What is a HELOC, and how does it work?

What is a home equity line of credit?

A HELOC is a type of revolving credit you can access using the equity in your home. It is similar to a home equity loan in that you borrow against your equity, but works more like a credit card in you only repay the amount that you withdraw.

Once you repay what you borrow, those funds are available to access again. This type of financing works best for ongoing expenses where you don’t know what the total costs will be, like some home renovations. It is also useful for covering emergency costs if you don’t have enough cash set aside, since it can be easier to borrow money during your open draw period than apply for a new personal loan.

» MORE: Reverse mortgage vs. home equity loan vs. HELOC

How does a HELOC work?

When you are approved for a HELOC, you will be able to borrow up to 85% of your home equity.

You can choose to make regular withdrawals from a HELOC or keep it open and available for use at a later time.

Your HELOC credit limit depends on the loan-to-value (LTV) ratio.

HELOCs are different from other forms of credit because there’s a specified period during which you can take out money (called the draw period). Most draw periods range from five to 10 years. You’ll make minimum monthly payments throughout the draw period, though you won’t begin repaying the principal until the repayment period begins.

After the draw period ends, the repayment period starts. Repayment periods are typically longer than draw periods — a HELOC with a five-year draw period could have a 10-year repayment period. During the repayment period, you’ll make monthly payments of principal and interest until the balance is paid off.

Some HELOCs require a balloon payment at the end of the draw period rather than an extended repayment period. A balloon payment is a large lump-sum payment of both principal and interest.

What can you use HELOC for?

Like other loans, you can use a HELOC for any number of reasons, like consolidating credit card debt, funding a home renovation project, paying for medical expenses or even starting a business.

According to Michael Borman, chief lending officer at JetStream Federal Credit Union in Miami Lakes, Florida, “The most popular uses of a HELOC are for home improvements, debt consolidation, college tuition and as a backup emergency fund in case of unexpected expenses. Sometimes, individuals utilize the HELOC to purchase another property, such as a vacation or rental property.”

However you decide to use a HELOC, it’s important to remember that your HELOC payment requirement could vary in the future. “A typical HELOC has a variable interest rate, which causes concern for consumers. … The interest you pay on the balance owed can rise and fall based on market conditions,” Borman said.

» MORE: Fixed-rate HELOCs: a cross between HELOCs and home equity loans

HELOC requirements

You’ll apply for a HELOC like you would apply for any loan. Be aware that each HELOC lender will have its own set of requirements, but typically you will need to have the following:

• 15% to 20% equity in your home
• Credit score of 680 or higher
• Income verification
• Debt-to-income (DTI) ratio of 43% or lower

HELOC pros and cons

There are several benefits and drawbacks to consider before applying for a HELOC. This financing option isn’t for everyone, even if you meet the minimum borrower requirements.

Risks of using a HELOC

A HELOC puts a lien on your home, and failing to repay what you’ve borrowed puts you at risk of foreclosure.

A HELOC places an additional lien on the property, making it a type of second mortgage. Using your house as collateral can be risky, especially if there’s a chance you may not be able to pay back what you’ve borrowed.

Defaulting gives the lender the right to foreclose on your property and sell it to get its money back. In this case, you would lose any equity from the loan proceeds.

Another risk of using a HELOC is rising interest rates. (since HELOCs typically have variable rates), which can in turn make your monthly payments more than you might be able to afford. And if you have an interest-only loan, you’ll want to watch out for balloon payments once the interest-free period ends.

HELOC alternatives

HELOCs aren’t the only means to accessing the equity in your home. If you’re looking for a loan that offers access to cash upfront instead of a line of credit, a home equity loan, cash-out refinance or reverse mortgage may be a better alternative, depending on your individual situation.

HELOC vs. home equity loan

A home equity loan provides loan funds upfront in a single payment. You begin making payments on both the principal and interest immediately. While HELOCs typically carry variable interest rates, home equity loans offer fixed rates that won’t change over the life of the loan.

HELOC vs. cash-out refinance

A cash-out refinance replaces your current mortgage loan with a new loan for your remaining principal balance plus an additional amount that you receive in cash. You typically need at least 20% equity in your home to get started. With a cash-out refi, you can generally choose between a variable or fixed rate.

HELOC vs. reverse mortgage

A reverse mortgage is a loan for older homeowners (typically 62 and older) who want to trade their equity for regular payments or a lump sum. The borrower doesn’t repay the loan as long as they remain in the home and don’t sell it. To qualify, you have to have paid off your mortgage or have significant equity in your home.

Bottom line

A HELOC is a form of home equity borrowing giving you access to a revolving line of credit. You usually need at least 15% equity to qualify. HELOCs come with a number of risks, including a variable interest rate, which could mean unpredictable payment increases.

A HELOC might be right for you if you want to borrow against the equity in your home and need funds for ongoing expenses or debt consolidation.