How does a HELOC work? Learn how to use a HELOC

Peter Warden
Peter Warden
The Mortgage Reports Editor
October 5, 2022 - 11 min read

How does a HELOC work?

A home equity line of credit (HELOC) is a type of mortgage secured by your property. But it doesn’t work like a standard mortgage. A HELOC works more like a credit card, offering a credit limit that you can borrow from, pay back, and re-borrow as needed.

A HELOC can be an affordable way to turn home equity into cash — especially if you have a great mortgage rate and don’t want to touch your existing home loan. As a “second mortgage,” the HELOC taps only your available equity and leaves your current low-rate mortgage unchanged.


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How a HELOC works: Using and repaying your HELOC

A HELOC has two phases: the draw period and the repayment period. During the draw period, you can borrow from your credit line and use the funds however you want. During the repayment period, you can no longer borrow funds and will have to repay any remaining loan balance on a monthly payment schedule.

The draw period

The first part of a HELOC is called the “draw period” because this is when you can “draw on” (withdraw funds from) your line of credit. During the draw period, you can borrow up to your pre-approved HELOC loan limit, which is based on your available home equity. You can also repay any money you’ve borrowed and reuse the HELOC as many times as you want, just like you can with a credit card.

A typical draw period lasts 10 years, though you may be able to shop around and find lenders offering shorter or longer draw periods if you desire.

You’ll make monthly interest payments on any funds you borrow from your HELOC during the draw period. But you don’t have to start paying off the loan balance right away. If you prefer, you can wait to pay back all that you borrow until the “repayment period” kicks in.

The repayment period

The repayment period starts the moment your draw period ends. Once it begins, you can no longer borrow money from your HELOC account. Instead, you must repay the amount you borrowed in full along with interest. HELOCs are typically repaid in monthly installments over 10 to 20 years; the size of your monthly HELOC payments will depend on your interest rate and how much money you borrowed.

Keep in mind that HELOC interest rates are variable, so your interest rate and payment can change throughout the repayment period.

Some people come to rely on their HELOCs during the draw period and find repayment periods painful. If it’s too difficult to adjust to a higher HELOC payment, homeowners might refinance to a new HELOC or a fixed-rate home equity loan — or pay off the HELOC using a cash-out refinance.

The HELOC process

Because a HELOC is a second mortgage, the application process involves several stages. If you’re really lucky (and choose a highly efficient lender that’s not too busy), you might get your line of credit in as little as two weeks. But the HELOC process can often take six weeks or more. Much will depend on the strength of your application and whether the lender has any questions about your financial situation.

Here are the main stages in the HELOC process:

  1. Apply with a HELOC lender online, in person, or over the phone. Many online mortgage lenders and major banks offer HELOCs
  2. Submit supporting documents including photo ID, paystubs, tax returns, proof of assets, bank statements, current mortgage details, and other financial information
  3. Get an initial, conditional approval from the lender
  4. Have the home appraised. Your mortgage lender will order and schedule the appraisal
  5. Wait for underwriting to be done. One of your lender’s underwriters will check your application and make sure everything’s in order
  6. Receive final approval from the underwriter
  7. Close the loan and receive funding. Since a HELOC is not a lump sum loan, you’ll receive a special account or card allowing you to access your HELOC as needed

The biggest reason HELOCs take so long is that lenders need to schedule a third-party appraisal to verify your home’s current value. This helps determine how much equity you have available, and therefore what your maximum HELOC amount will be.

Once your HELOC is in place, your bank will provide a way for you to access the credit line. You may be able to transfer money, or you might get a checkbook and debit card. Some people use their HELOCs as their checking accounts, depositing their salaries in them.

How HELOC interest rates work

HELOCs tend to have much lower interest rates than other forms of borrowing because they’re secured mortgages. The loan is tied to your home, which lowers the lender’s risk of losing money if you default. Expect to pay a fraction of the annual percentage rate (APR) you’d pay on a credit card or personal loan.

It’s important to note that nearly all HELOCs come with variable interest rates. And, every time the Federal Reserve hikes its federal funds rate, that will push your HELOC rate and payment higher. By contrast, a home equity loan typically has a fixed rate, meaning your interest rate and monthly payments will never change.

Many lenders will offer to fix the HELOC rate on a particular balance or for a set period of time. But, of course, you’ll pay for the privilege with an above-market rate.

How HELOC payments work

One key benefit of a HELOC is that, during the draw period, you make interest-only payments on the amount you’ve borrowed. So a zero or low balance means zero or little interest. When the repayment period comes, you only have to pay off what you’ve withdrawn from the HELOC. That means if you use a fraction of your available credit line, you’ll pay a fraction of it back. This could result in ultra-low monthly payments.

A home equity loan, by contrast, is paid out as a lump sum upfront. So you must pay off the entire loan balance regardless of how much cash you actually ended up using.

Understand that a HELOC becomes an installment loan at the start of its repayment period. You’ll be given a monthly payment, including interest, that will zero out your balance by the time the HELOC reaches its end date. Because HELOC rates are adjustable, that monthly payment could rise or fall in line with general interest rates.

