What is a home equity line of credit?

When you buy your first house, you typically have to save a boatload of cash — tens of thousands of dollars or even more — depending on your financial situation and the price of your property.

It’s a big chunk of change, to be sure. But once you get your foot in the door and start making monthly mortgage payments, you begin to build equity. Build up enough equity, and you may be eligible to take out a home equity line of credit (HELOC) and draw against it if you need some extra cash.

As a new homeowner, one of the best things you can do is plan ahead and have a game plan for the future. That being the case, it pays to know how HELOCs work, when it makes sense to use one, and when to stay away.

If you’re looking to learn more about HELOCs, you’ve come to the right place. This article covers everything you need to know about HELOCs, including what HELOCs are, how they work, how you can use them, HELOC alternatives, and more.

Home equity line of credit defined

A HELOC is a type of revolving credit line that enables homeowners to borrow money against the equity they’ve built up in their homes. This flexible form of financing is secured using the value of the property as collateral.

If you’re like most people, you’re going to need to secure a mortgage when you buy your first home. If you’re able to cobble together a 20% down payment, you’ll need to finance the other 80% of the house. In this scenario, you’ll own 20% of your property when you close the deal, and the bank will own the remaining 80%.

From that point on, each monthly mortgage payment you make increases your equity, meaning you own more of your property over time. If you ever need some extra cash and have enough equity in your home, a HELOC may be appealing to cover things like renovations, home improvement costs, and upgrades.

Essentially, HELOCs are revolving credit lines that can be borrowed against as needed; you’ll have to pay interest on whatever funds you draw. As you repay your balance, the credit line is replenished, and you can continue drawing against it.

Is it common to use a HELOC?

In the past, using a HELOC was less common. But in today’s inflationary environment, things are becoming increasingly expensive. This, in turn, is making it that much harder for young homeowners to pay their bills. In fact, one recent report found that roughly 34% of 25 to 39-year-olds currently have trouble meeting their financial obligations. Even worse, more than 70% of younger Americans are saving less because of inflation compared to Gen X and Baby Boomers.

In light of this, homeowners are looking for alternative ways to make ends meet while still reaching their family, investing, and real estate goals. As a result, many are exploring HELOCs for the first time.

In fact, HELOC applications increased 30% year-over-year in 2022. What’s more, Google searches for HELOCs hit an all-time high in July 2023. This uptick is mainly due to high prices across the overall economy.

How does a HELOC work?

A HELOC is a personal loan you borrow against your own assets. Just like any other type of loan, you have to pay any funds you use back to the bank, and you also have to pay interest on what you draw. There may be other fees too, like closing costs, annual fees, and late payment penalties, among others.

Considering this, a HELOC isn’t free even though you’re borrowing against your own equity. After all, banks offer products like HELOCs to make money.

Even so, HELOCs can be particularly beneficial in certain circumstances. If you’re thinking about applying for a HELOC, here’s the process you can expect to encounter.

1. Determine eligibility

First, a lender runs a credit check to determine your credit score and assess your credit history. This helps the lender determine your trustworthiness and ability to repay loans.

At this stage, the lender will also evaluate your overall financial situation. Typically, they’ll look at your debt-to-income ratio, your employment history, and any other assets you might have — like houses, cars, or investments.

2. Calculate your equity

Next, the lender will assess the value of your home and subtract your outstanding mortgage balance. If your home is worth $400,000 and you owe $150,000 on your mortgage, you’ll have $250,000 in equity.

The lender will also calculate a loan-to-value (LTV) ratio, which measures the total mortgage debt compared to the property’s appraised value. Having a lower LTV means that you have more equity in your property.

3. Get approved

After assessing your eligibility, credit history, income, and debt, the lender will determine whether you qualify for a HELOC. If you receive approval, the lender will set a credit limit, indicating the maximum amount you can borrow.

In addition, the HELOC will likely have a draw period — the duration that you can access funds — which typically lasts anywhere from five to 10 years. Some lenders also offer 20-year repayment periods. It’s also important to note that most HELOCs have variable interest rates, which change based on market fluctuations.

4. Access your funds

Once approved, you can access your line of credit as needed. As you take funds during the draw period, your monthly payments will reflect the interest on the amount you borrow — just like a credit card.

How can you use a HELOC?

One of the advantages of a HELOC is that it’s a highly flexible type of loan compared to other forms of borrowing. In fact, you don’t even have to use the funds for real estate purposes. Simply put, the bank doesn’t care how you use the money; all spending is at your discretion.

For this reason, keep an eye on your spending and current interest rates when you use the funds. It’s easy to burn through your HELOC and wind up in serious debt.

With all this in mind, let’s examine some of the more common ways homeowners use HELOCs.

Finance home improvements

You can use a HELOC to renovate or upgrade your existing home — potentially adding value and enhancing your living space. For example, you might decide to finish your basement, build a garage, pave your driveway, or replace your roof.

Whenever you make a major home renovation, consult with a real estate professional to determine its impact on your home value; never assume that a project will automatically make your home worth more. For example, something that seems like a lock-in for extra value — like adding an in-ground swimming pool — may actually detract from your property.

