How Does a HELOC Work? Home Equity Line of Credit Explained

What Is a HELOC?

Definition and Basic Functionality

A Home Equity Line of Credit (HELOC) is a revolving credit line that allows homeowners to borrow against the equity in their home. Equity is the difference between what your home is worth and what you owe on your mortgage. Unlike a home equity loan, which provides a lump sum, a HELOC works more like a credit card. You can borrow, repay, and borrow again within a set draw period.

What’s the difference between a HELOC and a Home Equity Loan?

A HELOC provides flexibility and the option to draw with a revolving line of credit, while a home equity loan pays a lump sum of cash with a set repayment schedule. HELOCs often have variable interest rates, whereas home equity loans usually come with fixed rates. This makes HELOCs better suited for ongoing or unpredictable expenses.

How Does a HELOC Work?

The Draw Period and Repayment Period Explained

HELOCs typically have two phases: the draw period and the repayment period. The draw period usually lasts 5 to 10 years. During this time, you can withdraw funds as needed. Some lenders may require you to take out 50%, 75%, or even 100% of your approved amount upfront. Others allow flexible withdrawals.

After the draw period, the repayment period begins. This phase often lasts 10 to 20 years. You can no longer draw funds, and you must start repaying both the principal and the interest.

How Interest Is Calculated

Interest on a HELOC is generally variable and tied to the prime rate. During the draw period, many lenders offer interest-only payments. This keeps monthly costs low initially but can lead to payment shock during the repayment period.

Credit Limits and How They’re Determined

Lenders determine your credit limit based on your home’s equity, credit score, income, and debt-to-income (DTI) ratio. Most will lend up to 85% of your home’s value minus any existing mortgage. Some HELOCs require a minimum draw at opening, especially those with fixed draw period terms such as 1, 3, or 5 years.

Example Scenario: Using a $75,000 HELOC for Renovations Imagine you have $150,000 in equity. A lender approves a $75,000 HELOC. You draw $25,000 to renovate your kitchen. Later, you draw another $20,000 for a bathroom update. You only pay interest on the amount used, and you can reuse funds as you repay them.

What Are the Benefits of a HELOC?

• Flexible borrowing and repayment
• Interest-only payments during draw period
• Funds can be reused
• Competitive interest rates
• Potential tax deductions on interest (consult a tax advisor)

What Are the Risks or Downsides of a HELOC?

• Variable interest rates can increase
• Risk of foreclosure if payments are missed
• May include fees (appraisal, annual, early closure)
• Payment shock after draw period ends

How to Qualify for a HELOC

Credit Score Requirements

Most lenders look for a minimum credit score of 620, but higher scores typically qualify for better rates.

Home Equity and LTV Ratio

You need substantial equity in your home. Lenders often require a loan-to-value (LTV) ratio of 85% or less.

Income and Debt-to-Income Ratio

Lenders assess your ability to repay by evaluating your income and DTI ratio. A lower DTI ratio strengthens your application.

HELOC vs. Cash-Out Refinance: Which Is Better?

HELOCs are ideal for recurring or unpredictable costs, while cash-out refinancing may suit large, one-time needs.

Smart Ways to Use a HELOC

• Home improvements that boost value
• Debt consolidation
• Covering college tuition
• Emergency expenses or medical bills

What Not to Use a HELOC For Avoid using a HELOC for non-essential purchases like vacations, new vehicles, or speculative investments. These uses can put your home at risk unnecessarily.

Understanding how a HELOC works can help you make more informed financial decisions, especially when planning for long-term expenses or managing debt responsibly.