HELOCs and credit scores

Some homeowners worry that a high balance on their HELOC could hurt their credit score. With credit cards, borrowing more than 30% of your credit limit is likely to hurt your score. But will the same happen if you borrow more than 30% of your available HELOC limit?

It’s true that credit scores depend partly on your “credit utilization ratio,” which typically applies to “revolving credit.” But, although HELOCs are a form of revolving credit, they’re exempt from credit utilization rules.

Credit bureau Experian explains that “because a HELOC differs from other credit lines in that it is secured by your home, FICO® (the credit score used most often by lenders) is designed to exclude HELOCs from revolving credit utilization calculations.”

In other words, maxing out your HELOC balance should not have a negative impact on your credit score like maxing out your credit cards would. So you can borrow as much as you need from a HELOC without fear of harming your score. However, you will harm your score if you make late payments, default, or exceed your credit limit. And, because HELOCs are a form of second mortgage, you risk foreclosure if things go badly wrong.

It’s important to use your HELOC carefully and budget for repayment. Keep in mind as you plan for the repayment period that HELOC rates are variable, so your payment could increase from time to time. Leave room in your budget for higher-than-anticipated payments to make sure you never default on your HELOC.

How much can you borrow using a HELOC?

Lenders typically want you to retain 15% or 20% of your home’s value as “equity” after all loans are added up. That means your existing mortgage balance plus your new HELOC can’t exceed 80-85% of the home’s value. The more you still owe on your primary home loan, the less you can borrow using a HELOC.

That’s a bit complicated. So let’s look at an example of this “combined loan-to-value" (CLTV) ratio in action.

Suppose your home is worth $400,000 and you owe $200,000 on your first mortgage. Your total equity is $200,000 ($400,000 - $200,000 = $200,000). But you can borrow only some of that because your lender needs you to have an equity stake remaining in your home.

Let’s say your lender’s maximum combined loan-to-value ratio is 85%, meaning you must retain 15% of the home’s value as equity. That’s quite common for HELOCs.

  • 15% of your home’s value is $60,000 ($400,000 x 15% = $60,000)
  • You can borrow a total of $340,000 across both mortgages ($400,000 - $60,000 = $340,000)
  • You already owe $200,000 on your first mortgage
  • The most you can borrow with your HELOC is $140,000

Bear in mind that the more equity you have in your home, the lower your HELOC interest rate is likely to be. So there are advantages to not maxing out your borrowing.

How HELOCs affect your current mortgage

First mortgages generally aren’t affected by a HELOC. However, there are a couple of ways in which one could intrude on the other:

  • If you default on your HELOC, your lender can foreclose on the home. That would force your first-mortgage lender to do the same. That first-mortgage lender gets the first bite of the cherry. This is called “lien priority,” and the basic principle is the “first in time, first in right” rule
  • Lien priority can cause problems if you have a second mortgage and want to refinance your first mortgage. Because your second mortgage will then be the earlier one, that lender gets the first bite. And no first-mortgage refinancer will allow that. So be sure your HELOC lender will waive its lien priority rights before you sign up

How a HELOC works: FAQ

Is a HELOC a mortgage?

Yes. A HELOC is a second mortgage, which means it’s secured by your home’s equity (just like a primary home loan) and you’ll likely pay a much lower interest rate than with unsecured borrowing. However, the fact that it is secured on your home means you could ultimately face foreclosure if your HELOC goes badly wrong.

How is a HELOC paid back?

HELOCs are very flexible. You can borrow from and repay your HELOC as often as you want during the draw period. Once the repayment period begins, your balance is amortized, which is a fancy way of saying you’ll repay that balance in equal monthly installments (subject to interest rate changes) over 10-20 years. Your HELOC will be fully paid off at the end of the repayment period.

Can you pay off a HELOC early?

The answer is almost always yes. Prepayment penalties are very rare nowadays. Still, it’s worth checking with your prospective lender to make sure it doesn’t still charge them.

Does a HELOC affect your credit score? 

A HELOC should only hurt your credit score if you make late payments, default, or suffer a foreclosure. Of course, if you manage your HELOC account well, it should help your credit score. Importantly, there’s no penalty for your score if you have a high balance. The credit utilization rules that apply to credit cards don’t apply to HELOCs.

How long does it take to get a HELOC?

It usually takes about six weeks to get a HELOC, from the time you apply to the time you receive funds. Very occasionally, it might be two weeks, but that sort of turnaround is rare. Much will depend on how efficient and busy your lender and appraiser are. And how quickly you submit documents and respond to queries.

How much interest do you pay on a HELOC? 

During the draw period, you pay interest only on the amount you’ve borrowed from your HELOC. This could be far lower than your maximum HELOC limit. During the repayment period, the amount of interest you pay depends on your remaining loan balance and your interest rate. HELOC rates are variable and change often, so the best way to check current rates is by getting a quote from a lender.

Is a HELOC a good idea right now?

When mortgage rates are rising, many homeowners prefer a HELOC over a cash-out refinance. That’s because a HELOC is a second mortgage; it lets you borrow only what you need from your home equity and leaves your existing mortgage loan in place. This can be ideal if you have a low rate on your current loan. Home equity loans are another second mortgage option that can help you tap equity without refinancing. If you’re unsure which type of loan to use, get in touch with a mortgage lender who can walk you through your options.