Consolidate debt

If you aren’t careful, it’s easy to rack up debt after a few years of homeownership. On average, Americans now carry around $5,733 in credit card debt.

If you wind up in this situation, a HELOC can help with debt consolidation. You can pay off high-interest debts — like credit card balances and personal loans — with a lower-interest home equity loan.

Just remember that high credit card debt can impact your eligibility for a HELOC, along with its terms, since lenders analyze things like debt, credit scores, and available credit before issuing loans. As such, it’s essential to consider your overall financial situation before using a HELOC to pay down high-interest debt.

Cover emergencies

Life comes at you quickly. One minute you’re relaxing on your back porch without a care in the world, and before you know it, you’re racing to the emergency room, scrambling to find a job, or calling your insurance company about a flood. While it’s advisable to have a few months of savings to cover surprise events, 53% of Americans say they don’t have any emergency funds.

HELOCs can serve as an emergency fund, helping you cover things like unexpected medical bills or car repairs. Depending on your interest rate and terms, this could be cheaper than securing a traditional bank loan.

Of course, HELOCs can cover non-emergency purchases, too. Some homeowners use HELOCs to protect big-ticket items like new cars, boats, or weddings.

Invest

Investing can be challenging when you’re struggling to make mortgage payments or put food on the table. Some investors use HELOC funds to overcome cash flow limitations and access the funds they need to invest in stocks and real estate instead of tapping into their paychecks. However, this is generally risky since you can lose money from investments and potentially wind up in a bigger financial hole.

Start a business

Launching a business can be very resource-intensive. Companies often require significant capital to get off the ground and many operate in the red for several months or years before becoming profitable.

Using a HELOC to launch a business is risky since 20% of small businesses fail in the first year. Remember, in addition to increasing your debt burden, you’ll also have to make interest payments — which could put pressure on you to make the business succeed faster.

Before using a HELOC to fund a business, thoroughly evaluate the business idea, create a plan, and assess your risk tolerance.

Cover education costs

Education costs are going up yearly. Today, the average price of college is upwards of $36,000 per student. This trajectory is forcing parents to explore alternative types of financing apart from traditional student loans and scholarships.

Families often make HELOC withdrawals to pay for tuition, books, food, housing, transportation, and other education expenses. Financing education with HELOC funds can potentially create a sense of commitment for students to complete their studies, helping prevent financial hardships for their families.

That said, roughly 40% of undergraduate students leave universities and colleges annually — resulting in a gigantic waste of money. Think twice before using a HELOC for education.

Finance a new home

One of the best ways to use a HELOC is to finance a new property as an investment or permanent residence. This option can be advantageous if you’re looking to upgrade your existing home and jump into a new space without putting all of your savings on the line.

If you have a significant amount of equity, you may be able to use these funds as a down payment on a new home. This can be particularly useful if you want to preserve your cash reserves or if you’re in a situation where you don’t want to sell your current home before buying a new one.

The significant disadvantage to using a HELOC for a down payment is that it can lead to overleveraging, which occurs when you owe more on your new property than it’s worth. This could happen if the real estate market value takes a sudden downturn.

How is your credit score impacted by a HELOC?

HELOCs can impact your credit score in both directions. Here are some considerations to keep in mind about the link between HELOCs and credit scores:

If you’re a responsible borrower, HELOCs can help diversify your credit mix and improve your payment history.
When applying for a HELOC, it helps to have a decent credit score. The better your score, the better the loan amount, interest rate, and terms. For example, borrowers with higher scores may be eligible for more favorable loan terms — like longer repayment periods or lower interest rates.
When you apply for a HELOC, your account will be hit with a credit inquiry, which can slightly lower your credit score in the short term. Using a HELOC and running up a balance could also increase your debt and credit utilization rate, potentially negatively impacting your score. Other risks include missing payments and lowering your creditworthiness.

Remember: Taking out a HELOC is a major financial decision that could jeopardize years of progress of building equity in your home. If you want to take out a HELOC, consider consulting with a financial advisor or conducting a top-down financial assessment to ensure you can take on extra risk.

Alternatives to HELOCs to know about

Is a HELOC the best financial instrument for you? Here are some additional financing options for homeowners:

Unsecured personal loans, which can be obtained from banks, online lenders, and credit unions, don’t require any collateral. In exchange, they typically have higher interest rates.
401(k) loans, which involve borrowing money from your 401(k) retirement plan. Most 401(k) loans come with strict repayment deadlines.
Unsecured home improvement loans, which are available from some lenders and are specifically earmarked for home improvement projects and repairs. These loans tend to have higher fixed interest rates because they don’t require any collateral.
Credit cards can also help fund small projects around the house. Some cards also have lucrative reward options, providing cash back or other incentives. However, you’ll need to pay your balance off in full each month unless you want to pay massive interest rates.

What is a home equity loan?

A home equity loan is similar to a HELOC; it enables homeowners to borrow against the equity they have in their property.

