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What is a HELOC and how does it work?

Turn your home’s equity into a revolving line of credit — but watch for fees and variable interest rates.

A HELOC works like a credit card that uses your home’s equity as collateral. It can provide a flexible stream of cash to fund big-ticket items — like ongoing home renovations, business ventures and education costs. But because it puts your home at risk, clearly understand how HELOCs work before taking one out.

What is a HELOC?

A home equity line of credit (HELOC) is a type of revolving credit that uses your home’s value as collateral. You pull money from your HELOC for a set number of years — or your “draw period” — up to a set credit limit before you’re required to start paying it back.

Draw periods range from five to 10 years, depending on the bank or financial institution. Once you enter the repayment period, you’re no longer allowed to withdraw additional funds from your approved line of credit.

Eligibility requirements

Requirements for a HELOC can vary by lender but will typically look for:

  1. At least 15% to 20% equity in your home.
  2. Credit score of 620 or higher.
  3. Proof of income, debt and employment.

HELOC credit limits

A HELOC’s credit limit is based on the equity you have in the home you’re using to secure the loan. Lenders usually allow you to borrow up to 85% of your home’s value, minus your outstanding mortgage.

Say you own a $400,000 home with $300,000 left on your mortgage. It means you’ve built up $100,000 in equity. In this case, you may be able to open a HELOC for up to $85,000.

Calculate your estimated credit limit with our HELOC credit limit calculator.

How HELOC interest rates work

Most HELOCs come with variable interest rates pegged to the Wall Street Journal prime rate. So when the prime rate goes up due to inflation or fed rate changes, your HELOC’s interest rate also rises.

For example, if the prime rate is 3% and your HELOC has a margin of 2%, your interest rate would be 5%. If the prime rate then goes up to 5%, your new interest rate would be 7%.

Fixed-rate HELOCs are less common, but they may be an option with some lenders. With fixed-rate HELOCs, your interest rate doesn’t change even if the prime rate increases, so your monthly payment always stays the same.

Is HELOC interest tax-deductible?

It could be. You may be able to deduct HELOC interest from your taxes if you use the loan to “buy, build or substantially improve your home,” according to the IRS.

Closing costs and other fees

There are many little fees to watch out for when you open a HELOC, including:

  • Application or origination fees. This is a nonrefundable charge you may pay just to apply for a HELOC.
  • Closing costs. Similar to your mortgage, you can expect to pay 2% to 5% in closing costs to finalize your HELOC.
  • Appraisal fees. Your lender will order an appraisal to determine the value of your home. This fee can be $300 or more.
  • Annual fees. This is a yearly fee charged by your lender just to keep your HELOC open.
  • Early termination fees. That’s right — you may be charged a fee if you pay off your HELOC early. This fee is meant to discourage borrowers from doing so, since lenders make money from your interest payments.
  • Inactivity fees. Your lender may also charge a fee if you don’t borrow from your HELOC for a set time.

How repayments work

HELOCs have two payment periods: a draw period and a repayment period.

During the draw period

The draw period starts first and can last five to 10 years, depending on the lender. You can borrow money from your HELOC as often as needed during the draw period.

You make interest payments only during the draw period, though you can also make payments on the principal if you want to lower your overall cost.

During the repayment period

The repayment period starts once the draw period ends. Lasting from 10 to 20 years, it’s when you start paying your loan back — principal, interest and all. You’re not allowed to make any withdrawals during this time.

Warning: Some HELOCs come with a balloon payment you must pay back in one lump sum when your HELOC ends. If you have a balloon payment and don’t have the funds to pay it off, you may need to refinance your loan or negotiate a longer term with your lender.

Advantages of HELOCs

  • Competitive interest rates. HELOCs typically have lower interest rates than conventional loans because they’re backed by your home. Rates are also lower than other types of revolving credit, such as credit cards.
  • Only pay interest on borrowed amount. Interest is applied to the money you withdraw from your HELOC only — not to your full line of credit.
  • Flexible repayment options. You have the option to only pay interest on your HELOC during the draw period, but you can still make payments toward the principal if you want to pay it off early.
  • Interest may be tax-deductible. If you use your HELOC for home improvements, you may be able to write the interest off on your taxes.

Disadvantages of HELOCs

  • Easy to overspend. Because you’re not required to pay back any principal during the draw period, it could be easier to borrow more than intended. As a result, your monthly payments could be higher than expected when it’s time to repay.
  • Variable interest rates. HELOC interest rates are variable and increase over time, making your monthly payments even more expensive.
  • Upfront costs. You’re on the hook for closing costs, application fees, and appraisal fees when you open a HELOC. And even then, you could still face ongoing fees throughout the life of your loan.
  • Risk of foreclosure. Lastly, HELOCs are secured by your home, which puts you at risk of foreclosure if you’re unable to make the payments.

HELOCs vs. home equity loans

A HELOC is a revolving line of credit, much like a credit card. You can use it to finance ongoing projects large and small, and you only pay interest on the amount you borrow. HELOCs are best for when you need flexible or ongoing access to your money.

A home equity loan is a lump-sum loan with a fixed interest rate. You borrow a set amount of money and pay it back over a set term, usually five to 15 years. Home equity loans are best for one-time projects, such as a major home renovation or pool installation.

For help deciding which is right for you, visit our HELOC vs. home equity loan page.

More alternatives to HELOCs

If you need access to cash but don’t want to take out a HELOC, you have other options available.

Personal loans are a type of unsecured loan that typically have fixed interest rates and terms, so you know exactly how much you’ll pay each month. But because they’re unsecured, many have high-interest rates that can keep you trapped in a cycle of debt.

Another option is a cash-out refinance, which allows you to refinance your existing mortgage for more than you owe and take the difference in cash. This can be a good option if interest rates have dropped or you’ve built up equity in your home. But closing costs and refinancing fees will apply.

Compare interest rates for home equity loans, HELOCs and cash-out refinancing

Use our tool to get personalized estimated rates from top lenders based on your location and financial details. Select whether you’re looking for a Home Equity Loan, HELOC or Cash-Out Refinance.

If you selected a home equity loan or HELOC, enter your ZIP code, credit score and information about your current home to see your personalized rates.

In the Cash-Out Refinance tab, select Refinance and enter your ZIP code, credit score and other property details to see what you might qualify for.

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Bottom line

HELOCs can be a great way to turn your home’s equity into a pool of money you can tap into on a regular basis. Be sure to read the fine print and weigh the pros and cons as you shop around for HELOCs.

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