Large, multi-story house in the suburbs with stone fencing and shaped hedges.

What Is A Home Equity Line Of Credit (HELOC)?

Jerry Brown8-minute read
February 01, 2022

If you’re a homeowner who needs cash to cover any ongoing expense or consolidate high-interest debt, opening a home equity line of credit (HELOC) is one solution. A major advantage is that HELOC interest rates are typically lower than those of personal loans and credit cards. Plus, you only pay interest on the amount you borrow.

But before you apply for a HELOC, you should understand the potential drawbacks and how they work. Let’s take a look at what you need to know, plus some alternative loan options.

What Is A HELOC?

A HELOC is a line of credit that’s secured by your home’s equity, which is your home’s value, minus your mortgage balance. For instance, if your home is worth $100,000, and your loan balance is $50,000, you have $50,000 or 50% of equity in your home.

You can use a HELOC for any purpose, such as paying for college, home improvements or consolidating high-interest debt.

It’s important to note that if you use your HELOC to fund a home improvement project, the interest you pay may be tax deductible.

How Does A Home Equity Line Of Credit Work?

A HELOC allows you to draw funds up to a certain credit limit. As you repay your outstanding balance, your available credit is replenished. Like a credit card, it typically comes with a variable interest rate that changes as often as specified in your contract.

Lenders set interest rates in part based on their own policies, and in part based on market movements. The lender decides on a certain percentage of profit margin. This is added to an index like the prime rate which is based on investor trading on the secondary market.

HELOCs usually have two different periods: a draw period and a repayment period. During the draw period, which often lasts 10 years, you can withdraw money as needed up to your credit limit. Depending on your lender, you may only have to make interest-only payments, though you can choose to pay a higher amount.

Once the draw period ends, unless your HELOC is renewed, the repayment period begins. During this period, you’ll be required to repay any outstanding balance, plus interest. For a 30-year HELOC, a common repayment period may last 20 years. Your HELOC payments are in addition to any primary mortgage payments you still have.

Home Equity Loan Vs. HELOC: What’s The Difference?

Many people confuse a home equity loan with a HELOC since both allow you to tap your home’s equity. But there are major differences.

A home equity loan operates like a personal loan. When you take one out, a lender issues you a lump sum of money. You pay it back over a certain period of time that typically ranges from 5 to 30 years.

Unlike a HELOC, home equity loans have fixed interest rates, so your monthly payment won’t fluctuate.

Because the payments are fixed, the rates are usually higher than the initial rate would be for a HELOC. Rates are also higher than they would be for a cash-out refinance based on your primary mortgage because the primary mortgage holder gets paid first in the event of default.

Though Rocket Mortgage® doesn't offer HELOCs, home equity loans are offered.

Here’s a side-by-side comparison of both home loan options:

 

 

HELOC

Home equity loan

Interest rate

Variable

Fixed

Disbursement of funds

As needed

Lump sum

Monthly payment

Fluctuates

Fixed

Repayment

Begins after loan funds are disbursed

Usually interest-only payments during the draw period

 

Principal + interest payments during repayment period

HELOC Pros And Cons

Like any financial product, a HELOC has its advantages and disadvantages. Weigh the pros and cons to help you decide if taking one out is the right move.

Pros Of A Home Equity Line Of Credit

  • Lower average interest rate than other types of debt: Since a HELOC is secured by the equity in your home, it often comes with a lower interest rate than a personal loan or credit card.
  • Flexibility: You can withdraw funds to pay for any expense as needed and only pay interest on the amount you borrow.
  • Interest can be tax-deductible: The interest paid on your HELOC may be tax-deductible if you use the funds to build or substantially improve your home.
  • You can borrow a large amount: Depending on how much equity you have in your home, you may be able to borrow a larger amount than you would with a credit card or personal loan.

Cons Of A Home Equity Line Of Credit

  • Variable interest rate: If interest rates rise, your interest rates and monthly payments could increase. As a result, this could make it more difficult for you to stick to your budget.
  • Risk of using your home as collateral: If you default on your HELOC, a lender can foreclose on your home.
  • Losing equity in your home: Also, if the value of your home drops substantially, you could risk becoming underwater on your mortgage. In that scenario, you’d owe more on your home than your home is worth.
  • Potential for payment shock: Because you only have to make interest payments during the draw period, when it comes time to add principal to those payments during the repayment period, there’s the potential for payment shock, particularly if you’re carrying a high balance up to that point. This could mean it’s harder for you to fit the repayment into your budget.
  • Rate is typically higher than primary mortgage: The rate on a HELOC will usually be higher than what you could get on a cash-out refinance on your primary mortgage. If you default on a HELOC, your primary mortgage lender gets paid first. The only time it may be different is when you don’t have an existing mortgage on the property.

