A home equity line of credit, or HELOC, is a loan that allows you to borrow against your home equity and unlock your equity as cash at a low interest rate. A HELOC is a revolving line of credit that functions like a credit card, which means you can keep withdrawing from it over time, whenever you need additional funds, instead of receiving the loan as a lump sum. HELOCs have draw periods -- the period of time when you can use your line of credit -- that range from five to 20 years, with 10 years being the typical draw period.
This makes a HELOC an appealing way to tap into your home’s equity because it gives you access to a large amount of funds over a long period of time. Your home equity is the difference between what you owe on your mortgage and what your home is worth. So, for example, if your home is worth $400,000 and your mortgage balance is $300,000, you have $100,000 of equity in your home that you can borrow against using a HELOC.
To qualify for a HELOC, lenders want to see that you have at least 15% to 20% of equity in your home (you can usually borrow up to 85%), as well as a good credit score of 700 or higher to secure the best rates (although you may qualify with a score as low as 620), and are carrying a low debt balance overall. HELOCs are secured by your home, which means your property could be repossessed if you miss payments or default on your loan. Most homeowners use HELOCs for major life expenses such as home renovations, consolidating high-interest debt or paying recurring costs like college tuition.
Here’s what you need to know about HELOC draw periods, how they work, and alternatives to a HELOC if it isn’t the type of financing for your personal financial situation.
What is a HELOC draw period?
A HELOC draw period is simply the time period when you’re allowed to withdraw money from your open line of credit. When the draw period ends, your line of credit closes and you can’t take out any more funds. After your draw period closes -- say, for example, after 10 years -- the next stage of your HELOC is called the repayment period, which lasts usually 20 years. That’s when you have to pay back the interest plus principal, but can’t borrow any additional funds.
Keep in mind, even though your HELOC draw period will never change, HELOCs have variable interest rates, so your rate will rise and fall depending on what’s happening with interest rate trends and the economy overall, which means you should have enough breathing room in your budget to manage monthly payments that will likely go up and down over time.
How do HELOC draw periods work?
During the draw period, you can continually access your funds as needed. You don’t need to take your loan as a lump sum. If, for example, you have a $100,000 HELOC, during your draw period you can take out $15,000, and then six months later take out another $15,000, and so on. Your lender may have minimum required amounts for withdrawals, so make you sure you understand the full terms of your loan before you commit to it.
One of the biggest benefits of a HELOC is that you can make interest-only payments during the draw period, which keeps your payments low in the beginning. That means you can access cash for as long as a decade, but only make minimal payments on a large balance. How much your monthly payments are will vary depending on your loan amount and interest rate. You can use a HELOC calculator to figure out how high of a payment you can afford.
This is also where HELOCs can be tricky: Once you’ve enjoyed the low payments during your draw period, you can be in for sticker shock when your repayment period begins and you are required to begin paying back your principal loan balance as well. Be prepared for your payments to go up significantly if you’ve only been making interest-only payments during the draw period -- and for those larger payments to rise and fall as interest rates rise and fall depending on what’s happening with the economy.
Your lender will have its own requirements for terms such as minimum withdrawal amounts, maximum number of withdrawals, and whether you qualify for a lower, introductory interest rate. Make sure you understand the agreement you’re entering into with your lender and what it does -- and doesn’t -- allow you to do with your money.
Once your draw period ends, your repayment period begins. That period is usually 20 years, but will vary between lenders. Once the repayment period begins, you can’t borrow any more money; you can only pay it back.
How do you access your HELOC funds?
Most lenders and banks will offer you an online option to login and manage your account, as well as a physical credit card or checks to spend your funds. You should be regularly monitoring your HELOC balance and payments. If you can pay more than the required interest-only payments every month during your draw period, it will lower your balance faster and minimize the amount of interest you pay over time. It’s a good idea to stay on top of your credit overall because your HELOC is an open line of credit that you’ll carry a balance on for years. To be on top of your credit now, take advantage of enrolling in free weekly credit reports through the end of this year.
What happens when a HELOC draw period ends?
You cannot spend any more money once your draw period comes to a close, with the exception of paying off your HELOC in full (in which case you can start drawing from it again up to your limit if your lender offers that option). Once your draw period ends, your repayment begins, and you can only continue paying back what you borrowed – not borrow more. Your repayment period will usually be a 20-year period, but the timeframe will also vary between lenders.
A key difference during the repayment period is that unlike during the draw period -- when your minimum payments are based on the amount you’ve withdrawn (not your total line of credit), your payments during the repayment period are based on the total amount of your loan (the principal) plus interest. So don’t be in shock when you see a hefty increase in your monthly output. Make sure you can comfortably afford your increased payment on top of your regular monthly mortgage payment.
What are alternative payment options a homeowner can consider?
If a HELOC isn’t the right type of loan for your personal situation, consider other types of financing. There are pros and cons to all kinds of financing, but interest rates should always be at the top of your mind when considering the best option for your specific needs.
Home equity loans: These types of loans also are secured by your home, but you receive the loan upfront as a lump sum of cash at a fixed-interest rate. This means you’ll have consistent, fixed monthly payments instead of variable ones. You can’t continually withdraw from a home equity loan like you can with a HELOC, and you have to make payments on the total loan amount from the beginning of your loan term.
Fix the interest rate: It’s possible to secure a consistent interest rate on your loan. “Ask your current HELOC lender if they will fix the interest rate on your outstanding balance,” said Greg McBride, chief financial analyst at Bankrate, CNET’s sister site. “Some lenders offer this, many do not.”
Refinance your HELOC: You can convert your HELOC into a home equity loan. “If fixing the interest rate is not an option, you can look into refinancing your HELOC into a fixed-rate home equity loan,” said McBride. “The rate may not be much different from what you’re currently paying on your HELOC, but it does provide certainty on your interest rate, monthly payment and payback period,” he added.
Cash-out refinance: A cash-out refinance also provides you with a lump sum of cash, but it pays off and replaces your current mortgage with a new mortgage so you only have to make one monthly mortgage payment, instead of two. This option may not be feasible for most homeowners in today’s rising interest rate environment, because your refinance rate typically has to be lower than your current mortgage rate for refinancing to make financial sense.
Personal loans and credit cards: These types of financing don’t require you to put your home up as collateral because they’re unsecured loans. Expect to pay higher interest rates for such unsecured financing options.
The bottom line
HELOC draw periods last for years (ranging from five to 20 years, but usually 10 years), which gives you access to an open line of credit at a low interest rate for an extended period of time. Before signing on the dotted line, be sure you understand the risks of using your home as collateral to secure a HELOC if you decide to go this route for financing. As always, shop around and compare offers from lenders to secure the most favorable rate and term available to you. Even 1/10 of a percentage point can make a huge difference in the amount of interest you pay over the lifetime of a loan, especially a large, variable-rate loan such as a HELOC.