What Is a HELOC and How Does It Work?

If you’ve built equity in your home, you may have heard about a HELOC as a flexible way to borrow money. A home equity line of credit is a favorite among homeowners who want to tap into the equity of their residence while enjoying better flexibility than a home equity loan. 

Our guide unpacks important questions, such as “What is a HELOC?” and “How does a HELOC work?” so that you can determine whether a home equity line of credit is the right product for your financial goals. 

What is a HELOC?

A home equity line of credit functions as a revolving credit line. Your home secures the line of credit. You won’t receive a lump sum up front. Instead, a lender will approve you for a maximum borrowing limit. You don’t have to max out the limit. Draw money from the account as needed over a set time, which is known as the draw period. 

Your borrowing limit is based on how much equity you have in your home. Your home’s equity represents the difference between what it’s worth and how much you owe. 

Let’s say your home is worth $300,000 and you owe $200,000. In this scenario, you have $100,000 in equity. However, you can’t borrow the full $100,000. Lenders typically allow you to borrow until you reach a loan-to-value of 80%. An 80% LTV on a home that is worth $300,000 is $240,000. In this case, you could borrow up to $40,000. 

A HELOC functions as a revolving credit line, which means it works more like a credit card than a traditional loan. During the draw period, you can borrow money, repay part of what you borrowed, and take out more cash up to the limit. 

How does a HELOC work?

A home equity line of credit is divided into two components, which are:

The draw period

The draw period comes first. It’s the phase where you are allowed to draw against your home’s equity, up to the borrowing limit. Typically, the draw period will last 5 to 10 years. During that time, you can:

• Borrow money up to your credit limit
• Use funds as needed
• Make interest payments (or more, if preferred)

Your monthly payment may be relatively low during the draw period, as you’ll only be paying interest on your loan balance. As you draw more money, the payment goes up. However, your principal balance will not decrease during the draw period unless you choose to make principal plus interest payments. 

Typically, HELOCs have variable interest rates. The rate will go up or down based on market conditions, which can affect your monthly payments over time. 

The repayment period

After your draw period ends, the HELOC transitions into the repayment period. The repayment period can last 10 to 20 years. At this stage:

• You can no longer borrow money
• You must repay both principal and interest
• Monthly payments typically go up

Some borrowers experience payment shock, since the bill can be much higher compared to the draw period. Make sure you consider the repayment period when choosing when and how much to borrow from your HELOC. 

HELOC vs. home equity loan

Both options let you tap into the equity of your home. However, each financial product works a bit differently. A HELOC:

• Provides you with a revolving line of credit
• Has a variable interest rate
• Is more flexible during the draw period

A home equity loan provides you with a lump sum up front. The interest rate is fixed, and you begin making payments right away. If you know how much you need to borrow and want the entire sum right away, a home equity loan can be a better fit. A HELOC may be better if you want ongoing access to funds. 

Pros and cons of a HELOC 

There are benefits and drawbacks to every financial product, including a home equity line of credit. The pros of a HELOC include:

• Flexible borrowing that lets you access only what you need
• Lower initial payments during the draw period
• Potentially lower rates compared to credit cards or unsecured personal loans
• A reusable credit line that you can pay down and borrow from again

The cons are:

• Variable interest rates that can increase your payments over time
• Your home is used as collateral 
• Payments increase after the draw period ends
• Easy access to funds can lead to overspending 

HELOCs aren’t good or bad. The tool works for some people and is a bad fit for others. Consider your goals and financial situation before choosing which approach to use. 

How to qualify for a HELOC

When you apply for a HELOC, lenders will consider the following:

• How much equity you have in your home
• Your credit score and payment history
• Debt-to-income ratio (DTI)
• Income stability 

Lenders want to know that you can afford to repay the money you borrow, especially when the draw period ends and your payments go up. 

Conclusion

A HELOC gives you flexible access to your home's equity, but that flexibility comes with real trade-offs.

Payments stay low during the draw period because you're generally only covering interest, then jump once repayment begins and principal is added. Variable rates can move against you in the meantime, and your home is the collateral throughout.

If you know exactly how much you need up front, a home equity loan with a fixed rate may suit you better.

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