What Is a HELOC? And How Does It Work?

Written by Kim PinnelliUpdated: 28th Dec 2021
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A HELOC helps you borrow against your home’s equity, putting it to good use. Whether you need the money now or setting yourself up for future expenses, a HELOC can be a great way to help yourself financially.

Learn what a HELOC is and how it works below.

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit is a loan against the equity in your home. Equity is the difference between your home’s value and any outstanding mortgagebalances.

For example, if your home is worth $400,000 and has a $200,000 mortgage balance, you have $200,000 in home equity.

A HELOC or home equity line of credit is a loan against that equity. You take out the line of credit and use it like a credit card. Some lenders provide you with a debit/credit card to use it or a checkbook.

Like your first mortgage, a HELOC is a lien on your home, but it takes a second lien position. If you default on your loans, the first mortgage lender receives a payout before the second mortgage lender.

How Does a HELOC Work?

You apply for a HELOC like you’d apply for a traditional mortgage. Only this time, you’re applying for a second mortgage.

The lender will ask for proof you can afford the loan and that you have a solid payment history.

They’ll pull your credit, evaluate your income and liabilities, and order an appraisal to determine the home’s value.

If approved, the lender will provide you with a credit limit. You close on the loan for the full amount, but you may not receive any of it in hand at the closing.

If you just wanted the HELOC to have a line of credit for future expenses, home renovations, or even an emergency expense, you’ll receive access to the funds but won’t draw any out of the home.

If you are consolidating debt or paying for an immediate expense, you can request to receive funds at the closing.

There’s one area the HELOC differs from just about any other mortgage loan you could get – the payment.

You don’t make fully amortized payments right away, or you aren’t required to. The minimum payment required is the interest accrued on any funds you withdrew, just like a credit card.

You’re free to make principal payments too, but you must always make the minimum payment.

Since the interest rate changes monthly on HELOCs, it’s hard to predict the amount of the payment, so always pay close attention to your statement and pay the correct amount.

You can continue using and reusing funds in your credit line (if you pay them back) for 10 years.

After 10 years, your loan becomes a traditionally amortized loan with principal and interest payments required for the next 20 years.

How Do You Qualify for a Home Equity Line of Credit?

Every lender has different qualifying requirements for a HELOC, just like they do for traditional mortgages.

The difference here is that HELOCs aren’t regulated by any government agency. Lenders typically keep HELOCs on their books, which means they can create their own requirements.

In general, expect the following qualifying requirements:

  • Minimum 640 – 660 credit score
  • Maximum 43% debt-to-income ratio
  • Stable income and employment for the last 2 years
  • On-time mortgage payment history for the last 12 – 24 months
  • Adequate equity in your home

Most lenders will lend up to 80% of the home’s value, including your first mortgage. Some lenders may go as high as 85%, though. If you need over 80%, you’ll need to shop around for a more flexible lender.

Like with a traditional loan, the higher your credit score is, the more likely you are to get approved and for the amount you want.

Since HELOCs are against your equity, if you have a lower credit score or high debt ratio, you may get approved, but at a loan-to-value ratio much lower than 80%, not giving you full access to the money tied up in your home.

If you have a blemished mortgage payment history, you probably won’t get approved – lenders look closely at your housing payment history since they’ll take a second lien position and risk receiving any payout at all if you default.

How Much Can You Borrow with a HELOC?

To figure out how much you can borrow for a HELOC, find out your home’s value. It can be an estimate but get as close as you can. Appraisers and real estate agents are great resources to find out your home’s value.

If you don’t have access to either, you can use a site like Zillow to get a close estimate, just don’t think it’s set in stone.

Once you know your home’s value, multiply it by 80% and subtract the amount of your first mortgage. The number you have left is how much you can borrow with a HELOC if you qualify for it.

Just because lenders say you can borrow up to 80% of your home’s value doesn’t mean you can afford it.

You must prove that you can afford the payment with your income, current liabilities, and housing payment history.

HELOC Example

Let’s look at a quick example of qualifying for a HELOC.

John owns a house that’s worth $400,000. He has a 1st mortgage on it that he’s had for 10 years.

He originally borrowed 95% of the home’s price, but he’s paid the mortgage down, and the home has appreciated too, so he has decent equity.

Currently, John’s mortgage balance is $275,000. He has great credit and very few debts. He also made his mortgage payments on time for the last few years. John wants to borrow the full amount he’s eligible for, which is $45,000.

John applies for a HELOC for $45,000 and gets it. He closes on the loan but doesn’t draw any money out right away.

He leaves the HELOC untouched for six months, so he didn’t owe any payments. At the six-month mark, though, he withdrew money to renovate his house. He then owed interest payments on the money he withdrew.

How to Get a HELOC (Step-by-Step)

It sounds complicated to get a HELOC, but we’ve broken it down step-by-step for you.

#1. Determine Your Current Home Equity

First, you must know your home’s equity. Find out your home’s value and subtract any existing mortgage debt from it, as we talked about above.

That’s the equity or the portion of your home that you own. If you were to sell the home today, you’d walk away with that money or most of it after paying closing costs.

#2. Shop Around and Compare Various Lenders

Get quotes from several lenders. It doesn’t cost anything to do so, and if you do it within three-four weeks, the credit bureaus will only hit you with one credit inquiry.

When comparing offers from lenders, look at the interest rate, closing costs, and loan terms.

HELOCs are different than a first mortgage. Compare your offers carefully, looking at the bottom line – how much will the loan cost you overall?

#3. Choose a Lender

Once you’re ready, choose the offer that makes the most sense. You’ll tell that lender you’re ready to move forward, and they’ll continue processing your loan.

