Everything You Need to Know About a Home Equity Line of Credit (HELOC)

Generating home equity is one of the significant benefits of owning a home. Renting puts money into a landlord’s pocket, but owning a home helps you increase the value of your investment over time. Once you build up enough home equity, cash-out options can open up to you, which can be used for home improvements, education expenses, paying off debt or other projects.

How can you tap into your equity and turn it into cash? You have a few options. One popular way is with a home equity loan. Another method is doing a cash-out refinance, which involves replacing your current mortgage with a new one for a higher amount, giving you the difference in cash. An alternative to both options is a home equity line of credit (HELOC).

Let’s look at what a HELOC is, its pros and cons and how it differs from a home equity loan and cash-out refinance.

While we provide information about HELOCs, it’s important to note that Pennymac does not offer the specific product at this time. We also understand that HELOCs are not the best choice for everyone, or for every rate environment. For a custom review of all the ways you can harness the spendable power of your own home equity, connect with a Pennymac Loan Expert.

What Is a Home Equity Line of Credit (HELOC)

A HELOC allows you to access your home equity by providing a line of credit, similar to a credit card. You borrow the amount you need, when you need it, up to your approved limit. Keep in mind that most HELOCs use variable rates, so the interest rate will fluctuate based on certain benchmark rates and the current market.

How Does a HELOC Work?

Like a home equity loan or cash-out refinance, a HELOC lets you borrow against your available home equity. The difference with this method is that you get the funds using a line of credit with a variable interest rate. Think of it like a credit card: You can access a set credit line, withdraw funds as needed and repay them with interest.

What’s also unique about a HELOC is that there are two periods: the draw period and the repayment period. During the draw period, you can borrow money and typically make interest-only payments. The repayment period begins once the draw period ends, requiring the monthly payments to cover both the principal and interest, at a variable rate depending on market fluctuations. With the addition of principal to the monthly payments, keep in mind that the amount owed each month could go up significantly compared to the initial draw period, especially if benchmark rates happen to rise concurrently.

As with any mortgage option, your home serves as the loan’s collateral.

HELOC Rates

Sharing some features with Adjustable Rate Mortgages (ARMs), HELOCs often have lower interest rates during the initial term — in this case the draw period — compared to other loan options. However, like ARMs again, HELOC interest rates are usually variable, meaning they fluctuate with the market.

Variable rates come with pros and cons, as they are dependent on the current market and economy, changing according to benchmark interest rates, which can raise or lower your payments in both HELOC phases. Your eligibility will also affect the kind of rate you qualify for. Many lenders offer rate caps so that your interest rate won’t exceed a certain percentage. When choosing a lender or applying for a HELOC, be sure to check for these caps in the contract and factor them into your decision.

If you prefer the certainty of a fixed interest rate, a home equity loan could be a better fit, with set monthly payments you can rely on for the entirety of your loan term. This stability makes it easier to budget and plan for, and can provide peace of mind and potentially more long-term savings if market rate fluctuations are a concern.

How to Pay Back a HELOC

A home equity line of credit is paid back with interest on whatever you take out of your revolving funds. As mentioned before, HELOCs have two phases: the draw and repayment periods. These names can be misleading though, since you will make payments during both periods. The combined periods can last up to 30 years, although durations vary. And the periods are not usually split evenly. For example, the draw phase may be 10 years and the repayment period could be 20 years.

Let’s look at how the two phases work.

Phase 1: The Draw Period

The first phase of a HELOC is the draw period, typically lasting 5 to 15 years. During this time, you can borrow funds as needed, up to your credit limit, making it a flexible spending phase. Remember that the credit line is revolving — if you reach the limit, you’ll need to repay some of the balance before borrowing more.

Making interest-only payments during the draw period

During the draw period, borrowers typically make interest-only payments on the amount borrowed. While this keeps monthly payments low, it doesn’t reduce the loan balance, as no principal is being paid off.

You may be able to reduce your principal balance if you choose to pay more than the interest-only amount during this phase. This will decrease the total amount owed and may lead to smaller payments during the repayment period. However, most lenders impose prepayment penalties if you pay off your HELOC early or make more than the minimum interest payments.

Homeowners often opt for minimum payments, while others, such as investors, may borrow the maximum amount multiple times and repay it repeatedly.

The HELOC’s repayment structure differs from that of a home equity loan, which, similar to a conventional fixed-rate mortgage, includes both principal and interest starting at payment number one through the end of the term, with the principal loan balance steadily reducing over time. Compared to a HELOC, this more traditional structure minimizes total interest paid over time, saving you money and potentially helping you pay off the loan faster.

