How Do HELOCs Work?

8 Min Read | Last updated: August 9, 2024

A family of three gathered around a table, engaged with a laptop, discussing home equity line of credit options.

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HELOCs let you borrow funds from your home equity. Learn how HELOCs work and why they can be a cost-effective way to finance home improvement projects.

At-A-Glance

A HELOC is a revolving line of credit that lets you borrow a portion of your home equity, for a set period of time, to be paid back with interest.
If you have high home equity and are considered creditworthy by lenders, HELOCs can be a useful alternative to loans or credit cards because interest rates are typically lower.
With a HELOC, your home is collateral. This means that missing payments will risk foreclosure.
You may be able to refinance a HELOC to get lower interest rates once the borrowing period ends and the repayment period begins.

If you’re looking for a way to finance a home improvement project or big-ticket purchase that might help increase the value of your home, it may be worth considering a home equity line of credit (HELOC). HELOCs come with a number of advantages, such as historically lower interest rates than other lending options, borrowing and repayment flexibility, and tax benefits. But like all forms of debt, HELOCs sometimes come with particular risks, too: You’re essentially borrowing funds from the value of your home, but every penny you use must be repaid with interest.

Learning how HELOCs work may help you decide whether they’re the right lending option for your financial needs.

What Is a HELOC?

A HELOC is a form of revolving credit that lets you borrow money against the equity of your house. HELOCs work similarly to credit cards in the sense that you receive a predetermined credit limit that you could tap into and repay in monthly bills. You can use as little or as much of the credit limit as you like, as long as you don’t exceed it, and interest is charged on the amount you borrow.¹

But there are a few key differences that set HELOCs apart from credit cards. For HELOCs:¹

Your available credit limit is primarily based on how much home equity you have – along with your creditworthiness and debt-to-income ratio. You can’t get a HELOC unless you own equity in a home.
You’ll typically receive lower interest rates.¹ Historically, HELOCs have had lower interest rates, about 7% to 9% in October 2023²– compared to credit cards, whose annual percentage rates (APRs) averaged approximately 22.8% in 2023.³
You can only withdraw during the draw period. This is the amount of time your credit line is available for withdrawal, usually 10 years. When you repay any withdrawals before your draw period is up, the balance will return to your revolving credit line and can be borrowed again – similar to a credit card’s revolving balance. HELOCs require you to make interest-only payments during the draw period, but this means you may get large bills with bigger interest charges once the draw period ends and the repayment period begins.
You’ll enter a repayment period after the draw period ends. The repayment period is the time you have to repay any outstanding balance on your HELOC, usually over the 20 years following the end of the draw period. You can no longer make withdrawals during this period and your payments will include principal and interest charges. During the repayment period, a typical HELOC looks and feels like a regular mortgage.

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How to Qualify for a HELOC

In addition to having at least 15% – 20% equity on your home, lenders will also look at other factors to determine whether you’re eligible for a HELOC:¹

Your credit score and credit history.
Monthly debt-to-income ratio.
Proof of employment.

All of the above will help the lender decide your creditworthiness and whether you will be able to repay the HELOC. Depending on your personal financial situation, you may be able to borrow up to 85% of your total equity minus how much you owe on your mortgage.¹ Put simply, the more equity you have in your home, the more you will be able to take out in a HELOC.

How HELOCs Work: Key Factors to Consider

Before applying for a HELOC, it’s a good idea to keep the following in mind.

You’re putting your home up for collateral. If you don’t repay your HELOC, your home could end up in foreclosure.¹ Failing to pay credit card debt, on the other hand, could put a big dent on your credit score – and you may have to file for bankruptcy – but the chances of losing your home are significantly smaller.

Be careful where you spend your HELOC money. It may be tempting to use HELOC funds to finance a vacation or a new car, but financial experts recommend using HELOCs to pay for home improvement projects, like a kitchen renovation, that can increase the value of your home – since HELOCs pull from your home’s equity.

Interest rates are variable during the draw period. During your draw period, you might only have to pay interest on what you borrow. This means you may not have to pay off the amount you borrowed until your repayment period begins. But HELOC interest rates are variable, meaning they’re generally tied to the U.S. prime rate and might fluctuate.¹

You may be able to opt for a fixed-rate interest in the repayment period. Some HELOCs will let you switch to a fixed interest rate on your outstanding balance during your repayment period.¹

HELOC interest can be tax-deductible. According to the IRS, deducting a HELOC’s interest you paid from your taxes is possible as long as the funds are being used to “buy, build, or substantially improve the residence.”⁴

HELOCs might have fees. Depending on the lender, you may have to pay closing fees before opening your HELOC. Closing fees might include application fees, credit report fees, home appraisal fees, and attorney fees.²

You can shop around for HELOCs. You don’t have to get a HELOC from the same lender that holds your mortgage. You may shop around for the best interest rates and plans that work for your financial needs.²

HELOCs are subject to underwriting standards. That means that your income, credit, and home value will be taken more seriously than when applying for a credit card, for example. This also means the process may take more time, and you may need to go through extra application steps like getting your home officially appraised.¹

Can You Refinance a HELOC to Take Advantage of a Lower Rate?

Once your HELOC enters the repayment period, you can no longer make withdrawals and must begin paying back any outstanding balance. But if your interest rate is high and market rates turn lower, you may be able to refinance your HELOC to take advantage of those lower rates.¹ For example, you could apply for a second HELOC to pay the outstanding balance on the first.

To refinance a HELOC, you’ll need to meet application requirements again, and being approved once before does not guarantee you’ll be eligible to refinance. In case you don’t qualify, there are other options that may help lessen the burden of higher HELOC payments, including:⁵

Cash-out refinancing. You may be able to replace your mortgage with a new one under a cash-out refinance. This leaves you with a single loan and payment structure.
Taking out a personal loan. Personal loans have the benefit of a fixed interest rate and usually don’t require collateral, so you can cover your HELOC balance without risking home foreclosure.
Getting a home equity loan. If you qualify for a home equity loan at better rates than your HELOC, you may be able to use the lump sum to pay off the HELOC. You may also be able to apply for an extended repayment period.

No matter what option you choose, it’s important to do careful research and make sure your decision will help improve your financial situation.

What’s the Difference Between a HELOC and a Home Equity Loan?

HELOCs aren’t the only way to use your home equity as collateral. You can also take out a home equity loan. But what’s the difference? For home equity loans:^1,2

Instead of a revolving credit line, you’ll receive a lump sum and make monthly payments towards the outstanding balance.
Interest rates are usually fixed. This means you’ll know from the beginning how much you’re going to pay and rates won’t be affected by market conditions. However, rates on home equity loans tend to be slightly higher than HELOCs.
The repayment period is up to 30 years, and there is no draw period because you receive all the money in a lump sum up front.

The Takeaway

Getting a HELOC may be a good idea if you’re planning on a big home improvement project or other major purchase that could increase the value of your home. Like all financial decisions, there are pros and cons to opening a HELOC. On one hand, you might get lower interest rates and flexible withdrawal and repayment options. On the other, interest rates can vary and your home is at risk if you’re unable to repay your balance. Before opening a HELOC, it’s a good idea to carefully consider your options.

¹ “What Is a Home Equity Line of Credit (HELOC)?,” Experian

² “What Is a Good HELOC Interest Rate?,” Experian

³ “Credit card interest rate margins at all-time high,” Consumer Financial Protection Bureau

⁴ “Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses),” Internal Revenue Service

⁵ “Can You Refinance a HELOC?,” Experian

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Megan Doyle is a business technology writer and researcher whose work focuses on financial services and cross-cultural diversity and inclusion.

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.

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