How does a HELOC work?

Mortgage payments don't just keep a roof over your head—they help build equity in your home. As your home's value rises (and your loan balance shrinks), that equity could grow into a powerful resource.

A home equity line of credit (HELOC) is a revolving line of credit that lets you borrow against the equity in your home. You can borrow, repay, and borrow more, up to your limit during a set draw period. Payments during this time could be interest-only or interest-and-principal. After the draw period ends, you enter a repayment period where you make regular monthly payments to pay off what you borrowed with interest.

HELOCs offer flexible and reusable financing that could work well for a variety of financial goals. Say you want to remodel your home. Because a HELOC allows phased borrowing, you can borrow for one project, pay it down, then borrow for the next project down the line as long as the draw period lasts.

Ready to learn more? Let's explore how HELOCs work, how you could get one, and what happens once you're approved.

How a HELOC works, step by step 

• Build equity in your home. To qualify for a HELOC, you must have equity in your home. Equity is the difference between what you owe on your home and its current market value. Most lenders require you to maintain 10% to 20% equity in your home, and that includes your mortgage and the HELOC.

• Apply and get a home valuation. To apply for a HELOC, you fill out a loan application with your personal information, as well as details on your income and current debts. Since the HELOC is a secured loan backed by your home, this step will also include a valuation of your home. This may be an in-personal appraisal or digital valuation.

• Get approved and receive your credit line. If you meet the lender's requirements for a HELOC, you'll get approved and receive your credit line. The credit limit you get will depend on your income, credit, and home equity.

• Borrow during the draw period. Most lenders have a required minimum draw that you'll need to meet at first, typically $10,000 up to 100% of your credit limit. After that, you can borrow, repay, and borrow again, over and over during the draw period up to your max. Payments during this period may be interest-only or interest-and-principal, depending on your lender and loan terms.

• Focus on payments during the repayment period. When the repayment period begins, your line of credit is frozen and it’s time to focus on repaying the loan. If you had interest-only payments during the draw period, your monthly payment now increases to cover both the principal and interest.

The length of the draw period and repayment period will vary based on your lender and loan terms. Typically, the draw period is five to 10 years and the repayment period is 10 to 20 years.

This structure is what differentiates a HELOC vs. a home equity loan. A home equity loan gives you a single lump sum at the beginning, then you repay it and that's it. You could think of a HELOC as a reusable home equity loan.

Imagine you borrow $75,000 to build an in-law suite. It turns out so well you decide to remodel other parts of the house. A HELOC lets you pay down what you borrowed so you can borrow again—and again—-during the draw period when new projects arise. Then, you'll have a long repayment period to pay it all off.

What is the HELOC draw period? 

A HELOC’s draw period is the time you can use your credit line. The draw period is usually the initial five to 10 years—it varies by lender—when you can borrow, repay, and borrow again as often as you like, up to your credit limit. 

HELOC draw period example:

Let’s say you get a HELOC with a $100,000 limit, and you borrow the full amount when your loan closes. You pay the balance down to $70,000, and you’re still in your draw period. If you then decide to tackle another project, you could borrow another $30,000.

A lender usually offers to distribute the money from a HELOC in one of several ways:

• Paper checks

• Debit cards

• Credit cards

• Electronic transfers directly to your bank account

If you get a HELOC from a bank or credit union with a branch near you, you might also be able to withdraw cash in person.

Payments during the draw period could be interest-only, or they could be amortized, which means your payments go to interest plus the principal. Generally, interest-only payments are lower, but they could cost more over time and you won't make any progress toward paying down your principal. 

What happens during the HELOC repayment period?

The repayment period is the second phase of a HELOC. When you enter the repayment period, you can't use your credit line anymore. Instead, the focus turns to paying back what you borrowed plus interest.

Depending on your lender and loan terms, the repayment period typically lasts five to 20 years. Here’s what you can expect during the repayment period:

• The line of credit closes, and you can’t withdraw any more money.