Processing a HELOC doesn’t take as long as a first mortgage, so you’ll close quicker than you think.

#4. Apply for the HELOC

When you’re ready, you’ll officially apply for the HELOC. If the lender did a soft credit pull to qualify you for the loan, they’ll do a hard credit pull now. You’ll also complete an application to officially apply for the loan.

#5. Gather Necessary Documentation and Home Appraisal

Just like when you applied for your first mortgage, you must provide the lender with your documentation.

This includes your paystubs, W-2s, tax returns, asset statements, and current liability statements.

You’ll also need to pay for a home appraisal. For HELOC loans, most lenders allow a drive-by appraisal which is just an exterior evaluation of your home, so you may not have to be home for the appraisal.

#6. Review Disclosure Documents

Within 3 business days of applying for the loan, you’ll receive disclosure documents. Review them carefully, especially the rate, term, and repayment options. Make sure you understand the terms and agree with them before signing any paperwork.

#7. Close on the HELOC

Your final step is to close on your HELOC. A loan closing agent will help you understand the documents.

If you have any questions while closing, call your loan officer to clarify any misunderstandings. Once you sign the documents, the loan is yours, so be careful.

How Is a HELOC Paid Back?

As we talked about above, HELOCs have a different repayment period – there are two periods: draw and repayment.

Draw Period

The draw period is when you can use the funds. This occurs for the first 10 years of the loan. During this time, it works like a credit card.

Repayment Period

The repayment period is years 11 – 30. You can’t draw on the funds during this time, but you must repay the funds you withdrew.

You’ll pay principal and interest for the next 20 years. Some lenders also allow you to lock in your rate during the repayment period to help make your payments more predictable.

Can You Use a HELOC for Anything?

Most lenders don’t tell you how to use a HELOC. You are free to use the funds however you want unless you have a high debt-to-income ratio, and the lender requires you to use some of the funds to pay off your debts.

What Are the Advantages to Getting a HELOC?

A HELOC allows you to tap into your home’s equity. Rather than leaving the funds tied up in your home, you can take out up to 80% of the home’s value and put the money to good use.

For example, you may use the funds to renovate your home, pay for college, cover a medical procedure, or just as an emergency fund.

What Are the Disadvantages of Getting a HELOC?

Like any loan, HELOCs have disadvantages, and they’re similar to a traditional mortgage. You’ll pay interest on the amount you borrow, and there are closing fees to access your own money in your home.

Perhaps the largest downside, however, is the variable interest rate. It’s hard to predict how much your payment will be, especially if you withdraw more funds each month.

Is It Better to Get a HELOC or Home Equity Loan?

A HELOC and home equity loans are both second mortgages on your home, but they are different. Many people wonder if a HELOC is better than a home equity loan?

The answer is that it depends.

A HELOC is better if you’re looking for funds you can reuse or withdraw over time without paying anything but interest.

But, if you have a one-time need for funds, a home equity loan may be better since you’ll get a fixed interest rate.

But with a home equity loan, you make principal and interest payments from the start, and you can’t reuse the funds even after you repay them.

>> More:HELOC vs. Home Equity Loan

HELOC Fees: What Fees Are There?

Every lender differs in what they charge for a HELOC, but in general, they charge:

  • An origination fee
  • Title fee
  • Appraisal fee
  • Application fee

Shop around to make sure you get the best deal for your loan.

How Does a HELOC Affect Your Credit Score?

Like any loan, your credit score may drop when you first take out a HELOC. The new loan makes your credit score dip. But if you make your payments on time, it may even help your credit score.

One big factor is how the lender reports the debt to the credit bureaus. If they report it as revolving debt, you must keep your outstanding balance at 30% or less of the credit line, or it will hurt your credit.

If they report it as an installment loan, you don’t have to worry about the maximum amount outstanding, and it won’t hurt your credit.

Alternatives to a HELOC

Whether or not a HELOC makes sense is entirely up to you and the financial position you are in. However, it is still important to know what alternatives are available.

Home Equity Loan

The home equity loan is a second mortgage that you receive in one lump sum. You don’t get access to reuse the funds.

It’s a second mortgage that’s just like the first, with a fixed interest rate and predictable payment.

Cash-Out Refinance

A cash-out refinance is a first mortgage. You pay off your first mortgage with the new loan that’s a higher loan amount.

The amount that remains comes to you as cash. You make principal and interest payments right from the start, and most cash-out refinance loans are a fixed interest rate loan.

>> Next Steps: How to Refinance Your Mortgage

Personal Loan

If you only need a small amount of money and don’t need the credit line, an unsecured personal loan may be a better option.

You don’t put your house on the line, and you pay fewer closing costs. The interest rate will be higher than a mortgage, but the term is shorter, so you pay the loan off fast.

What Is the Minimum Payment on a HELOC?

The minimum payment on a HELOC is equal to the interest charges. The exact amount depends on how much money you withdrew and the interest rate at the time.

When Should You Get a HELOC?

You should get a HELOC when you have equity in your home that you want to access. A HELOC makes sense if you need or want ongoing access to the funds.

Just make sure you’re responsible for its use – don’t use the money just because it’s there. Reserve it for its purpose and make sure you can afford at least the interest payments each month.

Bottom Line: What Is a HELOC?

A HELOC is a great way to access your home’s equity. It helps you turn your house into cash while allowing you to live in it still.

It’s a great way to pay for home renovations, college, or any other large expenses you have coming up.

It’s like a large credit card that uses your home as collateral. Use the funds wisely, and you can safely use your home’s equity with a HELOC.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.