HELOC Qualifications

Although HELOC requirements vary, lenders usually consider these factors:

  • Income: A lender will review your income to see if you can afford to repay funds withdrawn from your HELOC.
  • Debt-to-income (DTI) ratio: Your DTI compares your monthly debt with your gross monthly income. For example, if your monthly debt is $1,000 and your gross monthly income is $2,000, your DTI is 50%. Though DTI requirements vary, most lenders require you to have a 43% or lower DTI.
  • Credit score: When reviewing your application, a lender will review your credit score and credit history to assess the amount of risk it is taking on. The higher your credit score, the better your chances of qualifying and receiving a lower interest rate.
  • Equity in your home: Lenders usually require you to have at least 15% – 20% equity in your home. To calculate your home’s equity, divide your current loan balance by your home’s market value. For instance, if your loan balance is $50,000 and your home is worth $200,000, you have 25% equity in your home.

Home Equity Line Of Credit FAQs

Here are answers to some common questions about HELOCs.

Is it worth having a home equity line of credit?

Whether you should take out a HELOC depends on your unique financial circumstances and goals.

That said, there are several potential good uses including using it for projects where you might not know a fixed cost upfront or to cover emergency expenses.

Another potential use is to put the money toward college tuition or another situation where payments are made on a periodic basis. That way, you don’t take out the funds until you need them. You also have the option of putting funds back in during the draw period in order to keep the balance down.

On the other hand, taking out a HELOC may not be a good idea if you know you’re going to need to access a large portion of the balance that you can’t pay back for several years. The reason for this is that the larger your balance is at the end of the draw period, the greater the payment shock when you start having to pay back both principal and interest.

What credit score is needed for a HELOC?

Credit score requirements vary by lender, but lenders often require you to have a minimum score of 620. Although it may be possible to qualify with a lower credit score, a lender will likely charge you a higher interest rate.

How do I apply for a home equity line of credit?

If you’re ready to take out a HELOC, you can follow these steps:

  1. Check your credit. Before you apply, review your credit score to see where your credit stands. The higher your credit score, the better your chances of securing a lower interest rate. You can check your credit score for free using a free credit scoring website. Also, review your credit reports for any inaccuracies by visiting AnnualCreditReport.com.
  2. Shop around. To get the best deal based on your financial circumstances, compare rates and terms from as many lenders as possible.
  3. Apply for a HELOC. Submit a formal loan application once you’ve found a lender that matches your borrowing needs. You’ll need to provide personal and financial information, such as your name, Social Security number, last two years of W-2s or 1099s and tax returns. your most recent pay stubs and the estimated value of your home.
  4. Get an appraisal. After a lender verifies your income and the documents you’ve submitted, you may have to get an appraisal done to assess your home’s market value.
  5. Close on your HELOC. At closing, carefully read the terms of your loan documents before signing them and pay any closing fees.

What are the alternatives to a HELOC?

Although taking out a HELOC could be a good idea, it’s not the best move for everyone. For example, say you want to tap your home’s equity to cover a one-time expense. In that case, a home equity loan would probably be a better option.

Another alternative is a cash-out refinance. A cash-out refinance replaces your existing mortgage with a new, larger mortgage. You then pocket the difference in cash, minus any closing costs.

If you don’t think tapping your home’s equity is the right move for you, consider these alternatives:

  • 0% APR credit card: If you have good to excellent credit, you may qualify for a 0% interest credit card. The interest-free period on these cards typically ranges from six to 18 months. As long as you pay your balance in full before the promotional period expires, you can avoid paying interest.
  • Personal loan: A personal loan is a fixed-rate installment loan that’s usually unsecured, meaning you don’t have to pledge any collateral, like a car or a home. Although rates for personal loans are typically higher than HELOCs, you won’t risk losing your home if you fail to repay the loan.
  • Family loan: A family member may be willing to loan you money at a low or 0% interest rate. If you find a lender, make sure to put the terms of the loan in writing. Repay the loan as promised to avoid harming your relationship.

The Bottom Line

Taking out a HELOC can be a good idea if you need to pay for ongoing expenses. But it’s not the right move for everyone. One major downside is that it usually comes with a variable interest rate, which means your monthly payments can fluctuate.

Before you apply for a HELOC, consider alternative borrowing options, like a home equity loan, cash-out refinance or a 0% APR credit card. If you need help deciding what to do, consider contacting a financial advisor.

If you’re interested in a cash-out refinance instead of a HELOC, consider getting started with Rocket Mortgage today.

Jerry Brown

Jerry Brown is a personal finance writer based in Baton Rouge, La. He's been writing about personal finance for three years. Financial products he enjoys covering include credit cards, personal loans, and mortgages. Jerry was nominated for a Plutus award for best social media for personal finance in 2020.