How Does a HELOC Work?

Home equity lines of credit—or HELOCs, as they’re more commonly known—are one of the most popular tools that homeowners use to borrow against their home equity. 

If you’re looking for a more flexible route than a traditional loan to borrow money, a HELOC may be a great choice. They work differently than most other types of debt, however, and that can lead a lot of people into murky financial waters if they don’t fully understand their HELOC. 

We’ll cover everything you need to know about how a HELOC works so you can decide whether it’s right for you, and if so, how to make the most of it.

What is a HELOC?

A HELOC is a revolving line of credit that uses your home as collateral, similar to a home equity loan or even a mortgage. Unlike those two loan types, however, it’s split up into two phases: a draw phase where you can borrow money and a repayment phase where you pay it all back. 

The amount of money you can borrow with a HELOC depends on a few factors, but one of the most important is the amount of equity you have in your home. Equity is the value of your home minus any debt tied to it, like your mortgage. Most lenders limit you to borrowing 80% to 90% of your home’s value minus your mortgage. 

For example, if you have:

• A home worth $200,000
• A $100,000 mortgage
• You have $100,000 worth of home equity, or 50% 
• If you qualified for a HELOC that leveraged 80% of that value, you would would qualify for an $80,000 HELOC.

As your home equity increases, so too does your borrowing power—and that explains a lot about why HELOCs are becoming more popular than ever. 

Thanks to a rapid rise in home prices, about 84 million Americans now have a median of $240,000 in home equity they can use to qualify for a home equity loan or HELOC, according to a recent TransUnion report. 

As a result, nearly 300,000 new HELOCs were opened during the last quarter of 2022, a 7% increase from the prior year alone. 

How does a HELOC differ from a home equity loan?

Home equity loans and HELOCs are very similar in that they both use your home equity as collateral for your debt, resulting in a lien against your home. 

They’re also referred to as second mortgages because they take the backseat to the primary lien against your house—your mortgage if you’re still repaying it. And just like your mortgage, if you default on a HELOC or home equity loan, your lender can foreclose on your home, evict you, and sell it to repay your debt. 

Home equity loans and HELOCs also have similar qualification requirements you’ll need to meet, which may vary by lender. Finally, you may also be able to deduct the interest you pay on both HELOCs and home equity loans, as long as they’re used for “substantial” home improvements and you meet other requirements.

Here are some of the ways in which HELOCs and home equity loans differ:

How does a HELOC application work?

Applying for a HELOC is more complicated than a credit card or a personal loan, largely because it’s tied to your home. So, you and your lender need to do some extra legwork. 

Keep in mind that each lender has its own procedures and ways of doing business when you apply for a HELOC. But in general, here’s how it works for most borrowers:

1. Check your credit: You’ll generally need good credit to get approved with most lenders. The higher your score, the lower your interest rate. Check your credit report to make sure it’s accurate and your credit score so you know what types of rates are fair. 
2. Gather documents: Your lender will request documents proving your identity, income, home ownership, mortgage, and financial situation. You may also need information about your homeowners’ insurance, HOA dues, and property taxes. 
3. Get preapproved: Most lenders allow you to get preapproved using a soft credit check that doesn’t harm your credit score. In return, you should get an estimate of your loan costs and HELOC structure. The CFPB has a good chart to compare all these details.  
4. Complete an application: Choose the lender whose offer matches your goals most closely and fill out a full application. They should reach out to you and explain the next steps within a few business days, which may vary by lender. 
5. Get an appraisal: Most HELOC lenders require a home appraisal, which can be done a few ways. Full home appraisals are more expensive and invasive but more accurate. Remote appraisals are cheaper and easier but may undervalue details in your home. 
6. Close on your HELOC: If you’re approved, you’ll generally need to meet with your lender to sign the documents and close on the HELOC. Federal law also gives you the right to cancel this agreement within three business days, within limits. 

How does interest work on a HELOC?

Most HELOCs come with variable rates that are calculated based on an index and a margin. Your lender starts with an index, such as the U.S. prime rate, and adds a margin as their cut of the deal. 

