How does a HELOC work? Draws, payments and limits in plain English

Most people hear “HELOC” and assume it means refinancing, or that they will owe the whole line the day they sign. Neither is true. Here is how a home equity line actually works: the two phases, the payment math, how big a line you can get, and the fine print that decides whether it helps you or hurts you.

How does a HELOC work, in simple terms?

A home equity line of credit is a loan against a home you own that works like a credit card, except it’s a checkbook. The lender approves a line, say $100,000. You owe nothing until you draw. Draw $20,000 and you pay interest on $20,000, not on $100,000. Pay it back down and that room opens up again, with no new application and no new closing costs.

Your first mortgage does not change. Same balance, same rate, same payment. The line is a separate loan that sits behind it, which is why it is called a second lien. If a home is ever sold in foreclosure, the first mortgage gets paid first and the line’s lender gets what is left: the bank that holds your mortgage eats first. That is why second-lien lenders are pickier about credit, value and payment history.

On a house that is paid off, there is no first mortgage, so the line is the only lien and sits in first position. Everything below works the same way.

The draw period and the repayment period

Every HELOC has two phases.

The draw period is when you can borrow. You draw what you need, when you need it, and on many lines the required payment is interest only. In my experience, many lines give you somewhere between 3 and 10 years to draw. Some credit unions offer a 15-year draw period, which is rare, and it is the first thing I look for.

The repayment period comes next. The line closes to new draws, and whatever you owe is paid back with principal and interest over a set number of years. The payment jumps, because every payment now has to retire the balance, not just cover the interest.

My three tests for any line, in order: how long can I get to the money, can I pay it back in a reasonable time, and can I use it freely, with a checkbook and nobody approving each draw. The rate comes after those. It’s not the interest rate, it’s the draw period.

What happens when the draw period ends?

The payment converts from interest only to principal and interest, and the size of the jump depends on how many years you get to repay.

On a 10-year repayment the payment nearly doubles. On a 15-year repayment it rises by about half. Either way, if you paid only the minimum during the draw period, you still owe the whole $50,000 the day the clock changes. Know your repayment length before you draw a dollar, and pay principal during the draw so the balance is smaller when it converts.

How is a HELOC payment calculated? The interest-only math

Here is the formula I walk through on almost every call. Balance times rate, divided by 12, is the monthly interest-only payment.

The minimum payment is for emergencies

The interest-only minimum never touches the balance. Pay only the minimum on $40,000 at that rate through a 15-year draw period and you will have paid $45,000 in interest and still owe the full $40,000 when repayment starts. The bank will love you. My rule: the minimum is for emergencies, never the actual payment.

The flexibility is the point. In a tight December you can drop to the minimum and catch up in January, which you cannot do on a fixed loan. And every dollar you pay down is room you can draw again, like a savings account you can write a check against.

Is a HELOC rate fixed or variable?

Most HELOC rates are variable. The rate is an index, usually the prime rate, plus a margin set by the lender. Say prime is 6.5% (an example; look up the current prime rate when you run your numbers) and your margin is 1 point: your rate is 7.5%. When prime moves, your rate moves the same amount, up or down. The margin is written into your agreement, so the lender cannot change it on a whim.

Each 1-point move in prime changes the interest-only payment by about $8.33 a month for every $10,000 you have drawn. On $40,000 drawn, that is about $33 a month per point. Most lines I see run about 1 to 1.25 points over prime. Some price every borrower who qualifies the same; others charge more as credit scores drop. Read three things in the agreement: the index, the margin, and the highest rate the line can ever charge.

The rate is higher than a first mortgage, but you pay it only on what you draw, and usually for shorter stretches. Next to credit cards and unsecured personal loans, borrowing against your home is usually the cheaper money, because the house secures it. That is also the risk. Fall behind on a line and it is your home on the line, not a credit card account.

HELOC vs home equity loan

If a variable rate keeps you up at night, a home equity loan, also called a fixed second mortgage, is the fixed version. Some lenders also offer lines where each draw locks its own fixed rate and term. Read the fee schedule on any fixed product: some charge a percentage fee on the first draw and add it to your balance.

Both leave your first mortgage alone. A cash-out refinance does not: it replaces your whole first mortgage at whatever rates are when you close. I put all three side by side, with the blended-rate math, in HELOC vs cash-out refinance vs a fixed second.

How much can you borrow? CLTV and the 100% HELOC

Lenders size a line with combined loan-to-value, or CLTV: your first mortgage plus the line, as a percent of the home’s value. Home value times the lender’s CLTV limit, minus what you owe, is your line, up to the lender’s dollar cap.

In my experience, most lines stop between 80% and 90% CLTV. Some credit unions offer lines up to 100% of the home’s value for strong borrowers on a primary residence, usually with a dollar cap, so a big-equity home can hit the cap first. A 100% line is uncommon because the second lien is the last one paid, and when you can get one it is the most access you can have without touching your first mortgage. The lender’s valuation sets the number, not a home-value website, so I run first guesses with a conservative value.

The line is fixed at closing. If your home goes up $60,000 next year, the line does not grow with it. To borrow against the new value you would apply for a new line, so do not close the old one unless you are replacing it.

Does a HELOC count in your debt-to-income?

Only what you have drawn. In my files, an open line with a zero balance adds nothing to your ratio. Once you draw, the required payment on the balance counts like any other monthly debt, and interest-only keeps it small: $30,000 drawn at an example rate of 7.5% is about $188 a month. Some lenders treat open lines their own way, so I check how the lender on your next loan will count yours before you apply. Ratios themselves are covered in how much house you can afford.