• You must pay both the principal (the amount you borrowed) and interest. 

• You follow a set monthly payment schedule until the entire loan balance is paid off.

A longer repayment period could get you a lower monthly payment, and a shorter repayment period helps you minimize the amount of interest you’ll pay. Your actual monthly payment depends on your balance, your interest rate, and your repayment term.

How do HELOC payments and interest work?

HELOC interest is charged only on the amount of money you borrow, not your full credit limit. So, if your HELOC limit is $50,000 but your balance is only $25,000, you pay interest just on the $25,000 you've borrowed.

When your repayment period starts, your monthly payment will be set to fully repay your loan by the end of the loan term.

Payments during the draw period could be smaller if your lender allows interest-only payments. If that’s the case, you pay only the accrued interest on the amount borrowed, not any of the principal. That means two things:

• Your payments will spike when you enter the regular repayment period. At that time, it’ll be a regular principal plus interest payment that’s big enough to pay off your loan by the end of your loan term.

• You won’t be able to borrow more once you hit your loan limit, even if you’re still in the draw period. Interest-only payments won’t reduce your balance or free up any of your available credit even if you make them for years.

Some lenders, including Achieve Loans, require you to make interest-and-principal payments the entire time. While this may make your monthly payments larger during the draw period, you won't get that sudden jump in payments when the draw period ends and you enter the repayment period.

Regular payments cover both interest and principal, with the proportion of each shifting over time. In the early days, more of the payment goes toward interest, but as the loan term progresses, a larger portion is applied to the principal. The advantage of a fully amortized loan is that you don’t have a lump sum due at the end of the repayment term.

How much can you borrow with a HELOC?

One of the most frequent questions people ask about home equity loans is how much you can borrow.  

The answer depends on:

• How much home equity you have

• The lender’s combined loan-to-value (CLTV) limit

• The lender’s maximum loan cap

• Your overall financial picture

Home equity is the difference between your home's market value and the amount you owe on your mortgage. If your home is worth $400,000 on the open market and your mortgage balance is $270,000, you have $130,000 in equity. Here’s the simple calculation:

• $400,000 − $270,000 = $130,000

Lenders usually limit the amount of mortgage debt you can have against one property. A HELOC is considered a second mortgage. (It could be a primary mortgage if you don't already have a mortgage on the home.) The loan limit includes the amount you owe on your principal mortgage plus the amount you want for the new HELOC. 

Most lenders won't let you borrow more than 80% of your home's value between all of your mortgages (actual limit varies by lender and loan). They use combined loan-to-value (CLTV) to calculate your max borrowing limit. To figure out how much you could potentially borrow, multiply your home's value by the lender's CLTV limit. Then, subtract your existing mortgage balances.

Using the number from above:

• $400,000 x 0.80 = $320,000

• $320,000 − $270,000 = $50,000

In this case, you could potentially borrow up to $50,000.

Your lender's other qualifications will also impact how much you can borrow. For instance, lenders have loan limits that cap how much they'll let anyone borrow with a HELOC. 

Last, lenders will review your credit, your income, and your debts. HELOCs are secured by your home, so credit score requirements are usually more flexible than with other types of debt. A credit score in the 600+ range could be enough to qualify you.

Your debt-to-income (DTI) ratio will also be important to setting your borrowing limit. DTI is how much of your income you spend on debt and housing each month. The lender will want to be sure you have room in your budget for a new loan payment.

How do you know your home’s value?

You can get an idea of your home’s value by looking at real estate websites, but when it comes time to review your loan application, expect your lender to do their own appraisal. For HELOCs, many lenders determine the value of your home using technology rather than an in-person appraiser who visits your home. The technology is called Automated Valuation Software.

What is the interest rate on a HELOC? 

The interest rate on a HELOC is often lower than the rate you would pay to borrow with a credit card or a personal loan. That's because a HELOC is a secured loan, which lowers the lender's risk since they could foreclose on your home if you stop making payments.

