What is a HELOC?

HELOCs are particularly in demand, with originations jumping 41% last year. In the second quarter of 2023 alone, over 250,000 HELOCs were issued in the US.  

Part of this is due to a high demand for home renovations — a common use for HELOC funds. Much higher interest rates on credit cards and cash-out refinances have also made HELOCs more attractive.

Whatever the reason, though, one thing is clear: Homeowners have HELOCs in their sights. Should you, too? Here’s what you need to know about HELOCs, how they work, and how to qualify for one if you need to.

A home equity line of credit, or HELOC, is a type of second mortgage. It allows you to borrow against your house, taking a portion of your home equity — your home’s value minus your mortgage balance — and turn that into a line of credit. Much like the way credit cards work, you can pull from this credit line when you need cash.

One of the biggest perks of HELOCs is that the funds can usually be used for anything and, if you put the money toward improving your house, it might qualify you for a tax write-off.

Additionally, they allow you to keep your interest costs to a minimum. For one, their rates are typically much lower than those seen on credit cards and personal loans. They also allow you to borrow — and pay interest on — only what you need (rather than the entire credit line or loan amount). 

“This can help you keep monthly payments lower and avoid unnecessary debt,” says Matt Vernon, head of retail lending at Bank of America.

The draw period is the time during which you can pull money out of your credit line. In most cases, it’s 10 years. That’s when you can take money out, pay some back, and take out more when you need it. “You can pay it down to zero whenever you want,” says Josip Rupena, founder and CEO of mortgage lender Milo. “Then reuse it as needed.” 

During the draw period, you may only pay for interest on what you withdraw or, depending on your lender, you may pay interest plus a minimum monthly payment.

Once you enter the repayment period, though, that’s when you stop withdrawing money and full payments will come due. These may be fixed principal and interest payments spread across 20 years, or you may owe a balloon payment all at once — meaning the full balance remaining on your HELOC.

HELOC interest rates are usually variable. If your HELOC has a variable rate, Vernon says, it means your rate “changes in conjunction with an index, typically the US Prime Rate, which follows the federal funds rate. Your interest rate will increase or decrease when the index does. ”

Some lenders offer fixed-rate HELOCs, which maintain the same interest rate for the entire term. Just keep in mind that these rates may be higher than those on variable-rate loans — at least at the beginning (before the rate starts adjusting). 

“You’ll likely pay a higher interest rate,” Rupena says. “You won’t have to worry about rising rates in the future, though, which is especially important if you’re living on a fixed income.”

Either way, the rate you get on your HELOC will depend on a number of personal factors — things like the total credit line amount and your credit score, debts, income, and more. The lender you choose matters, too, as every company has its own overhead costs, fees, and appetite for risk. 

For a little more predictability, a home equity loan is another great option. Money from a home equity loan is delivered as a lump sum and has a fixed interest rate for the entire term. Shopping around online is a great way to compare rate estimates from a variety of lenders for both HELOCs and home equity loans.

To qualify for a HELOC, you first need to have equity in your home — “enough to serve as collateral,” says Kyle Enright, president of Achieve Lending.

The exact amount of equity you need varies by lender, but usually it’s at least 10% to 20%. This means the balance on your mortgage and the value of your HELOC add up to no more than 80% to 90% of your home’s value.

Lenders will also look at your credit history and credit score to evaluate how you handle debt. Credit score minimums depend on the lender, but you’ll typically need a score that’s at least in the mid-600 range. Some lenders may accept borrowers with lower scores than this (though you should be prepared to pay a higher interest rate).

Finally, your debt-to-income ratio — or how much of your monthly income your debt payments and HELOC payments take up — will also factor in. Lenders want to see that you have the free income to comfortably cover your expected HELOC commitments. 

If you want to improve your chances of getting approved for a HELOC, Vernon says to “work on improving your credit and reducing your debt relative to your income.” 

You should also “Start by reviewing a copy of your credit report and scan it for any errors,” he says, as this can improve your score. “Additionally, make sure to avoid late payments and keep your credit utilization ratio low.”

HELOCs come with some serious benefits, but there are drawbacks you’ll want to consider, too. First, variable rates can be hard to budget for and may strain your finances once your interest rate adjusts. There is also the chance of a balloon payment — meaning your lender asks you to pay the full balance of your HELOC all at once. (However, not all HELOCs come with balloon payments, so there’s no harm in shopping for other options if the first lender requires one.)

On top of this, there’s a chance your credit line could be frozen, cutting off access to your HELOC funds down the line. This would typically only happen if your home loses a significant amount of value. 

Finally, and most importantly, HELOCs (and home equity loans, for that matter) require you to borrow against your house, which means you put yourself at risk of foreclosure if you can’t make your payments. As Vernon puts it, “A HELOC is secured by your home, so you must ensure you’re able to make monthly payments before taking out the loan. ”

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as the Home and Financial Services Editor for the Hearst E-Commerce team. Email her at [email protected].