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Home equity lines of credit (HELOCs): How they work

Couple discussing what is a HELOC and comparing them to home equity loans

Please note: Discover® Home Loans offers a home equity loan product, but does not offer HELOCs.

If you're considering getting a home equity line of credit (HELOC), you probably have a lot of questions. Here are answers to 15 of the most common of those questions. Clearly, there are many factors to consider when deciding whether to move forward with applying for a HELOC or other home equity loan. So, doing your research is important. Top of the list is making sure you understand the key details such as what is a HELOC, how does a HELOC work and other aspects of how this type of credit can help your financial situation. 

Without further ado, here are answers to 15 most frequently asked questions (FAQs) about HELOCs that will arm you with the knowledge you need to kickstart your home equity loan journey:

1. What is a HELOC?

A home equity line of credit (HELOC) is a type of credit account that lets you borrow money against the value of your home. Because the money you borrow is a secured debt that uses your home as collateral, you can typically obtain a lower interest rate on a HELOC or other home equity loan than you could get for other types of consumer loans.

2. How does a HELOC work?

With a HELOC, a lender issues you a certain amount of credit based on the value of your home and the amount of money you still owe on your mortgage. This is a flexible option to help you unlock some of the cash value of your home and use that money for other purchases. Many people use HELOC funds to pay for home repairs and renovations, to pay off other, higher interest debts, to make major one-time purchases or for other financial goals. Unlike a traditional home equity loan (HEL), where you receive all of the money at once as a lump sum and then you repay the loan with fixed payments, a HELOC allows you to access an ongoing line of credit. That way you can withdraw as much or as little money as you want (within the limit of the line of credit)—paying interest on only what you withdraw—and then pay back the money on a flexible basis.

3. What is a line of credit?

A line of credit is a “revolving" credit account—because you can keep borrowing from the same account over and over again, as long as you stay within the approved credit limit. As it relates to home equity, unlike a traditional term loan where you borrow a fixed amount of money and pay it off over time with fixed payments, a line of credit is more flexible. A line of credit lets you get approval from your lender to borrow up to a certain level, and repay the borrowed money all at once or over time (with interest, of course).

4. How does a line of credit work?

A line of credit works similarly to a credit card. Just like with a credit card, a line of credit assigns you a certain credit limit, based on your credit score and other qualifications, and, in terms of home equity, you can choose to borrow up to that total amount.

5. What's the difference between a HELOC and a home equity loan?

A home equity loan (HEL) lets you borrow a certain amount of money all at once, as a fixed lump sum that you repay over time with a fixed interest rate and fixed monthly payments over the term of the loan. For example, home equity loans from Discover Home Loans have repayment terms of 10, 15, 20 and 30 years.

A home equity line of credit lets you borrow from your home's equity as needed on a flexible basis, instead of having to commit upfront to a fixed loan amount. A HELOC will typically have a multiyear period known as the “draw period," usually 5 to 10 years, where you are approved and able to borrow from the line of credit.

After this draw period ends, depending on your agreement with your lender, you generally have a defined repayment period of 10 to 20 years to pay off the loan balance or you might be able to renew your HELOC and keep accessing credit as needed.

It depends on the loan amount, the interest rate, and other aspects of your financial situation to decide whether a home equity loan or HELOC is right for you.

6. What's the difference between a HELOC and a cash out refinance?

A HELOC is a new, separate line of credit secured by your home (often referred to as a “second mortgage”) that is in addition to your regular (“first”) mortgage, in that it lets you borrow and repay money separately from your usual first mortgage monthly payment. When you apply and close a HELOC loan, you pay an additional monthly payment for that second mortgage loan and continue paying your first mortgage like usual, and your first mortgage terms remain the same.

A cash out refinance lets you refinance your existing mortgage into a new loan amount, with a new term and perhaps a new interest rate, while taking out a lump sum of cash.

For example, if your home is worth $400,000 and you still owe $250,000 on it, that means you have $150,000 in equity. A cash out refinance would potentially let you refinance your mortgage while getting some amount of the equity as cash. Let's say you wanted to take out $50,000 of cash. You would refinance your mortgage into a new loan of $300,000, and you'd have a $50,000 lump sum of “cash out" of your home equity. Learn more with the cash out refinance calculator from Discover Home Loans.

7. How much money can I borrow with a HELOC?

It depends on how much home equity you have, how much your home is worth, your credit score and other factors. Many lenders will issue home equity lines of credit starting at $20,000 for less than 90% of the home's combined loan-to-value (CLTV) ratio—which is the combined amount of all mortgages on your property, including the home equity lending that you are trying to finance, versus your total property value. Discover® Home Loans offers home equity loans for amounts ranging from $35,000 to $300,000 and, if you qualify, allows you to obtain less than 90% cash value of your CLTV. Discover® Home Loans does not currently provide HELOCs, we provide this guidance so you can evaluate a HELOC against a home equity loan from Discover Home Loans and find the home equity financing option that best meets your needs.

