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

A home equity line of credit (HELOC) is a revolving line of credit guaranteed by your home equity. Your credit limit is based in part on how much equity you have. You can borrow against your credit your credit limit during a draw period, repay what you owe, and borrow again as needed. Because your home secures the loan, interest rates are typically lower than those on personal loans or credit cards.

How a HELOC works

A home equity line of credit has two phases: a draw period and a repayment period. During the draw period, which typically lasts five to 15 years, you may access funds up to your approved credit limit. Your lender might only require interest-only payments on the amount you've borrowed during this phase, though paying toward the principal is an option. If you only pay interest, the balance you owe won’t go down, even if you pay for several years. 

When the draw period ends, the repayment period begins. This phase typically lasts 10 to 20 years. During the repayment period, you make principal and interest payments, and you can’t borrow any more. Because you're now paying down the full balance, monthly payments are higher than they were during the draw period if you were only paying the interest.

What can a HELOC be used for?

Homeowners commonly use HELOCs for home improvements and renovations, debt consolidation, education costs, and large expenses. Because interest rates are typically lower than those of other borrowing options, a HELOC is often considered for large expenses that would otherwise go on a credit card or personal loan. 

How much could you borrow with a HELOC?

Lenders use the combined loan-to-value (CLTV) ratio to determine how much they will lend you. The CLTV compares your home's market value against all the loans you have against the home (that usually means your mortgage plus the HELOC you want). Most lenders have a max CLTV cap of 80% to 90%. 

To determine the HELOC you might be able to get, multiply the lender's CLTV cap by your home's value, then subtract your mortgage.

For example, say your home is worth $500,000. You still owe $200,000 on the mortgage, and the lender has a max CLTV of 85%. The numbers would work out like this:

$500,000 x 0.85 = $425,000

$425,000 - $200,000 = $225,000

In this example, you could apply for a $225,000 HELOC. You still need to meet all of the lender's requirements. 

What do you need to apply for a HELOC?

Lenders generally review several factors when you apply for a HELOC. 

• Home equity: Most lenders require that you have at least 15% to 20% equity in your home.

• Credit score: Lenders typically require a credit score of at least 600 to 670.

• Income: Lenders verify income to confirm that you should be able to cover payments.

• Debt-to-income ratio: DTI compares how much you’re spending each month on debt to your income, expressed as a percentage. Lenders generally want a DTI ratio no higher than 43%. You can figure yours out with a debt-to-income ratio calculator.

HELOC interest rates explained

Most HELOCs have variable interest rates, meaning the rate could rise or fall over time based on market conditions. So your monthly payment amount might change throughout the life of the loan. 

Some lenders offer fixed rate HELOCs. Your interest rate is set when you get the loan, and never changes. This makes monthly payments more predictable.

When a HELOC may not be the right fit

A HELOC may not be the best fit in certain situations:

• When there’s a chance you might sell your home soon. If you sell, you have to pay back the HELOC with the money you get from selling the home. If you don’t sell for enough to fully repay your mortgage and your HELOC amount, payment comes out of your pocket.

• When the housing market—and your home’s future value—is tough to predict. Consider waiting until home values stabilize, particularly if they’re trending down.

• If the amount you want is under the lender’s minimum.

• If your expected time for repayment is short, maybe just a year or two, paying the HELOC’s closing costs might not be worth it. A lower-fee personal loan or even a credit card with an introductory rate might be a better fit.

• If you’re borrowing for travel, lifestyle spending, or everyday purchases.

Next steps

Now that you’re in the know about HELOCs, you can give some thought to whether one makes sense for you. Maybe you’ve been daydreaming about enclosing your porch, or finally getting those sleek new kitchen cabinets you’ve been eyeing. Maybe a HELOC offers you a way to consolidate debts, or get out from under a student loan.

Consider exploring more by learning about Achieve Loans fixed-rate HELOC or other options. You could be on your way to the financial future you envision.