What Is a HELOC and How Does it Work?

A home equity line of credit can be a convenient way to access cash, but you must be prepared to put your home up as collateral to secure the loan.

A large beige two-story suburban house
Phillip Spears/Getty

A home equity line of credit, or HELOC, is a home loan that allows you to tap into your home's equity over an extended period of time.

A HELOC functions as a revolving line of credit that you can continually access. The time period when you can draw money from your line of credit is called the draw period, and it's typically 10 years. This could be a good option if you need access to money but aren't sure how much you'll need (or when you'll need it). HELOCs may have lower interest rates than other types of home loans or personal loans.

If you need money to pay for home improvements or higher education costs, a HELOC can be helpful because you can repeatedly withdraw money over the course of your loan term. Plus, you only have to pay interest on the money that you withdraw. So, if you're approved for a HELOC of $100,000 and only withdraw $25,000, you'll only pay interest on the $25,000. 

How do HELOCs work?

HELOCs are a revolving line of credit. During the draw period, you can take out money as many times as you need via check or a debit card, as long as it's below your total loan amount. You must also make minimal monthly payments, typically just for the interest that accrues during the draw period. As you repay your HELOC, this money is added back to your revolving balance (so you can continue to withdraw funds).

Once the draw period comes to an end, you enter the repayment period, which usually lasts between 10 to 20 years. At this point, you can't take more money out of your HELOC. Once you're in the repayment period, your monthly payments will increase because you must start paying back the principal (the amount you withdrew) in addition to the accrued interest.

You can typically borrow up to 85% of your home's value, minus the amount you still owe on your mortgage. To determine how much equity you have in your home, subtract your remaining mortgage balance from the house's current market value. So if your house is worth $500,000 and you have $300,000 left to pay off on your mortgage, you would have $200,000 in equity. If you borrowed 85% of your home's equity, your loan amount would be $170,000.

HELOC requirements

Factors like how much equity you have in your home, how much debt you're carrying and your credit score all play a role in how likely you are to be approved for a HELOC, as well as determining your interest rate

For example, most lenders prefer to see a credit score of at least 700, but it's possible to be approved with a lower credit score depending on your personal financial situation.

Requirements:

  • At least 15% to 20% equity in your home
  • Minimum credit score of 620 
  • A debt-to-income ratio, or DTI, of 43% or less
  • Adequate, verifiable income 

How to pay back a HELOC

A HELOC is divided into two separate payment periods over the length of the loan: the draw period and the repayment period.

  • Draw period: The first is the draw period, which is typically 10 years and the time when you can make repeated withdrawals as needed up to your credit limit. One of the benefits of a HELOC is that during the draw period you can make interest-only payments on the funds you withdraw and not the entire amount of the loan, which means you're able to make minimal monthly payments while borrowing a large amount of money. Similarly, if you end up not needing all of the cash from your HELOC, you aren't required to use it and can take out only what you need.
  • Repayment period: When your draw period ends, you can't withdraw more money from your HELOC, and you begin your repayment period. The repayment period typically lasts for 20 years. During this period, you're required to begin paying back your principal loan balance in addition to the interest your loan has been accruing – which means you'll have a much larger monthly payment than when you were only paying down your interest. Be prepared for your HELOC payment to spike when the draw period comes to a close.

Pros of a HELOC

  • Lower interest rates: HELOCs may have lower interest rates than other home equity loans, personal loans or credit cards. 
  • Long draw and repayment periods: Most HELOCs let you withdraw money for as long as 10 years and then offer an even longer repayment period (usually up to 20 years).
  • You can take the money in installments: You don't have to use all of the money available at once, and you only have to pay interest on the funds you withdraw.

Cons of a HELOC

  • You have to use your own home as collateral: If you default on a HELOC or can't make your payments, you could lose your home. When you put a house up as collateral and cannot repay your loan, the bank or lender can foreclose on your home, which means they can take ownership of your house in order to make up for the money they lost. 
  • They have variable interest rates: Your initial interest rate may be low, but HELOC rates are variable and not fixed. This means they can fluctuate depending on what's happening with the economy and the benchmark interest rate. This means your monthly payments are not predictable and can fluctuate over the course of the loan. While there are fixed-rate HELOCs, they are less common and are considered a hybrid between a HELOC and a home equity loan.
  • There may be minimum withdrawal amounts: Some HELOCs have minimal initial withdrawal amounts, which could lead you to taking out more money than planned (and having to pay back more than planned).

HELOCs vs. home equity loans

HELOCs and home equity loans both allow you to borrow against the equity you've built up in a home. With both, you take out a second home loan in addition to your mortgage. Your home is also used as collateral to secure either type of loan. A home equity loan, however, offers a lump sum of cash that you pay back in fixed monthly installments. A HELOC, on the other hand, approves you for a set loan amount and then allows you to withdraw only what you need, when you need it.

A HELOC has a variable interest rate, whereas home equity loans are fixed-rate loans. This means, you'll have a more predictable monthly payment with a home equity loan. HELOCs are much more flexible, but your monthly payments can be more unpredictable since your interest rate can fluctuate. With a HELOC, you need to make sure you can afford your monthly interest payments if your rate shoots up.

A HELOC is better if

  • You need access to credit for an extended period of time (usually 10 years)
  • You need more time to repay the loan amount
  • You want the flexibility to withdraw your money in installments and not all at once

A home equity loan is better if

  • You want a fixed interest rate
  • You want a predictable monthly repayment schedule
  • You want one lump sum of cash and know exactly how much money you need

HELOCs vs. cash-out refinances

A cash-out refinance is a different type of loan than a HELOC: You are quite literally cashing out the equity you've built in your home over the years. It replaces your current mortgage with a new mortgage equal to your home's value and allows you to cash out the amount you've built in equity. If your home is valued at $300,000 and you still owe $100,000 on a mortgage, the difference of $200,000 is your home equity. Lenders often let you cash out 80% of your equity ($140,000 in this case).

With a HELOC, you're also cashing out your equity, but you are taking out an additional loan alongside your current mortgage. So, you will have to make your monthly mortgage payments in addition to repaying your HELOC each month. With a cash-out refinance, you are only responsible for your mortgage payment every month. However, your mortgage payment will be more expensive because you added more money onto your mortgage when you cashed out your equity.

A cash-out refinance offers you this equity in a lump sum, whereas a HELOC lets you draw on your equity in installments and offers a yearslong line of credit.

A HELOC is better if

  • You need access to credit for an extended period of time
  • You need a longer loan repayment period
  • You want to the flexibility to withdraw your money in installments

A cash-out refinance is better if

  • You want to refinance your mortgage to a lower interest rate or shorter term
  • You want one one lump sum of cash and know the amount
  • You want one fixed monthly mortgage payment