For example:

• You might see a HELOC advertised as “prime plus 0.50%.” 
• If the prime rate was 8.5%, your interest rate would be 9.0%: 8.5% for the index plus 0.50% for the margin. 

Most HELOCs come with limits on how often—and how much—your variable rate can change. There may be periodic caps that apply to each individual rate change, preventing your monthly payment from jumping too much at once. 

Lenders are also legally required to put lifetime caps in place to keep your interest rate from getting too out of control. Most lenders are still free to set that lifetime cap as high as they like as long as they disclose it to you before you sign up for the HELOC. 

Even so, most lenders typically set lifetime interest rate caps of 18.00% or less since that’s the legal maximum that credit unions are allowed to charge. These types of rate caps and adjustment frequencies are especially important to pay attention to when you’re shopping around.

A few rare lenders offer hybrid fixed-rate HELOCs, which may work differently. You may be charged a fixed rate right from the start on everything you borrow, or you may be able to convert a portion of your existing variable-rate debt over to a fixed rate. 

How do you pay back a HELOC?

Paying back a HELOC is one of the trickiest parts to understand and plan for because your HELOC is split into two periods: a draw phase when you can borrow and a repayment phase when you pay it all back. 

• The draw phase on a HELOC typically lasts for five to 10 years. You can borrow money during this time, with most lenders requiring interest-only minimum payments. You’re free to pay down the balance, although it’s not required yet. 

Paying more than the minimum during the draw phase has a few advantages, however. You’ll refresh your credit limit so you can borrow more again if needed in the future, lower or eliminate your current monthly payment, and you’ll also save money on interest.

• After the draw phase is over, the HELOC enters the repayment phase. This can work one of two ways, depending on the terms of your contract. 

Your HELOC will convert to a variable-rate loan with a 10 to 20-year term length. Alternatively, the outstanding balance will become due immediately in the form of a balloon payment. If you can’t pay this all at once, you’ll need to take out another loan. 

How does a HELOC work?

HELOCs tend to vary a bit more among lenders than, say, personal loans. It’s good to pay attention to these differences as you shop around. That said, the general way that HELOCs work is the same:

1. Open a HELOC: Depending on the lender and your qualifications, you may be able to borrow up to 80% to 90% of your home’s value, less any debt you have from a mortgage or other debts secured by your home.
2. Borrow as needed: You’ll be able to borrow money as you need it during the draw phase. Depending on the lender, you may need to submit a draw request to have cash deposited to your bank account, or you may receive a credit card or checkbook. 
3. Make interest-only payments during the draw phase: Aside from annual fees, you generally won’t need to make any payments unless you actually take a draw. Most HELOCs only require interest-only payments during this time.
4. Repay the full amount during the repayment phase: Once your HELOC converts over to the repayment phase, you won’t be able to borrow funds anymore. Most HELOCs convert into a variable-rate loan at this point, although some require a balloon payment. 

Example of how a HELOC works

The average U.S. home sold for $514,000 in August 2023, according to the U.S. Census Bureau. The average mortgage balance in 2022, on the other hand, was $236,443. The difference between your home value and your mortgage balance is the amount of home equity you have. That means the average homeowner had $277,557 in home equity. 

If you applied for a HELOC from a lender with a maximum loan-to-value ratio of 90%, you could borrow up to $462,600—if you didn’t have a mortgage. But since you do, you will only have access to a HELOC credit limit of $226,157. 

From here, you can calculate your monthly payments based on which HELOC phase they’re in (draw or repayment) and figure out how much interest you’ll pay. 

This is a bit trickier, however, because the interest rates may change frequently and most HELOC borrowers draw funds and repay it several times over the course of the HELOC. It’s still an interesting exercise, however.

