What is a HELOC and how does it work?

Father and son using tablet in kitchen looking at ceiling lampImage: Father and son using tablet in kitchen looking at ceiling lamp

In a Nutshell

A home equity line of credit can let homeowners borrow money against the equity they’ve built up in their home. HELOCs can offer flexibility in borrowing, but they have limitations. They also carry the risk of foreclosure and can require considerable discipline.
Editorial Note: Credit Karma receives compensation from third-party advertisers, but that doesn’t affect our editors’ opinions. Our third-party advertisers don’t review, approve or endorse our editorial content. It’s accurate to the best of our knowledge when posted.

Whether you need to update your kitchen or fix a leaky roof, a home improvement or repair project probably won’t be cheap.

The median cost for a major kitchen remodel was about $35,000 in mid-2019, according to the 2020 Houzz Kitchen Trends Study. And if you need to replace your roof, you’re looking at an average cost of $7,211, according to December 2019 data from HomeGuide.

Unless you’ve got that kind of cash available in your bank account, you’ll probably need to borrow money to make that remodel or repair happen. You may want to consider a home equity line of credit, or HELOC.

Read on for an introduction to HELOCs and a quick rundown on some of the most common alternatives.

What is a HELOC?

A HELOC — also known as a home equity line of credit — allows you to borrow against the equity you’ve already built up in your home.

As a line of credit, a HELOC allows for flexibility around both borrowing and repaying money. But it can also require borrowers to stay especially disciplined when it comes to taking out funds and repaying their lenders.

How does a HELOC work?

In its simplest form, a HELOC works somewhat like a credit card. You can borrow money up to a certain credit limit set by the lender and then pay back the borrowed amounts along with interest. This option can offer more flexibility — you can even withdraw and make payments on a daily or weekly basis, if necessary.

How do you spend HELOC funds?

If you’re approved for a HELOC, lenders may allow you to withdraw money during a fixed time known as a draw period.

Once your draw period has ended, your lender may let you renew the credit line. If not, you may need to repay the outstanding amount all at once or over a period of time, which is called a repayment period.

What’s the length of a HELOC term?

The length of a HELOC can vary, but they can run for as long as 30 years (often with about a 10-year draw period and a 20-year repayment period). While borrowers can choose to withdraw the available money immediately, lenders can structure HELOCs as long-term relationships.

How much can you borrow with a HELOC?

A HELOC’s credit limit depends on a number of factors, including your credit and unpaid debts, but it’s determined largely by the market value of your home and the amount you owe on your mortgage.

For instance, if you own a home valued at $400,000 and still owe $300,000 on your first mortgage, then your home equity stands at $100,000. Banks typically limit the amount you can borrow to no more than 85% of the appraised value of your home minus what you owe on your mortgage.

In this case, the maximum amount you’d be able to borrow is $40,000. Here’s how that’s calculated, assuming there are no other liens on your home.

Home’s market value: $400,000

85% of home’s value: $340,000

Minus mortgage balance: $340,000 – $300,000

Potential line of credit: $40,000

Are there any additional fees?

Setting up your HELOC could cost hundreds of dollars in fees. Here are some of the fees you might see with a HELOC.

  • Appraisal fees
  • Application fees
  • Upfront charges, like points
  • Attorney fees
  • Title search fees
  • Mortgage preparation and filing
  • Annual fee
  • Transaction fees

Many of the terms and fees for HELOCs are determined by the lender, so it’s a good idea to research these specifics before you enter any agreement. Some terms could even be open to negotiation.

Don’t forget that you’ll also pay interest. While most HELOCs offer variable interest rates, they may also come with introductory rates, which can be lower than normal rates but are temporary. Make sure to shop around and compare.

The risks of a HELOC

There are a number of risks with HELOCs, but one big risk is clear. Because you use your home as collateral, failure to make payments could result in the loss of your house.

Banks have attempted to limit how much you can borrow to help protect against such losses, but the risk still exists if you suddenly become unable to make the required payments.

There’s another risk with HELOCs: Your lender may have the ability to reduce or freeze your credit line. Lenders typically only make this move because of missed payments, changes in your home’s equity or in the midst of financial upheaval, but it’s still a possibility worth considering.

But even when managing to avoid unforeseen problems personally, HELOC borrowers might still have to contend with market forces.

A HELOC’s interest rate is usually variable and can change. The interest rate is often tied to the prime rate and can be affected by changes in the market over the life of the HELOC.

There may be limits to that uncertainty, though, like a periodic cap (a limit on rate changes at one time) or a lifetime cap (a limit on rate changes during the loan term).

Some alternatives to a HELOC

If you’re considering a HELOC but not sure it’s the right solution for you, here are some alternatives to consider.

Home equity loans

Home equity loans and HELOCs have similarities. But if you see the terms used interchangeably, be aware that these two products are actually different. And some of these differences might determine which option could be better for your needs.

  HELOC Home equity loan
Equity Taps into home equity Taps into home equity
Collateral Uses the home as collateral Uses the home as collateral
Funds Available up to the credit limit during the draw period to access funds as you need Paid out in a lump sum, upfront
Interest rate Usually a variable rate Usually a fixed rate
Payments Payments made only on the amount borrowed once funds are drawn Payments made periodically over a set time frame

HELOCs and home equity loans are similar: They both involve borrowing against your home equity and using the home itself as collateral. The differences between a HELOC and home equity loan might seem minor by comparison, but they can matter quite a bit when it comes time to borrow and pay.

For instance, a home equity loan doesn’t allow for a revolving line of credit like a HELOC. Instead, you get the loan amount as a lump sum upfront and spend the life of the loan paying it back (plus interest) on a set repayment schedule. This structure can be useful for people who know exactly how much money they need and when they’ll be able to pay it back.

A home equity loan also usually carries a fixed interest rate, which can provide more security over the life of the loan. This may allow you to plan more easily when putting together a budget for the loan’s repayment schedule. On the downside, the stability of that fixed rate usually means it’s higher than the rate you may get for a HELOC.

Cash-out refinance

A cash-out refinance also involves borrowing money against the value of your home, but it requires a full refinancing of your mortgage rather than setting up a separate agreement.

This can be a good way to consolidate debts or finance the same kinds of major expenses you’re looking to pay for with a HELOC or home equity loan. But it could also leave you with a higher interest rate on your mortgage and the need to pay closing costs.

Personal loan

If you don’t want to eat into your home equity or use your house as collateral, then it could be worth considering a personal loan.

While secured personal loans involve putting up some collateral, you can put up assets other than your home, such as a savings account or CD. Secured loans can offer quality terms and conditions to people with good credit who don’t want to risk losing their home. You may also want to consider an unsecured personal loan, which isn’t backed by collateral.

Unsecured loans have a drawback though — lenders consider them riskier than secured loans, so you’ll likely be charged a higher interest rate.

What’s next?

Before you decide to take out a HELOC, consider what you’ll need it for. If you’re planning to use a HELOC for home improvements, think about setting up a budget to save for the improvements over time, rather than borrowing money.

Draft a budget and make sure the monthly payments will fit into your lifestyle.

If you don’t have time to save and you want to borrow money, consider other loan options like a personal loan or a home equity loan. Weigh fees, repayment schedules and interest rates to make the best financial decision for you.

About the author: Erica Gellerman is a personal finance writer with an MBA in marketing and strategy from Duke University. She’s also the founder of The Worth Project: a weekly money newsletter you actually want to read. Her work has b… Read more.