What Is HELOC?
A Home Equity Line of Credit (HELOC) is a type of loan that allows a homeowner to borrow money against the equity in their home. Unlike a traditional loan that provides a lump sum, a HELOC functions as a revolving line of credit, similar to a credit card36, 37. This financial product falls under the broader category of Real Estate Finance, specifically within consumer lending, as it enables individuals to leverage the value of their primary asset. The amount of credit available is determined by the difference between the home's market value and the outstanding balance on the mortgage.
History and Origin
The concept of borrowing against home equity gained significant traction in the United States, particularly after the Tax Reform Act of 1986. This legislation made interest on most consumer debt non-deductible, while generally preserving the deductibility of interest rate on home equity loans. This shift incentivized homeowners to use their homes as collateral for borrowing, leading to increased popularity of HELOCs and home equity loans as alternatives to other forms of consumer debt. Over time, HELOCs became a widely utilized financial tool, offering homeowners flexibility in accessing their built-up home wealth. The Consumer Financial Protection Bureau (CFPB) provides comprehensive resources, including a booklet titled "What You Should Know about Home Equity Lines of Credit," which details the mechanics and considerations for these financial products33, 34, 35.
Key Takeaways
- A HELOC is a revolving line of credit secured by the equity in a home.
- Borrowers can draw funds as needed up to an approved limit during a "draw period."
- Interest is typically paid only on the amount borrowed, not the entire credit line.
- Most HELOCs have variable interest rates, meaning payments can fluctuate.
- The property serves as collateral, putting the home at risk if repayment obligations are not met.
Formula and Calculation
The maximum amount a homeowner can borrow with a HELOC is typically determined by the home's Loan-to-Value (LTV) ratio, which combines the first mortgage and the HELOC. Lenders often set a maximum combined LTV, usually around 80% to 85% of the home's appraised value29, 30, 31, 32.
The general calculation for the available HELOC amount is:
For example, if a home is valued at $400,000, and the lender's maximum LTV is 85%, and the outstanding mortgage principal is $200,000, the calculation would be:
This means the homeowner could potentially access up to $140,000 through a HELOC. The actual amount approved will also depend on the borrower's credit score and debt-to-income ratio28.
Interpreting the HELOC
Understanding a HELOC involves recognizing its two distinct phases: the draw period and the repayment period. During the draw period, which typically lasts 5 to 10 years, borrowers can access funds as needed, up to their credit limit, and usually make interest-only payments on the outstanding balance25, 26, 27. Once the draw period ends, the repayment period begins, generally lasting 10 to 20 years, during which the borrower can no longer withdraw funds and must make payments that include both principal and interest rate to amortization the loan24.
The variability of the interest rate is a key feature of most HELOCs. This rate is often tied to an index, such as the prime rate, plus a margin22, 23. Consequently, as market rates change, so too can the monthly payments, introducing a degree of unpredictability compared to fixed-rate loans.
Hypothetical Example
Consider Jane, a homeowner whose house is valued at $500,000, with an outstanding mortgage balance of $250,000. Her lender offers a HELOC with an 80% combined LTV.
- Calculate maximum combined loan amount: $500,000 (Home Value) * 0.80 (LTV) = $400,000
- Determine available HELOC limit: $400,000 (Maximum Combined Loan) - $250,000 (Outstanding Mortgage) = $150,000
Jane is approved for a HELOC of up to $150,000. She decides to use the HELOC to fund a kitchen renovation project. In the first year, she draws $30,000 for initial construction costs. During the draw period, she only pays interest on this $30,000. Six months later, she draws an additional $20,000 for appliances and finishes. Her interest payments then adjust to reflect the new outstanding balance of $50,000. As she makes payments, the available credit replenishes, meaning she could draw funds again up to her $150,000 limit, provided she stays within the draw period and repayment terms.
