A home equity line of credit—often referred to as a HELOC—is a line of credit that lets you borrow repeatedly against the equity in your home.
Understand the meaning and function of a HELOC in a practical sense, as well as what it offers and where it falls short, to determine whether it's the right financing option for you.
What Is a Home Equity Line of Credit?
A HELOC is a revolving line of credit with a credit limit based on the equity you have in your home. By definition, the revolving nature of a HELOC means you can borrow against it up to the credit limit, repay what you borrow, and borrow again until the end of the borrowing period. Your home secures and therefore serves as collateral for the HELOC, meaning that you could lose your home if you can't repay the debt.
- Acronym: HELOC
A home equity line of credit is different from a home equity loan. Home equity loans are installment loans that offer lump-sum payments based on your home equity, usually with a fixed interest rate. HELOCs are typically variable-rate lines of credit that you can pull from as needed for a set period.
How a Home Equity Line of Credit Works
HELOCs function much like credit cards. The lender will set a credit limit amounting to between 60% and 85% of your home equity—the assessed value of your home less the mortgage balance—depending on factors such as your creditworthiness.
You'll then be given a credit card or special checks to spend money during the draw period. This is a set period—typically 10 years—during which you can tap the credit line. Although you can’t exceed the credit limit offered by your lender, you can borrow less. You’ll also need to make minimum monthly payments to your lender during the draw period. These may be interest-only payments or payments on both the loan principal and interest, depending on the lender.
Once the draw period ends, you can't borrow any more money, and you'll enter the "repayment period." Depending on how your HELOC is structured, you'll either have to pay back your loan over time or make a lump-sum payment for the loan balance. If you make late payments or default on the loan, the lender may compel you to sell your home.
For example, suppose your home is worth $250,000, but you still owe $100,000 on the mortgage. Your equity in the home is $150,000. Your lender might offer you a HELOC with a credit limit of 85% of that amount, or $127,500.
Do I Need a Home Equity Line of Credit?
You can use the proceeds from HELOCs for any purpose. But they're the best option if you’re looking to fund a high-dollar purchase and want to spread its costs out over time. You can do so by making repeated draws against the HELOC rather than take out a home equity loan, which would get you a lump-sum payment.
For example, you might use a HELOC to cover renovations or home improvements or to pay for large expenses like tuition or medical bills. Some homeowners also use HELOCs for debt consolidation; they use the line of credit to pay off other, higher-interest debts.
Because HELOCs use your home as collateral, it’s usually not wise to use them for small or everyday expenses.
Pros and Cons of a Home Equity Line of Credit
As with all loan options, some advantages and disadvantages come with HELOCs.
Can help cover large expenses
Can borrow a flexible amount
Interest payments may be deductible
Uses your home as collateral
Has unpredictable, variable interest rates
Requires a second monthly payment
Comes with various upfront costs
HELOCs have many positives. Notably, they can offer you significant amounts of cash, which can be a huge help if you’re in a financial pinch or have a big purchase coming up.
Another benefit is flexibility. Unlike a loan, you don’t have to take the full amount of your HELOC at once. That can be useful if you’re doing, say, a renovation, where you may not be sure exactly how much you’ll need to borrow ahead of time.
HELOCs also offer a key tax benefit: You can deduct the interest you pay on the loan from your annual income taxes if you make substantial improvements to the home that secures it.
Despite their benefits, HELOCs are risky. Notably, they use your home as collateral, meaning that failure to repay puts your property at risk.
They also usually come with variable interest rates, meaning that your payments might be unpredictable and thus difficult to budget for and stay current on.
To complicate matters, payments are made in addition to your existing monthly mortgage payments, as a HELOC is a second mortgage.
Finally, HELOCs aren’t free to take out. You’ll usually need to pay an application fee, appraisal fee, as well as various closing costs. Some HELOCs also come with annual maintenance fees and transaction fees.
How To Get a Home Equity Line of Credit
As with any home loan, it's wise to shop around when seeking a HELOC. The terms of rates on home equity lines of credit vary greatly by the lender. Speak with a few different lenders before deciding whom to use, and consider HELOC attributes including:
- Terms and conditions: Learn how much you can borrow and for how long. Also know the monthly payment and repayment schedule, and whether you'll make interest-only payments or also pay down the principal during the draw period.
- Interest rates: Determine whether the annual percentage rate (APR) is variable or fixed. If it’s variable, identify the cap (limit on interest rate changes) and what, if any, index regulates it (which lenders will use to determine how much to raise or lower the rate over the loan term). Also, know about any introductory rates that could rise over time.
- Upfront costs: Assess charges such as closing costs, application fees, title searches, and other expenses. Try to negotiate these costs with the lender, then draw enough funds to make those costs worth it.
- Long-term costs: Consider any annual maintenance and membership fees.
Once you choose your lender, they’ll look at your income, credit history, and other financial details to determine whether you qualify for a HELOC, and, if so, how much you can draw.
- A home equity line of credit is, by definition, a revolving line of credit that lets a homeowner borrow money multiple times against the equity in their home.
- Homeowners can typically borrow up to a limit of between 60% to 85% of their home equity.
- HELOCs provide access to large sums of cash on a flexible schedule, but they can cause you to forfeit your home if you default on payments.
- Homeowners should shop around for lenders and understand the terms and various expenses of a HELOC before moving forward.