What is a HELOC mortgage? How a home equity line of credit works

What is a HELOC mortgage?

If you've built equity in your home, a home equity line of credit (HELOC) is one way to put that equity to work toward whatever’s most important to you. 

Home equity is the difference between the current value of your home and the amount you still owe on your mortgage. The more mortgage payments you've made and the more your home's value has increased since you bought it, the more equity you have.

A HELOC is a second mortgage that gives you access to a portion of the equity in your home. Unlike a traditional mortgage, which provides a one-time loan at closing, a HELOC works more like a credit card: you’re approved for a credit limit, you draw from it, repay it, and borrow again.

Your home secures your HELOC, which acts as insurance for the lender. If you're unable to keep up with the payments, the lender could foreclose to recover what's owed.

How a HELOC works

A HELOC enables you to tap into your home equity to get cash for virtually any purpose. But how does a HELOC work once you're approved? There are two distinct phases to know: the draw period and the repayment period. 

The draw period

The draw period, which is the initial period in which you can use your credit line, typically lasts five to 10 years. You borrow up to your credit limit, repay what you have borrowed, and borrow again. Most lenders require interest-only payments during the draw period. You may be able to pay down the principal earlier, depending on your lender's terms.

The repayment period

The repayment period follows the draw period. Repayment periods typically range from 10 to 20 years depending on your lender and the term you choose. Once this phase begins, you no longer draw from the line. Payments change to include both principal and interest, which generally means a higher monthly payment than during the draw period.

How much you could borrow

The amount available through a HELOC depends on how much equity you have in your home. Lenders typically allow you to borrow up to 80% to 85% of your home's value, minus your existing mortgage balance.

To find your home equity, subtract what you currently owe on your mortgage from your home's appraised value. An online real estate site may help you estimate what your home is worth. For example, if you owe $250,000 on your mortgage and your home is worth $500,000, you have a 50% LTV, or $250,000 in equity. 

A second calculation comes into play for HELOC approval: combined loan to value (CLTV) ratio. This figure measures all of the mortgages on a home (including first mortgages and HELOC mortgages) divided by the home's appraised value. A "good" CLTV for a HELOC is in the 80% to 85% range, including the new HELOC you want. So, going back to the previous example, you might be able to borrow $150,000 to $175,000 with a home equity line of credit.

$250,000 mortgage balance + $175,000 HELOC = $425,000

$425,000 is 85% of the home’s current market value.

In addition to equity, lenders also review your credit history, income, and debt-to-income (DTI) ratio when evaluating an application. Your DTI ratio is a measure of how much of your gross monthly income goes to debt and housing payments.

HELOC interest rates explained

Most HELOCs have variable interest rates, which means your rate and your monthly payment may change over time. Variable rates are typically tied to the U.S. Prime Rate, a benchmark rate that moves with the federal funds rate set by the Federal Reserve. When the Prime Rate rises or falls, your HELOC rate generally moves with it.

The rate you might receive depends on your credit score, income, and CLTV. Market conditions and the interest rate environment also play a part. If the Federal Reserve raises rates, then HELOC rates can climb higher; if rates are cut, then HELOC rates may drop.

Most lenders offer variable-rate HELOCs. Achieve Loans offers a fixed-rate HELOC, which may make monthly payments more predictable.

How to apply for a HELOC

Most lenders follow a similar review process:

1. Gather documents. Lenders typically ask for proof of income, recent mortgage statements, and information about your home's current value.

2. Confirm your equity. Most lenders prefer at least 15% to 20% equity in your home before you can prequalify for a HELOC.

3. Credit and income review. Lenders evaluate your credit history and debt-to-income ratio to assess your ability to manage the payments.

4. Credit line determination. Your lender sets a maximum credit limit based on your equity and financial profile.

A loan consultant may be able to walk through what the process could be like for your situation.

What you could use a HELOC for

Homeowners use HELOCs for a range of purposes. Common uses include:

• Home improvements. Renovations may add value to your property. If you use the funds to buy, build, or substantially improve the home that secures the loan, the interest may be tax-deductible, subject to dollar limitations. Consult a tax professional to understand what applies to your situation.

• Consolidate high-interest unsecured debt. Some homeowners use a HELOC to consolidate debt like credit card balances. HELOC rates may be lower than those on credit cards or personal loans, depending on your credit profile and lender.

• Education expenses. A HELOC could help cover tuition costs over multiple years, with draws timed to when payments come due.

• Emergency access. An open HELOC may provide financial flexibility when unexpected expenses arise.

• Medical expenses. You may use a HELOC to cover out-of-pocket medical expenses for yourself or a loved one that are not covered by insurance. You could also use a HELOC to pay outstanding vet bills for a family pet.

• Large expenses. Some homeowners use their HELOC to pay for large, planned expenses. For instance, you might use your line of credit to finance a wedding or start a business.

HELOC vs. home equity loan

A HELOC and a home equity loan are both secured by your home but they work differently. A home equity loan offers access to a lump sum of cash, typically at a fixed interest rate. There is no draw period, since you get all the money at once. Home equity loans tend to have fixed rates, and your payments cover the principal and the interest for the life of the loan. 

For homeowners with equity, a HELOC offers a way to access funds when you need them—on a timeline that works for you. If you're curious whether you qualify, a loan consultant can walk you through the details.