How Does a HELOC Loan Work?

17, August, 2022

If you're like most people, your residence is the biggest and most important investment you've ever made. So it's only natural you wish to protect that investment by taking advantage of home equity. A HELOC — home equity line of credit — is a great way to do that, but it's important to understand how a HELOC loan works before signing up. This helpful guide will give you all of the information you need to make an informed decision about whether a HELOC loan is right for you.

What's a HELOC or Home Equity Line of Credit?

A HELOC allows you to take a loan against the equity in your property. Equity refers to the amount of your property's value that you own outright, and it may decrease or increase along with changes in your home's value and how much you owe on your mortgage. A HELOC offers you access to a line of credit that you can use for various purposes, up to a certain limit. You'll pay interest only on the credit you use, and you can typically take up to 20 years to repay the loan.

How does a HELOC loan work?

A family looking to understand how a HELOC loan works

A HELOC loan is similar to a credit card. You're given a line of credit up to a certain limit, and you can borrow against that limit as needed. The major difference is that with a HELOC, the collateral for the loan is your home equity. That means if you default on the loan, the lender could foreclose on you. For that reason, it's important to borrow only what you can afford to repay and to ensure you have a plan for how you'll use the money.

What can you use a HELOC for?

There are several ways you can use a HELOC, including:

  • Home improvements or repairs
  • Tuition or other education expenses
  • Paying off debt
  • Major life events like tuition, weddings, or the purchase of a vehicle

A HELOC is a great way to access cash when needed without selling your home or taking out a traditional personal loan.

How to qualify for a HELOC

You'll need equity in your home to qualify for a HELOC. How much equity you need will vary depending on the lender. Some lenders allow a homeowner to go up to 95% LTV. You'll also need a good credit score and a healthy debt-to-income ratio.

How much can you borrow for HELOCs?

The amount of cash you can borrow with a HELOC will depend on several factors but the most important one is the amount of equity in your home. Most lenders will allow you to borrow 80% to 85% of your home's value but some will go up to 95% of your home’s value.

How does HELOC interest work?

HELOC interest rates are variable, which means they can go up or down over time. A good starting point for understanding HELOC interest rates is the prime rate. 

The prime rate is the interest rate banks charge their most creditworthy customers. It's used as a benchmark for other loan products. Say the prime rate is 4.25%. That means if you have a HELOC with an interest rate of Prime +1%, your interest rate would be 5.25%.

What about HELOC fees that I might have to pay?

There are fees you may encounter with a HELOC, including:

  • Application fee: you may be charged an application fee to cover the cost of processing your loan application. This fee is typically around $100.
  • Origination fee: you could be charged an origination fee, a percentage of the loan amount (usually 1% to 2%). For example, if you're taking out a HELOC for $30,000, your origination fee could be as much as $600.
  • Closing costs: you'll also be responsible for closing costs, including appraisal fees, title insurance, and credit report fees. These costs could add up to several thousand dollars.

Understanding the terms and conditions of your HELOC is important, as there may be other fees not listed here. It's also essential to note that some of these fees may be waived if you shop around and compare offers from different lenders.

How do HELOC payments work?

Using your home as collateral for a loan means your lender will want to protect their investment. That's why most HELOCs require you to make interest-only payments for the first ten years. That means you'll be responsible only for paying the interest on the loan, not the principal. After ten years, you'll typically be required to begin making principal and interest payments until the loan is paid off.

It's important to note that your payment may not stay the same just because you're only responsible for making interest-only payments for the first ten years. That's because your interest rate is variable, which means it can go up or down over time. If rates rise, your monthly payments will likely increase as well.

Differences between a HELOC and a home equity loan

HELOCs and home equity loans are both attractive options if you want to access your home's equity. But there are some differences between the two that you should be aware of before you decide which is right for you.

Loan amount

Both loan amounts are based on the amount of equity available in one’s home. The difference is how it’s distributed. A HELOC is a line of credit while a home equity loan is a lump sum payment.

Repayment terms

HELOCs usually have draw periods between 5-10 years and then roll into a repayment period of 10-20 years. You’re only required to make interest payments during your draw period. After your draw period, a borrower is required to make both principal and interest payments.

A home equity loan has a fixed repayment period with a fixed payment that is consistent throughout the payment terms.

Monthly payments

Your monthly payments may start lower with a HELOC because you're only responsible for paying the interest for the first ten years. After the draw period is over, your payment will depend on if you chose to pay some principal and interest during the draw period. If you choose to only pay interest during the draw period, there’s a possibility your payment could be more or less than a home equity loan based on what the interest rate could be at the time because it’s variable and not fixed.

A home equity loan’s payments are fixed throughout the repayment terms and consist of principal and interest.

HELOCs vs. cash-out refinances

If you're considering a HELOC, you may also consider a cash-out refinance. Both options allow you to tap into the equity in your home, but there are key differences between the two that you should be aware of before you make a decision.

How to increase the chances of approval

Here are four things you can do to increase the chances of getting approved for a HELOC loan:

  1. Credit score: First, ensure your credit score is as high as it can be. Lenders will typically approve only borrowers with excellent credit for HELOCs. If your credit score is unimpressive, you may want to consider a cash-out refinance instead.
  2. Home value: Second, your home will need to be worth enough to qualify for the loan amount you're requesting. The higher your home's value, the more equity you'll have and the better your chances of being approved.
  3. Debts: If you have an outstanding balance on your first mortgage, it’ll need to be paid off before you can take out a HELOC. A lump sum of cash or a new loan can be used to pay off the balance. 
  4. Income: Finally, you'll need to show that you have the income to make the monthly payments. Lenders typically approve only borrowers with a steady income and good employment history.

Keys to success

As we've seen, you can borrow money against the equity in your home through a home equity line of credit (HELOC). Unlike personal loans that typically come with a fixed interest rate, payments, and repayment terms, a HELOC gives you the flexibility to make payments over time, and the interest rate is variable.

You can maximize your credit limit by having a high credit score and a low debt-to-income ratio and by owning your home outright or having a low mortgage balance.

While HELOCs can be a great way to finance home improvements or consolidate debt, understand the terms and conditions before applying, as they can be complex. As with any loan, missing payments can put your home at risk of foreclosure.

Interested in learning more about how to tap into the equity in your home? Contact one of our licensed loan officers today.