Definition and Examples of HELOC
A HELOC—home equity line of credit—is a revolving line of credit secured by a percentage of the equity you've built in your home. You can borrow from a HELOC as needed up to a certain limit, similar to a credit card, as long as you stick to the terms.
- Alternate name: Home equity line of credit
For example, if your home is appraised at $300,000 and your current mortgage balance is $200,000, you have $100,000 of equity in your home. If your lender allows you to borrow against 80% of your equity, you can take out a HELOC with a limit of $80,000.
How Does a HELOC Work?
Sometimes you have financing needs that can't be handled with a credit card—debt consolidation, home improvements, medical expenses, or education expenses, to name a few. You can tap into your home’s equity as a source of funds for those more significant expenses. Because the line of credit is secured by the money you’ve paid into your home mortgage, you can often borrow larger amounts.
With a HELOC, the lender establishes a maximum credit line from which you can borrow as long as you have available credit and you're still in the draw period. The draw period is a timeframe that some lenders set for making purchases against your line of credit. During the draw period, you may be required to pay only the interest or a minimum payment of interest and principal.
HELOCs often have lower interest rates than other types of loans, allowing you to minimize your financing costs. However, the APR may be variable, which means it can fluctuate from month to month based on an underlying market rate.
Lenders are legally required to give you certain information about the HELOC, including the APR, payment terms, and any fees you're charged, like an application or appraisal fee. This way you're aware of how much you'll pay when you borrow from your credit line and can decide whether the pricing fits your requirements. (You can decide not to take the HELOC and have any fees you've paid refunded to you within three days, not including Sundays, if you change your mind.)
During the draw period, let's say the first 10 years, you can borrow as much as you need and you'll only have to make interest payments. You can also pay down your balance to free up additional credit for later. Once the draw period expires, you'll enter the repayment period, a fixed 20 years for instance, and won't be able to borrow from your HELOC.
Alternatives to a HELOC
Home Equity Loan
Similar to a HELOC, a home equity loan is also secured by the equity in your home. The biggest difference is that the loan is closed-ended, meaning you borrow a set amount once and repay it over a period of time. Since your home is collateral for the loan, the biggest risk is losing your home if you default on your loan payments.
Securities-Backed Line of Credit
A securities-backed line of credit (SBLOC), also referred to as a portfolio loan, allows you to borrow against an investment portfolio without selling the assets within the portfolio. You can't use the credit line to purchase additional securities, but you can use it for a number of other things like buying or purchasing a new home, covering education expenses, or funding business costs. You can only borrow a certain percentage of your portfolio and could be required to add more to the portfolio if the value of your investment decreases.
Personal Line of Credit
With a personal line of credit, the lender uses your credit history and income to determine whether you qualify and the maximum credit line you can access. You can be approved quickly, since there's no appraisal process. However, since you're not offering any collateral, you'll typically pay higher interest rates compared to a HELOC.
Pros and Cons of HELOC
Access to a higher credit line
Reduced home equity
Risk of foreclosure
- Access to a higher credit line. Your borrowing limit is based on the equity you have in your home when you apply. Having more equity in your home allows you to borrow more than you might be able to with a credit card or personal loan.
- Lower APRs. HELOCs have lower interest rates than unsecured borrowing options like a credit card, personal line or credit, or personal loan allowing you to save money on financing.
- Flexible borrowing. With a line of credit, you can borrow as much or as little as you need rather than taking out a large lump-sum payment.
- Reduced home equity. Since the HELOC is secured by your home equity, you'll no longer have access to it. If the value of your home falls, you could end up with negative equity where you owe more than your home is worth.
- Unpredictable payments. This is especially true if you have a variable APR, which changes with the market. Your monthly payment can fluctuate, which can make it difficult to budget for your payments.
- Risk of foreclosure. Late payments on a HELOC put you at risk of having your home seized by your lender, even if your primary mortgage payments are on time.
- A HELOC allows you to access a line of credit to use for a variety of purposes, like home renovations or debt consolidation.
- The credit line is secured by a percentage of the equity in your home.
- You can make purchases against the credit line for the first few years with minimal payments.
- The biggest risk with a HELOC is the potential to have your home foreclosed if you default on payments.
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