Practical Applications
HELOCs are frequently used for a variety of purposes, allowing homeowners to convert their home equity into accessible cash. Common applications include:
- Home Improvements: Funding renovations, additions, or major repairs that can increase the home's value.
- Debt Consolidation: Combining higher-interest debt, such as credit card balances or personal loans, into a single, potentially lower-interest HELOC20, 21.
- Education Expenses: Covering tuition or other costs for higher education.
- Major Purchases: Financing significant expenses like a car or a wedding.
The ability to draw funds as needed and repay them makes HELOCs a flexible option for ongoing or uncertain expenses. Recent trends indicate an increase in HELOC borrowing, with homeowners leveraging accumulated equity amid a slower refinancing market. The Federal Reserve's Household Debt and Credit Report noted an increase in HELOC balances, reflecting a sustained growth in this segment of consumer borrowing17, 18, 19.
Additionally, under current tax law, interest paid on a HELOC may be tax-deductible if the funds are used to buy, build, or substantially improve the home that secures the loan15, 16. This potential tax benefit is a significant consideration for many borrowers, as outlined by the Internal Revenue Service (IRS) in Publication 936, "Home Mortgage Interest Deduction"13, 14.
Limitations and Criticisms
While a HELOC offers flexibility, it also carries notable limitations and risks. One primary concern is the variable interest rate which can lead to unpredictable monthly payments, potentially increasing significantly if market rates rise12. This variability introduces payment shock, especially when the draw period ends and the full principal and interest payments begin11.
Another significant risk is that the home serves as collateral. If a borrower defaults on HELOC payments, the lender can initiate foreclosure proceedings, leading to the loss of the home8, 9, 10. This consequence is more severe than defaulting on unsecured debt.
Furthermore, lenders have the ability to freeze or reduce a HELOC's credit limit under certain circumstances, such as a significant decline in home value or a perceived deterioration in the borrower's financial capacity7. This can leave borrowers without access to anticipated funds. The underwriting process for HELOCs can be stringent, with almost half of applicants being denied in some periods, highlighting the rigorous criteria lenders apply6.
HELOC vs. Home Equity Loan
HELOCs are often confused with home equity loans, but they operate distinctly5. While both allow homeowners to borrow against their home equity and use the property as collateral, their structures differ fundamentally:
| Feature | HELOC (Home Equity Line of Credit) | Home Equity Loan |
|---|---|---|
| Structure | Revolving line of credit | Lump sum loan with fixed payments |
| Fund Access | Borrow as needed during a draw period | Receive full amount upfront |
| Interest Rate | Typically variable | Usually fixed |
| Payments | Interest-only during draw period, then principal and interest | Fixed principal and interest payments |
| Flexibility | High; borrow, repay, and re-borrow within limit | Low; one-time access to funds |
| Best For | Ongoing or unpredictable expenses (e.g., renovations) | Large, one-time expenses (e.g., debt consolidation) |
The primary distinction lies in how funds are disbursed and repaid, and the nature of the interest rate2, 3, 4. A HELOC provides ongoing access to funds, while a home equity loan offers a single, predetermined payout1.
FAQs
Q: Is a HELOC a second mortgage?
A: Yes, a HELOC is considered a second mortgage because it uses your home as collateral and is subordinate to your primary mortgage.
Q: How is the HELOC interest rate determined?
A: Most HELOC interest rates are variable, tied to an index like the prime rate plus a margin set by the lender. This means the rate can fluctuate over the life of the loan.
Q: Can I get a HELOC if I still have a mortgage?
A: Yes, HELOCs are specifically designed for homeowners who have built equity in their homes, even if they still have an outstanding primary mortgage. The amount you can borrow is based on your available equity.
Q: What happens when the draw period ends?
A: When the draw period of a HELOC ends, you can no longer borrow additional funds. The repayment period then begins, requiring you to make payments that include both principal and interest rate to pay off the outstanding balance. These payments can be significantly higher than those made during the draw period.