How Does a Home Equity Line of Credit Work?

Home equity lines of credit (HELOC) are adaptable, adjustable financial tools that let homeowners tap into all that equity they’ve built up in their home.

HELOCs provide flexibility and can be used for a range of purposes, including:

Major expenses such as education costs or buying a car
Home renovations or improvements
Education expenses
Debt consolidation
Emergency expenses

But how does a home equity line of credit work? And why is it important to know?

Insight into how a home equity line of credit works can help you make a better-educated decision about leveraging your home’s equity to achieve your financial goals.

In this guide, we’ll explain the mechanics of a HELOC, including the application process, draw and repayment periods, and key benefits.

What is home equity?

Before diving into the specifics of how a home equity line of credit works, it’s important to fully understand what home equity actually is.

Home equity is the value of a home minus any outstanding mortgage or other liens on the property.

Simply put, it’s the amount of the home that the owner actually possesses.

Let’s look at an example:

Home price:
- $363,438 (the current median home price in the United States)
Determine your outstanding mortgage balance:
- Example: $200,000
Calculate your equity:
- Take away your mortgage balance from your home’s value: $363,438 – $200,000 = $163,438

This equity represents the portion of your home that you truly own and can potentially borrow against. In this example, your home equity is 44%.

What is a HELOC?

A HELOC is a revolving or continuous line of credit secured by your home. It acts a lot like a credit card.

There’s a predetermined limit you can withdraw during a specified period: the draw period.

During the draw period, you can withdraw and repay funds as often as you need. This gives you tremendous adaptability for managing your finances.

Once the draw period comes to an end, your HELOC repayment period starts. This is when you’ll repay any remaining outstanding balance over a fixed term.

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The HELOC application process

The process of securing a HELOC involves several steps, including determining your eligibility, submitting an application, and completing the underwriting process.

Here’s a breakdown of each step:

Determine your eligibility: Most lenders require borrowers to have at least 15-20% equity in their home, a good credit score (typically 640 or higher for HomeEQ), stable income, and a low debt-to-income ratio.
Research lenders: Different lenders offer varying terms, interest rates, and fees for HELOCs—research and compare to find the one best suited to your financial needs.
Submit an application: Once you’ve chosen a lender, complete the application form with personal, financial, and property information.
Property appraisal: The lender will typically order an appraisal to determine your home’s current market value and assess the amount of equity you have.
Underwriting: The lender reviews your application, documentation, and appraisal report to decide whether to approve your HELOC. If approved, you’ll receive an offer detailing the terms and conditions.

The draw period

The draw period is the initial phase of a HELOC, typically lasting 5 to 10 years.

During this time, you can borrow funds up to your credit limit and repay them as needed.

Here are some key features of the draw period:

Accessing funds: You can access your HELOC funds through various methods, such as checks, a credit card linked to your HELOC account, or online transfers into another account, depending on the options provided by your lender.
Interest-only payments: Many HELOCs require interest-only payments during the draw period, which can help keep your initial payments low. Principal payments are acceptable here as well to reduce your outstanding balance.
Variable interest rates: HELOCs typically have variable interest rates, meaning your rate can fluctuate based on market conditions.

The repayment period

Once your HELOC’s draw period is over, the repayment period begins—usually between 10 and 20 years. You can’t borrow any additional funds and must repay the remaining balance.

Key features of the repayment period include:

Principal and interest payments: Unlike the draw period, you must make payments on both the principal and interest during the repayment period.
Fixed repayment term: The repayment period has a fixed term, meaning you must repay the entire balance by the end of this period.
Payment structure: Your monthly payments will be calculated based on the remaining balance, the interest rate, and the length of the repayment period. A variable interest rate means your payments may fluctuate over time.

Why would a homeowner get a HELOC?

HELOCs offer several benefits that can make it an appealing choice for homeowners looking to leverage their home equity. Here are some key benefits:

Flexibility: Being able to borrow and repay funds as needed during the draw period provides financial flexibility. This can be particularly beneficial for managing ongoing expenses or unexpected financial needs.
Lower interest rates: Because HELOCs use your home as collateral, they commonly have lower interest rates compared to credit cards and personal loans.
Interest-Only payments: The option to make interest-only payments during the draw period can help keep your initial payments low, freeing up cash flow for other expenses. Ask your lender if that is an option.
Tax Advantages: In certain scenarios, eligible borrowers can deduct the interest paid on a HELOC at tax time, provided the funds are used for home improvements. Consult with a tax advisor to determine if you qualify for this deduction.

Potential drawbacks of a HELOC

While a HELOC offers many benefits, it’s essential to be aware of potential drawbacks:

Variable interest rates: The variable interest rates associated with HELOCs can result in fluctuating payments, making it challenging to budget for future expenses.
Risk of foreclosure: Because your HELOC is backed by your home, failure to make payments could result in foreclosure.
Temptation to overspend: The flexibility of a HELOC can make it tempting to borrow more than you need, leading to increased debt. It’s important to use the funds responsibly and have a clear repayment plan.