Debt you roll into a line does not vanish from the math either. Pay off a $350 card minimum with a draw and the $350 leaves your ratio, but the line’s payment on that draw comes in.

HELOC requirements: what lenders check

Every lender sets its own rules, but five things decide almost every file I see.

• Mortgage payment history. A 30-day late on a mortgage is a showstopper for many second-lien lenders, and some look back years, not months. If you have one, tell me before anyone pulls credit.
• Credit score. The minimums I see run from about 620 to 700, depending on the lender and the product. If your credit is frozen, unfreeze it before you apply. More on what moves a score in credit scores for a mortgage.
• Equity. Enough room under the lender’s CLTV limit to make a line worth opening.
• Income and debt-to-income. Expect pay stubs, W-2s and often tax returns. Self-employed borrowers usually need two years of returns. The debt-to-income ceilings I see run from the mid-40s to the mid-50s, as a percent of gross income.
• Ownership. You have to own the home to borrow against it, and co-owners on the deed usually sign too.

Documents: 30 days of pay stubs, two years of W-2s, your latest mortgage statement, your homeowners insurance policy and any recent appraisal. The lines I see most often take about 30 days to close, so do not open one the week you need the money.

Some HELOC lenders pull your credit hard the moment you apply. Before anyone does, I pre-screen: a soft look at your credit and your latest mortgage statement. If a line does not make sense, you do not apply and you do not take the hit.

What a HELOC costs, including Virginia’s recordation tax

Some lenders charge closing costs on a line like a small mortgage. Some credit unions pay the closing costs for you, charge no annual fee, and take those costs back if you close the line or sell the house inside a set window, two years on the lines I see most often. That take-back is called an early-closure or recapture fee. It is not a penalty for using the line. It is the lender getting back what it paid to set the line up, and much of that is government recording charges.

In Virginia, a big piece is the recordation tax. Virginia taxes a HELOC’s deed of trust on the maximum amount that can be outstanding at one time, not on what you draw: 25 cents per $100 for the state, plus a local tax of one-third of that where the locality levies it. On a $150,000 line that is $375 to the state and up to $125 local, about $500, before the clerk’s recording fees, the title search and the valuation. The full list of what Virginia charges at closing is in Virginia closing costs.

Before you sign, get the early-closure fee in dollars and the date it goes away. Then do not close the line inside that window. If the plan you opened it for falls through, leave it open and let it ride.

Does a HELOC need an appraisal?

Often not a full one. Many lenders use an automated value, a computer model built from sales data, on smaller lines and order a full appraisal above a dollar cutoff that varies by lender. Some will reuse a recent purchase or refinance appraisal.

My usual advice is to take the automated value and let the bank carry the risk. You can pay for a full appraisal if you think the computer missed, but if the appraiser comes in lower, your line just got smaller.

Why open a HELOC while the home is your primary residence

Lenders save their strongest HELOC terms for the home you live in. A primary residence gets the highest CLTV limits, the biggest lines and lower margins than any other property type. On the lines I see, a second home tops out around 90% CLTV and an investment property around 75%, at higher rates, and many lenders will not open a line on a rental at all. A duplex to fourplex gets worse terms than a single-family home, even when you live in one of the units.

So if there is a real chance you will move someday and keep this house as a rental, the time to open the line is while you live in it. Once you move out, the better-priced version of that line is off the table for that house, and your options shrink to a smaller, pricier line or a cash-out refinance.

Two rules ride along with that. The application will ask whether you live in the home and what the money is for: answer both truthfully, including any plan to buy another home or rent this one. And before a tenant ever moves in, read what your line agreement says about occupancy and renting, and ask the lender if it is not clear. Buying the next house with the line has its own order of events, covered in using a HELOC for the down payment on your next home. It is also the engine of my Blue Collar House Hack.

What to use a HELOC for, and when to use something else

Uses that work: the down payment and closing costs on your next home, a standby reserve, repairs and improvements, high-rate debt and land. Uses I talk people out of: a car, a vacation, anything you would regret paying for over 15 years with your house as collateral. Whatever the use, the application asks the purpose. Give the real one.

Paying off credit cards and personal loans. This works when you keep paying what you were paying. Roll $30,000 of card and personal-loan debt into a line at an example rate of 7.5%, keep paying the old $900 a month, and it is gone in about three years with about $3,750 of interest. The catches: the debt moved rather than disappeared, and now your house secures it. Leave 0% and very low-rate debt where it is. If the cards fill back up, you have doubled the problem.

Paying off your mortgage with a HELOC. Some lines can sit in first position for exactly that, but it only makes sense on a small balance you will clear fast. Trading a fixed rate in the 3s or 4s for a higher variable rate is a raise for the bank, not for you.

Buying land. A line on the home you live in usually costs far less than a raw-land loan, which in my files wants 20% to 25% down at a much higher rate and a short term. If you build, I steer people toward stick-built homes for financing and resale; the building side is in construction loans.

Big repairs and the rainy-day reserve. This is where a line earns its keep. A $17,000 HVAC replacement or a month with no rent coming in is a draw, not a crisis. Better to have it and not need it than need it and not have it.

A line you understand is a tool. Start with three numbers: what the house is worth, what you owe, and what you would actually draw. Run the interest-only math on the draw, then the repayment math on the same balance, and make sure you can carry both before you sign.