What is a HELOC and how does it work?

Learn about costs, fees, how interest rates are calculated and more.

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A home equity line of credit (HELOC) can be a good option for short-term borrowing when you’re not sure exactly how much you need — such as home repairs or medical bills. But make sure you can afford the fees and payments, or you’ll risk foreclosure.

How HELOCs work

A HELOC is a revolving credit line from which you can periodically withdraw money. Lenders let you borrow against your home’s equity and use your home as collateral in case of default.

HELOCs have two payment periods. The draw period is when you can withdraw money and only pay interest on what you borrow. The repayment period is when you’ll start paying back both the principal and interest.

How is interest calculated?

HELOCs usually come with variable interest rates that are tied to a benchmark rate — like the Wall Street Journal prime rate — and fluctuate over time. How much you withdraw determines how much interest you’ll pay, meaning you’ll only accrue interest on the amount of equity you’re actively using.

For instance, if you have a line of credit for $50,000, but you only need $30,000 for a home renovation, you’ll pay interest on the $30,000 and not the $20,000 that you didn’t use. If you spend another $10,000 for vacation, you will pay interest on the total amount withdrawn — $40,000 — with a $10,000 line of credit left over.

How can I minimize the interest?

Always aim to get the lowest possible interest rate. Some banks charge a margin — or extra percentage points — on top of the benchmark rate. The higher your credit score and the more equity you have, the lower your HELOC margin should be. Shop around to compare lenders. Make sure you’re getting the best deal.

You can also cut down on interest by only borrowing what you absolutely need from your HELOC since interest is calculated on how much you withdraw. To save even more money over the life of your loan, you can make payments on both interest and the principal during the draw period, as well as extra payments during the repayment period.

When do I have to start repayments?

When you take out money from the HELOC during the draw period, you’ll usually only have to pay interest on the amount you borrowed. Some lenders will allow you to make payments toward the principal as well, which can help reduce the total cost of your HELOC over time. If you decide to make repayments toward the principal, that money can be added back into the line of credit to borrow again.

After the draw period is over, your repayment period begins. This period is when you’ll be on the hook for paying off the total amount you borrowed, plus any interest that accumulated. Be careful, though – the monthly payment amount is much higher during the repayment period than the draw period.

Costs and fees

Lenders charge different fees and may be willing to negotiate and waive certain charges. Some of the most common fees associated with HELOCs are:

  • Application fee: $0–$500
  • Appraisal fee: $300
  • Closing costs: 2%–5% of the loan amount
  • Cancellation or early termination fee: $100–$500
  • Annual fee: $50–$100
  • Inactivity fee: $100
  • Prepayment fee: $500

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Consider a HELOC if:

You’re looking to borrow money with an interest rate that’s typically lower than conventional loans. Periodic withdrawals can be helpful for borrowers who need cash in phases — for example, for a home renovation or to pay for a child’s college tuition. Note that you’ll need at least 15% to 20% equity in your home to qualify.

Avoid HELOCs if:

  • You can’t afford the payments. If you default on your payments, you’ll risk foreclosure.
  • You plan to refinance or sell your home. Since the HELOC is tied to your house, you’ll need to pay it off in full if you plan to refinance or sell your home.
  • You like a predictable mortgage payment. Most HELOCs have variable interest rates. That means your rate can fluctuate, which makes it difficult for homeowners to budget.
  • You want to pay off your home faster. A line of credit reduces the amount of equity you have. So you may end up taking a longer time to pay off your mortgage than before. Unfortunately, that also means more interest payments.
  • Home values are dropping. If home prices drop, you may end up underwater – owing more than your home is currently worth.

How to get a HELOC

Most credit unions, banks and private lenders offer HELOCs. You can apply online, in person or over the phone in most cases. You’ll also need to submit documents that verify your information — such as proof of income and home equity — as part of your application.

Frequently asked questions

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