For example, if your home is worth $300,000 and you owe $200,000 on your mortgage, that means you have $100,000 of equity. So, in this case, if you're allowed to take less than 90%, your HELOC amount would be calculated using this formula:

Combined loan-to-value ratio (CLTV) = (HELOC Amount + Mortgage Amount)/Home Value

0.90 = (HELOC Amount + $200,000)/$300,000

0.90 x $300,000 = HELOC Amount + $200,000

$270,000 = HELOC Amount + $200,000

HELOC Amount =  less than $70,000

Learn more about home equity loan amounts with the home equity loan calculator from Discover Home Loans.

8. What is the minimum credit score to earn HELOC approval?

The minimum credit score a lender will accept varies from lender to lender. In case you don't have a great credit score, there are other factors that can help you get approved for a home equity loan or line of credit. If you have a strong enough debt to income (DTI) ratio—which is your existing debt payments, as well as the projected payment for your new home equity loan compared to your total pre-tax or gross income—if you have a large enough amount of home equity and if you are willing to accept a smaller loan amount or a higher interest rate, you might still be able to get approved for a HELOC even with less than perfect credit.

9. What is a HELOC draw period?

Instead of fixed payment terms for a duration of years, a HELOC is structured to have a “draw period," typically 5 to 10 years—the time you are allowed to withdraw money from the account. There is also a repayment period (usually up to 20 years), where you have to repay any money outstanding at the end of the draw period.

Exact terms will depend on the agreement with your lender, and some lenders will renegotiate the terms of an HELOC; for example, if you want a longer draw period or want to arrange specific repayment terms or finance a new loan after the draw period ends. Having good credit and a good relationship with your lender will help you get more of what you want from your HELOC.

Couple searching how do HELOCs work on their computer as they consider a home equity loan

Unlike a home equity loan, which typically has a fixed interest rate, a HELOC can sometimes have a variable interest rate

10. What interest rate will I pay on a HELOC?

Unlike a home equity loan, which typically has a fixed interest rate for the life of the loan, a HELOC can sometimes have a variable interest rate that can change over the duration of the draw period. Your interest rate will be based on your credit score, your HELOC borrowing amount and other factors. And your rate might go up or down over time, depending on changes to the index used to calculate your interest rate, typically the index is the prime rate.

11. What are the additional costs associated with a HELOC?

Just like signing up for a mortgage, getting a home equity loan or HELOC will typically include certain fees and closing costs. Home Equity loans from Discover Home Loans are atypical compared to many lenders, because there are no application fees or origination fees, and there is zero cash required at closing.

12. What can I use a HELOC for?

You can use the funds from a HELOC, or a home equity loan, for almost any purpose; people often use their proceeds to pay off other debts, consolidate higher-interest credit card debts into a lower-interest loan to save money on payments, fund major home improvement projects or make major purchases.

13. Can I deduct HELOC interest from my taxes?

Although the Tax Cuts and Jobs Act of 2017 made changes to the deductibility of interest on home equity loans, the interest on your home equity loan or HELOC may still be tax deductible if the loan proceeds are used to make certain qualifying home improvements. Check out the IRS website and talk to a professional tax adviser to see if your particular circumstances qualify.

14. Do HELOCs charge penalties for early payment?

In general, HELOCs do not have prepayment penalties, although some lenders might charge a fee if you close your account before the agreed-upon draw period. Check with your lender if you have any questions.

15. What happens if you sell your home with a HELOC or HEL?

Having a HELOC or HEL is technically the same as having a second mortgage on your home, and this can sometimes complicate things when selling your home. If you still owe money on your HELOC or HEL when you sell your home, this will reduce your profits from the sale of your home. Also, your lender who issues your HELOC or HEL will serve as a secondary lien holder on your home; this means that if you sell your home, your lenders get paid first before you can take a profit on the sale.

What you can do: Make sure that your home's selling price is high enough to pay off the HELOC andHEL, or else you might encounter difficulties with getting the deal done. If your home is in negative equity, a short sale may be required, which can sometimes lead to delays and complications in selling a house as well as possible ramifications for your credit score.

A home equity loan is different from a HELOC in the sense that you will receive cash upfront in a lump sum. The interest rate and payments are fixed and the re-payment period starts immediately.  Ready to learn more about a home equity loan from Discover Home Loans? Talk to a Personal Banker today at 1-855-361-3435. We'll be happy to get to know your financial situation and help you decide which home equity loan can help you achieve your goals.

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