investments or debt consolidation. A HELOC may involve an annual fee, a minimum amount outstanding, or the withdrawal of an initial amount when the credit line is set up.

Be aware that if the value of your home decreases significantly, your lender might decide not to allow you to take out additional credit under your HELOC plan, and you may not be able to access as much money as you thought.

A lender could also freeze your ability to take out additional funds if they suspect you might miss payments.

1. Create a budget. Track your expenses as you draw funds and determine how quickly you can pay off your equity line.
2. Set borrowing limits. While an equity line can help you pay for value-adding improvements and renovations, you should avoid borrowing beyond your means. 
3. Make payments on time. Doing so will bolster your credit score and help you avoid penalties and fees for late payments.