How does a HELOC work?
	How to calculate it	Example
Home value	Get an appraisal or estimate it from real estate websites like Zillow	$514,000
Mortgage balance	Check your latest mortgage statement.	$236,443
Home equity ($)	Home value – mortgage balance	$277,557 ($514,000 – $236,443)
Home equity (%)	(Home equity ($) / home value) * 100	54% ($277,557 / $514,000) * 100
Maximum loan-to-value (LTV) ratio	Varies by lender, typically 80% to 90%	90%
Maximum credit limit	(Maximum LTV ratio * home value) – mortgage balance	$226,157 (0.9 * $514,000) – $236,443
Interest rate	Varies by lender	8.38%
Draw phase payments	Monthly interest-only payments based on your interest rate and the amount you borrow; use an interest-only loan calculator	If you borrow $20,000, your interest-only monthly payments would be $140 while the interest rate is at 8.38%
Repayment phase payments	Monthly payments toward principal and interest based on your interest rate, term length, and the amount you borrow; use a loan calculator	If your HELOC converts to a 15-year loan that repays a $20,000 balance, your monthly payments would be $196 while the interest rate is at 8.38%
Expected total interest paid	Add up monthly interest payments during the draw phase, plus the loan calculator results for total interest paid during the repayment phase	$40,398 If you borrowed $20,000 at the start of your HELOC and only made interest-only monthly payments of $140 during a 15-year draw phase, you’d have paid $25,200 in interest. Then, when it converts to the repayment phase, you’d pay an additional $15,198 in interest

HELOC eligibility

Each lender varies in terms of what requirements it sets to get approved for a HELOC; however there are some commonalities:

HELOC requirements
Credit score	620 or higher
Debt-to-income ratio	43% or less
Home equity	10% – 20%
Combined loan-to-value ratio	80% – 90%

In general, you will need at least 10% to 20% equity in your home before you’re eligible for a HELOC. After that, most lenders allow you to borrow a combined balance (your mortgage plus your HELOC or any other debts secured by your home) of up to 80% or 90% of your home’s value.

Your debt-to-income ratio, on the other hand, is the percentage of your total monthly income that goes towards debt payments. If you earn $2,000 per month and pay $100 towards a student loan bill and a personal loan, for example, your debt-to-income ratio would be 10%.

When should you take out a HELOC?

The best time to take out a HELOC depends on your reasons for wanting one. If you just want a HELOC as a backup in case of emergencies, then it’s wise to open it sooner rather than later so you’re prepared. 

According to Eric Kirste, CFP, “Home renovations and major home repairs, financial emergencies, consolidating high-interest debt, and making a downpayment on additional real estate are all some of the best uses of a HELOC.”

Since HELOCs feature variable rates, you don’t need to worry as much about waiting for a good interest-rate environment before applying, like many people do with fixed-rate debt. Rates may be high now, but you won’t be locked into them if rates go down in the future. Your HELOC scales accordingly. 

If you’re looking to use a HELOC for a specific ongoing need, such as a DIY renovation project, then it’s best to apply for it two to six weeks in advance. This is the average time it takes to complete the whole HELOC application process from start to finish. 

It’s best to get preapproved with at least three HELOC lenders so you can compare your options. Here are some questions you can ask to zero in on the right HELOC lender:

• Do you offer any discounts?
• What specific fees are involved?
• How often does the variable interest rate adjust, and by how much?
• Do you require an appraisal, and if so, how is it completed?
• What is the length of the draw and repayment phases?
• How are payments calculated during the draw and repayment phases?
• How do I take a draw against my HELOC?
• Do you have any minimum draw requirements?
• Do you allow the HELOC to be renewed at the end of the draw phase?
• Can I convert any portion of my HELOC balance to a fixed-rate loan?

Alternatives to a HELOC

Many homeowners choose HELOCs over other types of debt because of their flexibility and low interest rates. A HELOC also has clear disadvantages, however, such as the potential for foreclosure or borrowing too much money, and it may not even be an option for many people. 

“If other financing can offer you lower fees, shop your options to ensure you are getting the most cost effective financing option,” says Kirste. 