Phase 2: The Repayment Period

After the draw period ends, the repayment period begins, requiring you to make regular monthly payments. The credit line is closed, and you can no longer borrow against your home equity during this phase.

Your payment amount depends on factors such as whether you made interest-only payments during the draw period and the duration of each phase. For most HELOCs, which typically have variable interest rates, changes in the rate will also impact your payments.

If you opted for interest-only payments during the draw period, your monthly payments could increase significantly during the repayment period, as you’ll now need to pay both principal and interest. This new adjustment can often bring on payment shock, due to the immediate onset of a substantial increase in monthly obligation once you transition from an interest-only draw period into the principal-plus-interest repayment phase.

It’s important to plan ahead for the transition to the repayment period. Without preparation, you might find yourself relying on additional lines of credit to cover payments, potentially leading to deeper debt. If you’re not ready for repayment, refinancing your HELOC may be an option to explore. Understanding the timeline and financial impact of both periods is key to staying in control of your finances.

Benefits of a HELOC

HELOCs are a way to access the home equity you own, but there are risks with this method that you should be aware of. Not every scenario calls for a HELOC loan, so consider the following benefits and drawbacks.

Advantages of a HELOC

• Lower upfront costs. Compared to other loans, HELOCs tend to have lower upfront costs.
• Low or no closing costs. There are typically no closing costs for HELOCs. If there are closing costs, they are very low.
• Interest is charged accordingly. Much like a credit card, interest accrues only on funds that you have used. You may have $200,000 available to borrow, but if you’ve only taken out $20,000, interest is applied just to that 10% borrowed.
• Flexibility. Because you don’t have to borrow the full amount you are approved for, you have flexibility when it comes to your spending plan. You’ll have an affordable funding option if something unexpected pops up or a project costs more than anticipated.
• Tax deductions. As with home equity loans and cash-out refinancing, in some instances, the government allows homeowners with HELOCs a tax deduction for interest payments. Please consult your tax advisor regarding the tax benefits of HELOCs.

Disadvantages of a HELOC

• Your credit limit may change. One significant disadvantage of a HELOC is the lender’s ability to reduce or suspend the credit line after origination. This can happen if the lender or bank feels your home value has declined to the extent that it cannot support the existing, originally approved credit line. This can suddenly place you at or above your credit limit, which would then significantly impact your credit score in a negative way, as well as limit you from accessing needed funds you had planned on using for an emergency. Conversely, with a home equity loan or cash-out refinance, your funds are guaranteed upon closing, so in those cases there would be no lack of confidence that you will receive the funds you need.
• Minimum draws. Some lenders require you to use a certain amount of the equity funds. Even if you end up not needing the minimum, you still have to take out and pay back that money (with interest). Most lenders also charge an inactivity fee if the account isn’t being used.
• Upfront costs. Although upfront costs can be lower than other loans, HELOCs may still require application fees, home appraisal costs and other procedures. Consider the upfront expenses and determine if they’re worth the funds you would have access to.
• Variable interest rates. Unlike a fixed-rate home equity loan or most cash-out refinancing, a HELOC has a variable rate. That means rates can go up and down depending on the market and federal lending rate, which can affect your monthly HELOC payments. When they are low, it’s great for borrowers, but high interest rates can take a toll.
• Fees. You need to properly vet a lender to avoid getting stuck with unexpected or overwhelming fees such as cancellation fees, application fees, annual fees and prepayment penalties.
• Potential credit damage. In addition to the risk to your credit from unforeseen changes to your credit limit by the lender (as mentioned above), as with any loan, your credit score will take a hit if you cannot make payments.
• Large payments after the draw period. If you choose to pay only interest during the draw period, you may be responsible for managing significantly higher monthly payments once you transition to the repayment phase.
• Risking your home. Remember, your home is the collateral. If a homeowner mismanages their funds, misses payments and ultimately defaults when the repayment period rolls around, they could lose their home.
• Temptation to overspend. Having large amounts of available funds can feel liberating, but some homeowners struggle to use their funds only for essential or intentional spending, which can lead to greater debt that’s harder to pay off.

How to Qualify for a HELOC

Just like with home equity loans and cash-out refinancing, to qualify for a HELOC, you will need a sufficient amount of equity in your home, a good credit score and a low debt-to-income (DTI) ratio. Here are some tips to help you get started and increase your chances of qualification.

Start Building Home Equity

Since you usually need at least 15-20% home equity to qualify for most loans that allow you to tap into your equity for cash, you can start prioritizing increasing the value of your home. You can build your equity by making slightly larger payments on your principal balance for your current mortgage.