However, unlike HELOCs, this type of loan provides a one-time lump sum based on your home’s equity. With a HELOC, you get a revolving line of credit that you can tap into when you need to. Home equity loans are more like mortgages; you have to cover fixed monthly payments for the loan term. That being the case, you should only take a home equity loan if you’re comfortable paying monthly installments.

When you take out a home equity loan, your house serves as collateral. If you fail to repay, your lender can take possession of your property through foreclosure.

Home equity line of credit: FAQs

What are the pros and cons of HELOCs?

Pros

HELOCs provide a great deal of flexibility. You can use them for various needs ranging from home improvement and education to paying down debt and buying a new car. At the same time, you can tap into a HELOC as you need to. As long as you replenish your credit line, you can continue borrowing multiple times over the life of the loan.
During a draw period, you can usually make interest-only payments. This can help keep your monthly obligations lower.

Cons

HELOCs tend to have variable interest rates and can change over time. As a result, your monthly payments could increase when rates rise.

It can be tempting to overspend or overborrow with a HELOC.
Defaulting on a HELOC could result in the bank seizing your property and foreclosing your home. If you tap into a HELOC, you need to use it responsibly.
Since lenders look at your equity, finances, and creditworthiness, it may be harder to get approved for a HELOC compared to other types of loans.

Is a HELOC tax deductible?

When it comes to taxes, it’s always wise to consult with a licensed professional. That said, you can deduct HELOC interest on your taxes if you use the money to buy, build, or improve your home — but only if you itemize your deductions.

Is it possible to extend a HELOC draw period?

Some lenders may allow you to extend a HELOC draw period. However, it depends on the specific terms of your HELOC agreement and your lender’s policies. Some lenders offer flexible draw periods while others take a more rigid approach. When applying for a HELOC extension, your lender will likely consider several factors, including your eligibility and market conditions.

What is a cash-out refinance?

Cash-out refinancing involves restructuring your existing mortgage to increase the amount you owe and taking the difference in cash. If you own 50% of a $500,000 home, you can exchange half of your equity for $125,000, minus fees.

This strategy changes your mortgage terms by allowing you to make payments on a larger loan. Your new mortgage will include the remaining balance from your old loan and the extra funds you take out. Since you’re changing the terms, you’ll also have more time to pay the loan back.

While this can lengthen your mortgage repayment timeline and increase the amount you owe, it can help you solve temporary cash-flow issues.

Should I refinance my home?

Refinancing may make sense if you can get a lower interest rate. But with interest rates closing in around 7%, it’s probably not the best time to refinance.

When weighing a possible refinance, look for the break-even point: the time it takes for your monthly savings to offset the cost of refinancing. As a rule of thumb, you should only refinance if you plan to stay in your current home beyond that point.

How much does a HELOC cost?

HELOC costs vary by lender. Your HELOC may include:

Closing costs, like application fees, appraisal fees, attorney fees, title search fees, and more.
Origination fees, which cover the administrative costs associated with opening a HELOC.

Interest costs, which depend on how much you borrow, the interest rate, and the loan duration. Interest rates are usually based on the prime rate plus the lender’s margin.
Annual fees, which could add to the ongoing cost of maintaining your HELOC.
Application fees, which could also be necessary when requesting a line of credit.

Additionally, you should also be aware that your home’s appraised value can impact the overall cost of your HELOC. There may also be prepayment penalties in play, too.

Before applying for a HELOC, it’s a good idea to talk to multiple lenders to evaluate different HELOC rates and learn about potential hidden fees.

What happens if a lender denies a HELOC?

If your HELOC application is denied, the lender must provide an adverse action notice outlining the reasons for the rejection. Some reasons may include a low credit score, insufficient income, or low equity in your home. Should you be rejected, carefully review the reasons for the refusal to understand what aspects of your profile may require improvement.

That said, just because one lender denies your application doesn’t mean you can’t get a HELOC elsewhere. It may be worth it to apply for a HELOC with another lender that has different eligibility criteria or underwriting standards.

If your financial situation changes, you can also choose to reapply with the same lender down the line. For example, after you’ve paid off debts, increased your savings, and built more equity, you may be a more attractive candidate.

Do HELOCs use the Nationwide Mortgage Licensing System (NMLS)?

The NMLS is a database for licensing and regulating mortgage professionals and entities. It primarily serves to protect consumers and streamline licensing.

Since HELOCs are a mortgage product, they are subject to the NMLS. However, the application process can vary based on different state and federal regulations. Additionally, the professionals who originate HELOCs may also be subject to NMLS regulations.

Are HELOCs FDIC insured?

HELOCs do not typically have Federal Deposit Insurance Corporation (FDIC) protection. This is because FDIC insurance primarily covers deposit accounts — like checking accounts, savings accounts, certificates of deposit (CDs), and money market accounts. HELOCs, on the other hand, are a form of borrowing.

Brush up on mortgage loans!

Before you start worrying about things like HELOCs and refinancing, you have to secure a property and mortgage first — and that requires careful planning.

One of the best things you can do as a first-time homebuyer is to read up on the different types of mortgage loans that lenders offer. Check out our FREE guide to learn which type of mortgage is best for you.

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