Before you apply for a HELOC, it’s a good idea to rule out these other options first: 

HELOC alternatives
Type of debt	Tied to your home?	Better if …
Credit card	No	You want an easier method for everyday spending, especially to earn rewards or pay off purchases and balance transfers with a 0% intro APR offer.
Personal loan	No	You want a quick and easy loan that doesn’t risk your home and has steady fixed-rate payments.
Home equity loan	Yes	You want to finance a large one-time purchase at lower rates than a personal loan can offer, and you don’t mind using your home as collateral.
Cash-out mortgage refinance	Yes	You can qualify for a lower rate on a cash-out refinance than on your current mortgage and you don’t mind resetting the repayment clock back to the start.
Personal line of credit	No	You like the idea of being able to draw against a HELOC, but you don’t want to risk putting up your home for collateral.
Home equity conversion mortgage (HECM)	Yes	You’re at least 62 years old, don’t want to make payments, aren’t concerned about leaving your home to heirs, and fully understand the terms of your contract.

FAQ

Is a HELOC a good option for emergency funds?

You can use a HELOC as your emergency fund. It’s better than having nothing at all, but it’s not the best option. Most financial experts recommend saving up at least three to six months’ worth of expenses instead so that you earn interest and don’t need to worry about making payments. 

Can you lose your home with a HELOC?

Yes. If you default on your HELOC, your lender can evict you and foreclose on your home. This is the riskiest part of a HELOC, especially since the variable rates and the transition from the interest-free draw period to the full repayment period can cause big jumps in your payment amount.

Does a HELOC affect your credit score?

Yes. Your HELOC has the same effect on your credit as any other loan type. The amount you borrow and whether you pay on time can significantly impact your credit score. 

Your HELOC balance is not included in your credit utilization ratio like credit card debt, however, meaning you won’t be penalized for carrying a high balance relative to your credit limit. 

How do rate changes affect a HELOC?

Rate changes affect your HELOC minimum payment and the amount of interest you pay. Lenders are required to set lifetime caps for your HELOC, but they may have lifetime rate minimums as well. There may also be periodic rate adjustment caps limiting how far a rate can change at once. 

Are there any tax benefits with a HELOC?

Possibly. You can deduct the interest you pay on up to $750,000 of combined mortgage and home equity loan/HELOC debt on your primary home if the funds are used for substantial upgrades that increase your home’s value and you itemize your deductions instead of taking the standard deduction.

Can you use a HELOC for anything you want?

Yes, most lenders allow you to use a HELOC for anything you want. However, some uses are better than others. Using your HELOC to pay for upgrades, repairs, and other items that increase your home’s value is a better idea than using it to pay for a vacation, for example. 

“Have a plan in accessing your HELOC and be responsible,” says Kirste. “Like other credit, it can be tempting to draw more than planned and abuse access to the funds, thus getting your self in more debt.”

What are some of the worst uses of a HELOC? According to Kirste:

“Buying a car—with good credit, you can probably qualify for an auto loan at a lower interest rate than a HELOC. Likewise, starting a business— instead of putting your home at risk for a business idea, explore financing options such as a business loan,” he says. “And finally, investing—do not use your home as leverage to purchase risky assets and investments.”

Is it possible to refinance a HELOC?

Yes. Some lenders allow you to refinance your existing HELOC into a new one, often to roll over your HELOC into a new draw phase rather than switching over to the repayment phase. You can also apply for a HELOC with a new lender to repay your old HELOC or use another debt type, such as a personal loan, to repay it.  

How long does it take to get approved for a HELOC?

It typically takes two to six weeks, on average, to get approved for a HELOC. Some lenders process applications faster than others. If you need a full home appraisal or apply with a coborrower or cosigner, this can slow the process down. 

Are there closing costs on a HELOC?

Yes, most HELOCs charge closing costs such as appraisal fees, title search fees, attorney fees, origination fees, and more. 

Can I transfer a HELOC to another property?

Generally, no. Your HELOC is tied to your existing property, which you offered as collateral in exchange for the debt. You can, however, use your HELOC funds to pay for another property, such as a second home or a rental property.