Here are the three types of interest offered by HELOC lenders:

• Variable-rate HELOCs. Most HELOCs have a variable rate. That means the interest rate could increase or decrease as the economy fluctuates. Budgeting for this kind of HELOC could be tricky because you won't know when the cost of borrowing will change.

• Hybrid HELOCs. With a hybrid HELOC, your lender may let you lock in a fixed rate on part of the loan. The rest of your balance may have a variable interest rate or a different fixed rate. It would be up to the lender to determine which portions of your loan get which rate. These HELOCs have an element of unpredictability and can be pretty confusing. 

• Fixed-rate HELOCs. A fixed-rate HELOC has an interest rate that's locked in at approval and remains the same for the life of the loan. During the repayment period, your payment amount shouldn't change.

Pro tip: Interest paid on a home equity line of credit might be tax-deductible if you use the money for improvements or repairs to your home. Check with a tax professional for details on your specific tax situation.

Can you pay off a HELOC early?

Yes, you can usually pay off a HELOC early. The caveat is that some lenders charge a prepayment penalty. That’s a fee for paying off the loan ahead of schedule. Paying a HELOC early could be a good idea if you can afford it, because the faster you pay off a loan, the less interest you’ll pay. 

Pros and cons of a HELOC

Whether to take out a HELOC or not is a big decision, one with both pros and cons. Here are some points to consider:

Pros

• Lower interest rate. HELOCs are less risky for lenders compared to unsecured loans, so they tend to cost less. You could get a much lower interest rate than if you used a personal loan or credit card.

• Borrowing flexibility. You can borrow what you need, repay, then borrow again if you need to later in the draw period, up to your credit limit.

• Credit score boost over time. A HELOC is a revolving credit line that could add to your credit mix. Plus, if you make all your payments on time, it could positively impact your credit score.  

• Potentially tax-deductible. If you use HELOC funds to make improvements or repairs to your home, the interest you pay on the loan may be tax-deductible. Consult a tax professional.

Cons

• Some have variable interest rates. Some HELOCs have variable interest rates, meaning the rate can change. If the rate goes up, so can your monthly payments. 

• Home as collateral. Your home is the security for your HELOC, which means it acts as guarantee of payment. If you stop making HELOC payments as agreed, the lender could potentially foreclose on and sell your home to get the money you owe.

• Reduced equity. Borrowing against your home's equity means it isn't available until you pay down your loan balance. If you were to sell your home, the mortgage and HELOC would need to be paid off before you get any money from the sale.  

Is a HELOC a good idea? 

A HELOC can be an excellent option for a borrower who has a clear plan for how the money will be used—and repaid. For example, if you're considering a HELOC to rid yourself of high-interest debt, doing so could save you thousands of dollars in interest payments. If your home is in serious need of repairs and upgrades, each of those projects could improve your quality of life and possibly your home’s value. 

Ultimately, you must decide if the reason you're borrowing the money outweighs the potential risk. Asking yourself the following questions can help you make a solid decision:

• How's my emergency fund looking? Can I continue to make the HELOC payments if I lose my job or become ill?

• Do I have a clear plan for using the money and a clear plan for repayment?

• Am I using the money in a way that benefits me in the long run?

HELOCs from Achieve Loans

One thing that sets Achieve Loans HELOCs apart from the crowd is they have a fixed interest rate. A fixed rate means your monthly payment amount won’t change due to interest rates going up. Check your rate through Achieve Loans with no credit risk.

What's next 

• Check your credit. Review your credit reports for errors you can correct or to find other moves you can make to improve your credit standing.   

• Check your mortgage balance and estimate your home's value. You need equity to get a HELOC, so if you don't know what you owe on your home or what it's worth, find out.

• Prequalify and compare rates. Get prequalified to compare HELOC rates. Be sure the lenders you check will prequalify you using a soft credit check that doesn't impact your score.