What Is a HELOC & How Does It Work? [+ Pros & Cons]

A HELOC is a form of second mortgage that enables homeowners to draw cash from the equity they’ve built in their property, much like a home equity loan. However, instead of being structured like a typical home loan, a HELOC is more similar to a credit card in that it gives borrowers access to a line of credit that’s tied to their home’s equity.

Once a borrower is approved for a HELOC, the draw period begins. This is the amount of time (usually lasting 10 years) that homeowners have to utilize their available credit. During this time, borrowers are expected to make monthly interest payments while payments toward the principal are optional.

After the draw period expires, a HELOC will then enter the repayment period. In this phase, borrowers must pay off the remaining interest as well as the total amount used during the draw period. While the exact amount of time for repayment varies, 20 years is most common.Citation

A HELOC provides flexibility by allowing borrowers to access loaned funds as needed, rather than receiving a lump sum of cash (as they would with a home equity loan). It’s also a convenient way to secure the funds homeowners may require to cover various needs, such as college tuition, credit card debt or unexpected expenses.

Watch our video to learn more about home equity lines of credit and cash out refinances >>

If a HELOC sounds like an option that might be a good fit for your needs, you’re most likely wondering about what you’ll need to apply for one. In terms of qualifying requirements, most lenders favor applications that show:

• At least 20% equity in your home
• A minimum credit score of 620
• A debt-to-income (DTI) ratio of 43% or less
• A steady income that’s sufficient to cover your loan paymentsCitation

It’s also important to note that many HELOCs come with closing costs. To avoid a surprise expense, plan to spend between 2–5% of the loan amount on these fees. Additionally, depending on your lender, you may also be responsible for paying an annual fee, generally between $50 and $75.Citatio

When it comes to accessing your funds after approval, common methods include through an online bank transfer or via a bank card (similar to a debit card). Some lenders may also offer checks that are linked to your HELOC account.

As we mentioned previously, HELOCs are a great way to afford certain expenses as there are no restrictions on how you can use the funds. However, since these loans use your home as collateral, it isn’t wise to use your credit line to purchase assets that depreciate in value, as disposable income or to invest in high-risk ventures.

On the other hand, HELOCs are ideal for covering necessities you wouldn’t otherwise be able to afford or investments that will yield a significant return. Some examples of good HELOC use include:

• Consolidating debt
• Making home improvements
• Paying for college tuition
• Starting a business
• Purchasing investment properties
• Paying off medical bills

As you’re considering whether a HELOC is the right option for you, it’s crucial to weigh the advantages and drawbacks of this kind of loan. Let’s take a closer look at both:

Pros of Getting a HELOC

• Flexible use — With a home equity line of credit, there are no restrictions on how you can spend your money. Plus, you can spend as much — or as little — of the approved amount as you want.

• The interest may be tax deductible — According to the IRS, if you plan to use your funds to “buy, build, or substantially improve the residence,” the interest you pay on your HELOC may be tax deductible (but only for tax years 2018–2025).Citation

• It could increase your home’s value — Another benefit of using your HELOC for home improvement projects is that if the updates are substantial enough, you could see the overall value of your home increase as a result.

• You’ll get a better rate than with an unsecured loan — If securing your loan with your home feels too risky, another option is to take out a personal loan. However, as these loans are unsecured, they always come with much higher interest rates.

Cons of Getting a HELOC

• Variable interest rates — This means that over the life of your HELOC loan, your interest rate will fluctuate based on economic conditions, meaning that it’s possible you may be faced with a higher rate during repayment.

• Your house secures the loan — Since your home is used as collateral in a HELOC, there’s a risk of foreclosure if, for whatever reason, you can’t make your monthly payments.
• Potential penalties and fees — If you’re hoping to pay off your loan early, double-check with your lender that you won’t be charged an early termination fee. Some lenders will assess penalties if you close the loan during the draw period or shortly into repayment. Similarly, if you sell your home in the middle of a HELOC, you’ll need to repay your balance in full once the title transfers.
• Loss of equity — With a HELOC, you’re converting the equity you’ve built in your home into usable cash, reducing your cushion. If home values fall, you risk owing more on your loan than your home is worth.Citation

For a side-by-side comparison of the pros and cons of a HELOC, check out the chart below:

Q: What is a home equity line of credit?

A: A home equity line of credit (HELOC) is a form of second mortgage that enables homeowners to draw cash from the equity they’ve built in their property. Instead of being structured like a typical home loan, a HELOC is more similar to a credit card in that it gives borrowers access to a line of credit that’s tied to their home’s equity.

Q: Is a HELOC a good idea?

A: Whether or not a HELOC is the right option for you comes down to a few main factors, primarily how you plan on using your credit and if you want to pay off your loan early. HELOCs are best used for covering necessities you wouldn’t otherwise be able to afford or investments that will yield a significant return. Additionally, you may be charged penalties if you settle your balance while still in the draw period or early repayment.

Q: What are the differences between a home equity loan and a HELOC?
A: While both loans tap into the equity you’ve built in your home, a home equity loan is structured similarly to a traditional home loan, and it provides you with a lump sum of cash. On the other hand, a HELOC gives you access to a line of credit during a draw period. During this time, you can use as much or as little of your limit as you need before paying back your balance once the loan enters repayment.

Q: How do I apply for a HELOC?

A: If you determine that a HELOC is the right refinancing option for you, it’s a good idea to speak to several potential lenders to see who can offer you the best rates. Once you find a good match, you’ll submit an application. For the best chances of getting approved, your application should show that you have: at least 20% equity in your home, a minimum credit score of 620, a debt-to-income (DTI) ratio of 43% or less and a steady income that’s sufficient to cover your loan payments.

Q: What are the costs associated with a HELOC?

A: Many HELOCs come with closing costs, and you should budget between 2–5% of the loan amount to cover these fees. Also, depending on your lender, you may be charged an annual fee, which is generally between $50 and $75.

When it comes to finding the right lender for your HELOC, Blue Water Mortgage can help. We are an independent mortgage broker with a collective 150+ years of industry experience. Our team of experts is ready to answer all your questions — send us a message to start the conversation. Or, download your free copy of our mortgage FAQs eBook.