What is a home equity line of credit (HELOC), and how does it work?

When your home's market value is higher than your mortgage balance, that difference is equity. One way to harness your home equity to reach other financial goals by using it as collateral, or security, for a home equity line of credit (HELOC).

A HELOC is a revolving line of credit secured by your home. During a set draw period, you can borrow, repay, and borrow again up to your credit limit. After the draw period ends, you enter a repayment period, during which you focus on repaying your balance. 

Learning how HELOCs work before you borrow should help you plan your budget and avoid surprises down the road. The rate, monthly payment, and repayment structure could all change depending on your terms and the phase of the loan you're in. Here's what you need to know.

What is a HELOC and how does it work?

A HELOC is a revolving credit line with two main phases: 

• Draw period. The first five to 10 years (varies by lender), when you can borrow up to your credit limit, repay some or all, and borrow again, as often as you like. Payments during this phase could be interest-only or cover both interest and principal.

• Repayment period. Once the draw period ends, you enter the repayment period. This is usually the remaining 10 to 30 years, depending on your terms. Your credit line closes and you make regular monthly payments (both principal and interest) until the end of your loan term.

The length of each phase is set by your loan terms when you close on the loan.

This two-phase structure is what differentiates a HELOC vs. home equity loan. A home equity loan provides a one-time lump sum with principal-plus-interest payments that begin immediately. If you need to borrow more, you need to get a new loan. You could think of a HELOC as a reusable home equity loan.

What is the HELOC draw period?

A HELOC's draw period is the initial phase during which you can use, or draw from, your credit line. The draw period is usually the first five to 10 years, though it varies by loan and lender. 

HELOC draw period example:

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 while you're still in your draw period. If you decide to tackle another project, you could borrow an additional $30,000.

Payments during the draw period could be interest-only or amortized, meaning your payments go toward interest plus principal. With interest-only payments, monthly payments are lower but you're not paying down your principal balance at all. This means you'll pay more in interest fees overall compared to making interest-plus-principal payments from the start.

What happens during the HELOC repayment period?

The repayment period is the second phase of a HELOC, and it starts when the draw period ends. When you enter the repayment period, you can no longer use your credit line. The focus turns entirely to paying back what you borrowed (plus interest).

Depending on your lender and loan terms, the repayment period typically lasts 10 to 30 years. Here's what to expect:

• The credit line closes. You can no longer withdraw money.

• Payments typically increase. Monthly payments cover principal (the amount you borrowed) and interest.

• You repay your balance. You follow a set payment schedule until you pay off the full balance over your remaining term.

If you had interest-only payments during the draw period, your monthly payment will increase once repayment begins—often substantially. This is often called payment shock, and you'll need to plan ahead to make sure your budget can handle the larger payments.

A longer repayment period could get you a lower monthly payment. A shorter repayment period helps you minimize the total amount of interest you pay. Your actual monthly payment depends on your balance, interest rate, and 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. If your HELOC limit is $50,000 and your balance is $25,000, you pay interest on just the $25,000 you’ve borrowed.

During the draw period, some lenders allow interest-only payments. That means you pay only the accrued interest on the amount borrowed, not any of the principal. Two things to note with interest-only payments:

• You don't free up available credit. By making interest-only payments, your principal doesn't go down, even after years of paying. Once you hit your credit limit, you can't borrow more until you pay down the principal.

• You risk payment shock. Your payments will increase when the repayment period starts, because you'd then owe principal plus interest in amounts large enough to pay off your loan by the end of the term.

Some lenders, including Achieve Loans, require interest-and-principal payments from the start. The downside is your monthly payments will be larger than interest-only payments. The upside is you shouldn't face a sudden spike when the repayment period begins.

With fully amortized payments, more of each payment goes toward interest in the early years. Over time, a larger portion is applied to the principal. You could improve this ratio by making extra principal payments early on.

What is the interest rate on a HELOC?

The interest rate on a HELOC is often comparable to any other mortgage, though purchase mortgages are a bit lower on average. The interest rate on a HELOC is often quite a bit lower than the rate on a credit card or personal loan. 

That's because a HELOC is a secured loan that uses your home as collateral to back up the loan. This lowers the lender's risk since it could foreclose on your home if you don’t repay the loan. Lower risk for the lender usually translates to lower rates for you.

Most HELOCs have variable interest rates, but some lenders offer fixed-rate or hybrid HELOCs. Here's why that matters:

• Variable-rate HELOCs. The interest rate could increase or decrease as market conditions fluctuate. Budgeting for a variable rate could be trickier because your payment could change.

• Hybrid HELOCs. Your lender could give you the option to secure a fixed rate on part of the loan while the rest carries a variable rate. There might be a fee for this service.

• Fixed-rate HELOCs. A fixed-rate HELOC has an interest rate that's locked in at closing and remains the same for the life of the loan. Your payment amount won’t change just because the market does.

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 situation.

How to calculate your HELOC payment

Your HELOC payment depends on four main factors: 

1. Loan phase and structure

2. Remaining balance

3. Interest rate 

4. Repayment term

First, whether you're in the draw period or repayment period is key, especially if your lender allows interest-only payments during the draw period. After that, a higher balance or higher rate means a larger payment. A longer term spreads payments out and lowers the monthly amount, while a shorter term reduces total interest costs.

To get a personalized estimate, try the HELOC payment calculator. Try a variety of rates, terms, and amounts so you can estimate what your monthly payment could be.

Can you pay off a HELOC early?

Yes, you can usually pay off a HELOC early. This could reduce your total interest costs, plus free up your credit line to borrow again if you're still in the draw period.

Most lenders let you pay a HELOC to $0 without penalty. However, think twice before you decide to close the account and cancel the credit line. That could come with a fee, particularly if you're in the first three years of opening the HELOC.

You can skip any potential early closure fee by simply keeping your HELOC open after you pay it off. You can have a HELOC with a $0 balance without closing the account. Read your loan terms to make sure there is no inactivity fee if you don't plan to borrow against the credit line again.

HELOC repayment with Achieve Loans

A HELOC through Achieve Loans stands out in a couple key ways, starting with the fixed interest rate. Where most HELOCs have variable rates that could change at market whim, HELOCs through Achieve Loans have a set rate that stays the same for the life of the loan.

Achieve Loans also require interest-plus-principal payments from the get-go. This means you're paying down your principal the entire time, freeing up your credit line and avoiding payment shock.

Here are your next steps to getting a HELOC:

• Check your credit. Review your credit reports for errors and get a free credit score to see where you stand. 

• Estimate your equity. Get an estimate of the current market value of your home and subtract the total amount you still owe on your mortgage. You can use online real estate sites and your mortgage statements for the data.

• Get prequalified. Prequalify to compare HELOC rates. Many lenders use a soft credit check that doesn’t impact your score. From prequalification to funding, the HELOC process can take a few weeks, depending on the lender. 

Find out if you prequalify for a HELOC through Achieve Loans with no credit impact.