A home equity line of credit, or HELOC, works more like a credit card than a mortgage, except that your house secures it. This guide walks through how one works from opening to payoff: what you can borrow, the two phases of the loan, how the variable rate is set, and why the payment can jump partway through. It's general education. The terms of any real line are in the lender's disclosures.
What a HELOC is
The Consumer Financial Protection Bureau (CFPB) defines a HELOC as a loan that lets you "borrow, spend, and repay as you go, using your home as collateral." It's an open-end line of credit. You get a credit limit and can borrow against it again and again, instead of receiving one lump sum up front.
The money comes from your equity. The CFPB defines equity as what your home is currently worth minus what you still owe on any existing mortgage. Lenders typically let you borrow up to a specified percentage of that equity.
Lenders are required to give you the CFPB booklet What you should know about home equity lines of credit, which the Federal Reserve Board's consumer pages also link to. Most of what follows comes from it.
How much you can borrow: loan-to-value
The CFPB describes the loan-to-value (LTV) ratio as a comparison of the amount of your mortgage with the home's appraised value. A HELOC sits on top of any existing mortgage. So lenders look at the combined picture: everything secured by the home, including the new line, measured against the home's value. That's the combined loan-to-value, or CLTV. The CFPB's booklet describes the HELOC limit the same way, generally as a percentage of the home's appraised value minus what you owe on your mortgage.
Here's a hypothetical. A home is appraised at $400,000 with $250,000 left on the mortgage. A lender whose limit is 80% of the home's value would allow $320,000 of total borrowing against it. That leaves room for a line of up to $70,000. Each lender sets its own percentage.
Phase one: the draw period
Once a HELOC is open, you're in the draw period, which the booklet also calls the borrowing period. You can spend up to your limit whenever you want, usually with special checks or a card linked to the line. The CFPB gives 10 years as an example of how long a draw period might last. Some plans set a minimum amount for each draw or a minimum balance, and some require you to take an initial amount when the line opens.
Payments during the draw period depend on the plan:
- Principal plus interest. Some plans set a minimum payment that covers interest plus part of the principal. The CFPB notes that this principal portion typically won't pay off the balance by the end of the term.
- Interest only. Other plans let you pay just the interest during the draw period. That means you pay nothing toward the amount you borrowed.
Because most HELOCs have variable rates, your payment can change even if you don't borrow any more.
Phase two: the repayment period
When the draw period ends, you can't borrow any more and you enter the repayment period. The booklet describes two common setups:
- A repayment schedule. The lender sets payments to pay off the full balance over a fixed term. The CFPB mentions terms of 10 to 15 years in its booklet and 10 to 20 years in its Ask CFPB answer.
- A balloon payment. Some plans require the entire balance at once. The CFPB warns that you have to be ready to pay it, for example by refinancing with the same lender or borrowing from another, and that if you can't, you could lose your home.
The draw period sets your payment, and the repayment period shows what the loan really costs.
Payment shock at conversion
In supervisory guidance, the Federal Reserve and other banking agencies describe what happens at the end of the draw period. The outstanding principal "is either due immediately in a balloon payment or is repaid over the remaining loan term through higher monthly payments, resulting in payment shock."
A hypothetical shows the scale. Say you owe $50,000 at 8% and have been paying interest only. Your payment is about $333 a month. If that balance converts to a 15-year repayment schedule at the same rate, the payment rises to about $478, roughly 43% more, even though the rate hasn't changed. If the variable rate rises at the same time, the increase is larger.
The jump matters. A 2015 Federal Reserve working paper, End of the Line, found that HELOCs reaching the end of their draw period have a significantly higher cumulative default rate after the payment change. Lines with a balloon payment were more likely to default even after accounting for borrower and loan characteristics.
Variable rates: index plus margin
The CFPB says HELOCs typically have variable rather than fixed rates. A variable rate has two parts:
- The index is a published measure of interest rates that moves with the wider economy. Lenders use different indexes. The CFPB names the U.S. prime rate and the Constant Maturity Treasury (CMT) rate as common ones.
- The margin is a fixed extra percentage the lender adds on top of the index.
Your rate is the index plus the margin, so when the index moves, your rate and usually your payment move with it. Regulation Z requires lenders to disclose which index they use and where to find it, how the margin is applied, how often the rate can change, and any limits on how much it can rise.
Some lenders offer an introductory or "teaser" rate that's unusually low for a short period, such as six months. Some HELOCs let you convert part of the balance to a fixed rate, which the CFPB says is typically higher but more predictable.
Your home is the collateral
The CFPB is blunt: if you fall behind or can't repay the loan on schedule, you could lose your home. The collateral matters in other ways too:
- Selling the home. The CFPB says you're generally required to pay off the HELOC in full when you sell.
- Freezes and reductions. HELOCs generally let the lender freeze or reduce your line if your home's value falls or your finances get noticeably worse.
- Termination. Under Regulation Z, a lender can terminate a plan and demand repayment only in limited cases. These include fraud or material misrepresentation, failing to meet the repayment terms, or an action or inaction that harms the lender's security interest in the home.
Before you sign
The CFPB booklet includes a worksheet for comparing three offers. It covers the index and margin, how often the rate adjusts, rate caps and floors, the length of the draw and repayment periods, whether payments are interest-only, whether a balloon payment is due, and the up-front and ongoing fees. Federal law also gives you three days after the account is opened to cancel the line for any reason, in writing, and get back the fees you paid.