What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit (HELOC) is a revolving line of credit secured by your home. The lender approves a credit limit, and during a set draw period you borrow what you need, repay it, and borrow again, paying interest only on the balance you owe. When the draw period ends, you stop borrowing and repay the balance over a repayment period or, in some plans, all at once. Most HELOCs carry a variable rate tied to an index (a reference interest rate such as the prime rate), and because your home is the collateral, you can lose it if you do not repay.

How does a HELOC work?

Your home equity is your home's value minus what you owe on it. How home equity is calculated covers the details. A lender sets your HELOC limit as a percentage of your home's appraised value minus your mortgage balance, then checks your income, debts, and credit history. What lenders require to approve a HELOC walks through that calculation.

Once the line is open, it works much like a credit card, as the CFPB describes it:

1. You draw money when you need it. Lenders typically provide special checks or a card linked to the line. You pay no interest until you draw.
2. Interest accrues only on what you have drawn. If your limit is $80,000 and you draw $20,000, you pay interest on $20,000.
3. Repaying restores your available credit. Pay back $5,000 of that $20,000 and you can draw up to $65,000 again.
4. The draw period ends on a set date. The agreement states how long you can borrow. After that, no new draws are allowed.
5. You repay the balance. The lender either sets a payment schedule, often over 10 or 15 years according to the CFPB, or requires the full balance in one balloon payment.

Some plans require a minimum amount each time you draw (the CFPB gives $300 as an example), a minimum balance kept outstanding, or an initial draw when the line opens. Check those terms before you sign. If you sell your home, you generally must pay off the HELOC in full at closing.

What happens to your payment when the draw period ends?

Many HELOCs let you pay interest only during the draw period. Others require a small payment toward principal that does not pay off the balance by the end of the draw. Either way, your payment usually rises when repayment starts, because you begin paying down principal over a shorter period. Federal bank regulators call this payment shock in their guidance to lenders on lines reaching the end of the draw period.

Worked example: You have an $80,000 line and owe $50,000 when the draw period ends. Your rate is 8.00% (the 7.00% prime rate plus 1.00 percentage point added by the lender, called the margin), and for this example it stays the same.

• Interest-only payment during the draw: $50,000 x 0.08 / 12 = $333.33 a month.
• Payment when the balance is repaid over 15 years: $477.83 a month, an increase of $144.50, or about 43%.
• If the plan requires a balloon instead: the full $50,000 is due when the draw period ends. You would need cash, a refinance with the same lender, or a new loan elsewhere to pay it.

Because the rate is variable, a higher prime rate would raise both payments. A variable-rate payment can also change month to month even if you draw nothing new. How HELOC rates are calculated shows how a change in the prime rate flows into your payment.

What does a HELOC cost?

Some lenders waive some or all up-front costs. Others charge:

• Appraisal fee for a formal estimate of your home's value.
• Application fee, which may not be refunded if you are turned down.
• Closing costs, including attorney fees, title search, mortgage preparation and filing, property and title insurance, and taxes.
• Points or other up-front charges for opening the line.
• Ongoing fees, such as an annual fee, a fee per draw, or an inactivity fee if you do not use the line.
• An early termination fee if you close the line within a period set by the lender.

The annual percentage rate (APR) a lender quotes on a HELOC is the interest rate expressed for a full year. It does not include points or other financing charges, so compare the fee list as well as the rate.

Federal rules require lenders to give you the CFPB's HELOC booklet and a disclosure of the plan's terms and fees, and no one may charge you a nonrefundable fee until 3 business days after you receive them. If a disclosed term other than the index rate changes before the line opens and you decide not to go ahead because of that change, the lender must refund all fees you paid in connection with the application. A change solely to an estimated fee charged by a third party does not trigger this refund right.

If the HELOC is on your principal home, you can also cancel in writing and get your fees back. The deadline is midnight of the third business day after the latest of opening the line, receiving the required loan disclosures, or receiving the cancellation notice. For this deadline, count Saturdays, but exclude Sundays and federal legal holidays.

How is a HELOC different from a first mortgage and a home equity loan?

The lender may freeze borrowing or reduce the limit if, for example, your home's value falls significantly or a major financial change gives the lender reasonable grounds to believe you cannot repay.

When you already have a mortgage, a HELOC is a second mortgage. If the home is sold to pay its debts, the first mortgage is paid first and the HELOC second, which is why second mortgages often carry higher rates than first mortgages. Interest on a HELOC used to pay off credit cards or other debt is not deductible: IRS Publication 936 allows the deduction only when the money is used to buy, build, or substantially improve the home that secures the line, and only if you itemize.

A home equity loan suits a single known cost, such as a roof replacement with a firm bid. A HELOC suits costs that come in stages or are uncertain, such as a renovation paid over several months. HELOC compared with a home equity loan goes through that choice, and the drawbacks of a HELOC covers line freezes, balloon terms, and falling home values.

If you would rather have one loan with one payment, a cash-out refinance replaces your mortgage with a larger one instead of adding a second lien. What it means to refinance a mortgage explains how that option compares.