Know Your Credit Score and History

Just like with any loan, your credit score affects your eligibility for a second mortgage like a HELOC or home equity loan, similar to when you were a first-time homebuyer applying for your first mortgage. Most lenders require a minimum credit score between 580 and 620, although that is ultimately dependent on the type of loan you choose and other qualifying factors. HELOCS typically require a credit score on the higher end because they are considered a riskier option for a lender.

Decide Why You Need the Funds

You don’t want to be casual with your HELOC spending, so be specific and intentional with borrowing by having a plan in place. While you may use a HELOC to have flexible on-hand funds, that doesn’t mean you should be careless. Set boundaries from the beginning on what you can and can’t spend these funds on, how often you want to make payments, etc.

As with a home equity loan or a cash-out refinance, people may use a HELOC to pay for home renovations, unplanned expenses, education and special events like weddings.

Do Your Research

Talk to multiple lenders, compare rates and benefits and read reviews. Look for a credible lender who is upfront about fees, timelines and other expectations. When deciding who to work with, it’s important to carefully evaluate the HELOC’s fees and terms and the lender’s reputation.

You’ll also want to know the following:

• The length of the draw period, i.e., how long you’ll be able to access the funds
• The period of time you’ll have to pay the remaining balance after the draw period ends; sometimes, terms can be 15 years, and you may have a steep payment
• If the interest rate will be fixed once you can no longer access the credit line

Understand Typical Contracts and Look for Fees

Before agreeing to a HELOC and signing a contract, make sure you understand its terms and conditions and the overall costs.

• Are there prepayment penalties? Could those penalties prevent you from paying off more of your balance during the draw period?
• Is there a minimum amount you have to take out? Does it make sense to take out that much with your financial goals?
• Are there application fees or annual fees?
• Is there an interest rate cap to ensure your rate won’t exceed a certain percentage?

Know Your Debt-to-Income Ratio (DTI)

The debt-to-income ratio is the percentage of your monthly income that goes toward your current debt. Keep in mind that you can only have so much debt before lenders no longer consider you eligible.

Paying off debt demonstrates to lenders that you know how to manage your money. Having too much debt, especially compared to your income, will indicate to lenders that you can’t sustain a line of credit with interest. For a HELOC, lenders typically look for your DTI ratio to be lower than 40-45%. Reach out to a licensed loan officer who can help you figure out where you stand.

How Much Can You Borrow?

Even if you have substantial home equity, most lenders only allow you to take out some of what your home equity is worth.

Typically, you can use up to 85% of your home equity value, though it could be less depending on your financial history and other personal qualifications. Factors that influence your overall eligibility, how much you can borrow and the interest rate you may qualify for include:

• Credit score and credit history
• Current debt
• How much home equity you have
• Reliable income
• Payment history

What Can You Use a HELOC For?

Essentially, homeowners can use a HELOC for whatever they need to, though it’s not wise to use these funds for nonessentials or day-to-day expenses. HELOC funds are best used for the following:

• Home improvement. Home improvement is one of the best uses of HELOC funds. From renovations to additions, projects that increase the value of your home may also help contribute to your home equity. Plus, there are potential tax deductions for certain home improvement projects.
• Emergency funds. If you find yourself without a job or facing other emergencies, HELOCs are a good source of revolving funds that can be carefully managed, even in the draw period. Because interest doesn’t accrue on unused funds, you can use and pay off only what you need.
• Medical bills. Medical bills can add up quickly, especially for unexpected or ongoing health concerns. People often take advantage of HELOCs for these types of expenses.
• Education costs. Some people also use a home equity line of credit to pay off student loans or pay for tuition, especially because, depending on the market, HELOC interest rates can be lower than student loan interest rates.

HELOC Alternatives

HELOCs are just one option for leveraging your home equity. Two other popular choices for homeowners are a home equity loan and a cash-out refinance.

Home Equity Loan

A home equity loan also allows you to borrow against the equity you’ve built up in your home. Both HELOCs and home equity loans use the value of your house as collateral and are considered second mortgages. This means your current mortgage remains unchanged, and you’ll make your HELOC or home equity loan payments in addition to your existing mortgage payments. However, a home equity loan has some key differences:

Lump sum payment. Home equity loans aren’t a revolving source of funds like HELOCs are. Instead, homeowners are given the money as a one-time lump sum at closing and can spend it as needed.

Fixed interest rate. Unlike a home equity line of credit, home equity loans usually come with fixed interest rates. A fixed interest rate also means a fixed payment — you’ll know exactly what you’ll pay every month regardless of what’s going on in the market.

