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What is a HELOC and How Does It Work?

What is HELOC and how does it work?
Fiona Staff7/20/2022

If you’re like most people, your home is one of the single largest assets you own. As you pay off your mortgage loan each month, the portion of your home that you “own” (also known as your equity) increases. And over time, your property may even increase in market value, building up your equity in that property even faster.

Rather than let that equity sit unused for years, though, you can tap into this value with the help of a HELOC. A HELOC can give you access to cash that you can then use to pay off debt, cover a large purchase, or even use as a financial safety net.

Here’s a look at what HELOCs offer, how they work, and what you can do with that money.

What is a HELOC?

The acronym HELOC stands for a home equity line of credit. This is a revolving line of credit based on the equity you currently have in your home (or how much of your home’s value you own compared to what you still owe a mortgage lender). In taking out a HELOC, you are borrowing against this home equity, using that value as collateral to secure the debt for your lender.

You can use the funds from a HELOC to:

  • pay off large debt balance, such as high-interest credit cards or other loans

  • make home improvements

  • go on a family vacation

  • pay for unexpected medical expenses

  • cover short-term financial obligations

  • and more

This money can even be used to make a down payment on another large purchase, like an investment property or boat. Though this product really shines if you need to make a large purchase or pay off significant debt, a HELOC gives you access to cash from your home’s equity. That means you can choose to spend the money on whatever you need, as those financial needs arise.

How a HELOC works

A HELOC works similarly to a credit card. Your lender will give you a predetermined limit for your new line of credit, as well as an interest rate and draw period (or how long you have to borrow from the credit line). You can then choose to spend from that credit line or not, according to your financial situation and changing needs.

If you never need the money, you have no obligation to spend a penny. You also won’t have to make a monthly payment on the line of credit, as you haven’t actually borrowed anything from your lender. Your draw period will eventually end (after about five or 10 years, depending on your terms), and you will no longer be able to borrow from your home’s equity without applying for a new line of credit.

If you do find yourself needing those funds, though, you’ll have quick access to them at any time. Depending on your lender, you may be able to simply transfer cash from your HELOC into any connected checking account. As you borrow, your lender will require you to make minimum monthly payments on the new debt, just like they would if you spent from the line of credit on a credit card. 

Once your HELOC’s draw period ends, you’ll no longer be able to borrow money from that line of credit. You’ll enter a repayment period, which typically lasts between 10 and 20 years, and will need to make monthly payments until the borrowed amount is repaid.

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Things to note about HELOCs

If you have equity built up in your home, there are many reasons you might want to borrow against it with the help of a HELOC. But there are a few important things to consider before borrowing, as well.

You’re losing home equity

A home equity line of credit can be a great way to borrow against your home’s growing value. But once you borrow against that available equity, it’s important to note that it’s unavailable to you until the debt gets repaid. 

Your home’s equity — or the difference between your home’s current market value and how much you still owe to a mortgage lender — can be a valuable asset, especially as home values continue to increase. Many homeowners simply let this equity asset sit untouched until the home is sold, but others find value in borrowing against it for various uses.

However, by borrowing against your home’s equity, you are also eliminating one of your biggest financial safety nets. 

Let’s say you suddenly find yourself needing to sell your home. If you have borrowed against its equity with a HELOC, you may not get much (or any) money back from the sale once closing costs and realtor fees have been applied. This is especially true if market conditions have changed since you took out your HELOC, and you don’t have as much equity as before.

They don’t last forever

A HELOC works like a combination between an installment loan and a revolving line of credit (like a credit card). But unlike a credit card, a HELOC has a defined shelf life. 

When you take out a HELOC, your lender will give you both a draw period (when you can borrow) and a repayment period (when you need to repay the debt). Once the draw period ends, you can no longer borrow against that line of credit. Instead, you’ll need to pay regularly scheduled payments and ensure that the debt is cleared before the repayment period ends.

Terms may change once you enter the repayment period

Depending on the lender and how much you’ve borrowed, your interest rate and minimum monthly payment amount can shift once you move from the draw period to the repayment period of your HELOC. Be sure to keep an eye on your timeline, as your monthly repayments could suddenly increase once you enter repayment.

Bottom Line

A home equity line of credit, or HELOC, is a great financial tool if you’re looking to tap into the equity that you’ve built up in your home. Depending on your home’s value, this could give you access to tens (or even hundreds) of thousands of dollars in borrowing power… often significantly more than you could get from a personal loan.

A home equity line of credit allows you to borrow against your home’s equity as needed. Your credit line terms — including how long you have to borrow and how much you’ll pay in interest — will depend on factors like your credit history and the lender you choose.

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