Prepaid interest costs and closing costs. With a home equity loan, you may have prepaid interest costs that you’ll have to sometimes pay at closing time. You also usually have to pay 2-5% of the loan amount in closing costs, whereas a home equity line of credit doesn’t often have closing costs.

When Is a Home Equity Loan the Better Choice?

Home equity loans are often used when borrowers need a big sum of cash for a one-time expense. If you need more flexibility, a HELOC loan lets you acquire funds as needed (albeit with the weight of greater risk). If you know exactly what you need the money for and prefer fixed payments, a home equity loan is probably best.

Cash-Out Refinancing

HELOCs are flexible and offer a certain amount of freedom, but they aren’t for everyone. If you don’t want to take out a second mortgage, a cash-out refinance is a great option. And under the right market conditions, this type of refinance can allow you to not only obtain cash for large expenses but also gain more beneficial terms on your primary mortgage.

What Is Cash-Out Refinancing?

A cash-out refinance replaces your existing mortgage with a new loan with a higher balance, sometimes with more favorable terms than your current loan. The difference between these two loans is distributed to you as cash.

Cash-out refinancing allows you to maintain just one mortgage rather than two while still getting the immediate cash you need. These also offer fixed rates, which many people prefer for consistency, ease of planning and peace of mind.

Frequently Asked Questions

What Are the Differences Between a Home Equity Loan and a HELOC?

A home equity loan provides a lump sum with a fixed interest rate and set monthly payments throughout the life of the loan, great for large one-time expenses and lowering long-term interest paid through debt consolidation. A HELOC acts more like a credit card with a variable rate, offering a revolving line of credit that allows you to borrow funds as needed, but at the risk of unpredictable and fluctuating interest rates, as well as a potentially uncertain credit line that can change after you’ve borrowed against it. Home equity loans typically have closing costs, while HELOCs often have fewer upfront fees. A home equity loan is a good option if you want to pay for a significant one-time expense without the temptation to overspend, and don’t want to worry about facing an unexpected dramatic increase in your monthly payment down the road. A HELOC could be an option if you are prepared for potential future increases in your mortgage payments and feel comfortable and disciplined enough to manage the temptation of ongoing access to funds.

How Does Home Equity Work?

Many people want their home equity to work for them instead of being stagnant. That’s why HELOCs, home equity loans and cash-out refinance options exist. Homeowners should understand that though home equity refinancing can be helpful, you’re putting your home at risk if you aren’t properly prepared for the payments. Done correctly, though, home equity can be a great alternative source of funds and debt management.

How Can You Use Your Home Equity?

You can use your home equity loan for various objectives, as long as the lender hasn’t set certain limitations. Some lenders do limit what the line of credit can be used for, so it’s always best to discuss such limitations with lenders before signing anything. Also, remember that funds shouldn’t be used for nonessentials or like a traditional credit card. Most often, people use home equity loans, HELOCs and cash-out refinancing to add value to their home through home improvement, pay off substantial bills or expenses or to consolidate their current debt to get a better rate and lower costs (although HELOCs are not a recommended method for debt consolidation given the uncertainty of the variable rate).

Can You Pay Off a HELOC Early?

HELOCs are almost always going to have a prepayment penalty within the first 36 months of the draw period. Ask your lender about their prepayment policy.

What’s the Difference Between a HELOC and a Home Improvement Loan?

The main difference between a HELOC and a home improvement loan is how you receive the funds. HELOCs allow borrowers to take out smaller amounts of money depending on how home projects change and evolve. Home improvement loans are also limited to specific home projects, whereas HELOCs can be used outside the home for any purpose.

Is a HELOC Right for You?

A home equity line of credit can be a good solution for established homeowners who desire flexible spending options. If funds are used carefully alongside organized financial planning, for the right reasons and through a reliable lender, a HELOC can be a viable option under the right market conditions.

However, a home equity loan may be a more suitable choice if you could benefit from the certainty of a lump sum of immediate funds and prefer the security of fixed interest rates with predictable monthly payments. And depending on market conditions, a cash-out refinance might be worth considering if you want to access cash and consolidate your mortgage into a single loan with potentially lower interest rates or better terms.

To learn more about turning your available home equity into cash in hand, speak with a Pennymac Loan Expert today.

While Pennymac provides guidance and information on any comparable loan program that allows homeowners to borrow against their available home equity, we are currently not offering a HELOC product at this time. We’re here to answer any questions you may have, and help you make an informed decision about your mortgage options.

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