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How Does a HELOC Work?
If you understand how credit cards work, you already have a basic understanding of how HELOCs do too. With a credit card, the bank establishes a credit limit based on your household income, assets, and credit score. In each billing cycle, you can spend as much or as little as you want, as long as you stay under that limit. When you pay your bill, your available credit increases by the amount of your payment.
A HELOC functions similarly, but your credit limit is also based on how much equity you have in your home. There is a “draw” period, typically of five to 10 years, during which time you have access to funds in your credit limit, and then a “repayment” period, generally of 10 to 20 years after, when you can no longer get money but must instead pay any outstanding balance back with interest.1
While the basic concept of a HELOC resembles that of a credit card, there are a number of important differences between them. Borrowers should thoroughly understand these features before applying for a HELOC.
Underwriting Standards
HELOCs are subject to underwriting standards from lenders, which means that you will need to document your income and employment status as you would if you were refinancing your home mortgage.
When you apply for a credit card, you are asked to provide information about your income and employment, but you do not typically have to document it. Note that not all borrowers will qualify for a HELOC, and that qualifying for a credit card may be easier in general.
Collateral
As a HELOC is secured by your home's value; if you don’t repay it, you could end up in foreclosure.
A credit card, on the other hand, is a form of unsecured credit so you are significantly less likely to lose your home if you cannot repay what you borrow. With credit card default, even if your creditors sued you and you had to declare bankruptcy you might be able to keep your home.
Interest Rates
HELOCs, like most credit cards, have variable interest rates that change over time with rates in the economy. With a credit card, your interest rate is based on a benchmark interest rate, such as the prime rate or the London InterBank Offered Rate (LIBOR), plus a margin or mark-up that is based on your credit score, repayment history, and how much the lender needs to charge to potentially earn a profit.
HELOC interest rates are priced similarly. However, HELOCs often have significantly lower interest rates than credit cards due to the collateral giving the lender a cushion if you default. That being said, when interest rates increase, people who thought they were borrowing money cheaply could find themselves stuck with HELOCs whose interest rates are comparable to credit card rates.
There is also the possibility of getting a HELOC with a fixed-rate option. In this case, the loan will often have a variable interest rate during the initial draw period, and then converts to a fixed interest rate for the repayment period.
Interest Deductibility
Unlike credit card interest, HELOC interest can sometimes be tax-deductible, but only if the loan is “used to buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS).2 This provision was made law starting in 2018 by the Tax Cuts and Jobs Act (TCJA) of 2017, and it is currently slated to go away in 2026, when the previous situation of tax-deductible interest for any loan purpose is slated to be reinstated.
The TCJA also nearly doubled the standard deduction, making it less likely that most taxpayers will find it advantageous to itemize their deductions.3 Still, the tax-deductible interest option may make a HELOC additionally attractive in some cases.
High-Interest Debt Refinancing
If the interest rate on a HELOC is, say, 5.5% and the interest payments are tax-deductible—while the interest rate on your credit card debt is perhaps 29.9% and the interest payments are not tax-deductible—it is easy to see how a HELOC can save you a ton of money and help you get out of debt faster by consolidating your debt and using the HELOC proceeds to pay off your credit card balances. In effect, you will have swapped a high-interest loan for a low-interest loan.
However, some people will use a HELOC to pay off higher-interest debt, but then use their newly replenished credit card limits to accumulate even more high-interest debt. This is a practice known as “reloading,” and it often doesn’t end well. Indeed, remember, if you default on a HELOC you could lose your home, but going bust on a credit card often does not bring such consequences.
The Bottom Line
If you want to borrow against the equity in your home using a HELOC, make sure you understand how it works. In particular, you need to know when and by how much your interest rate might change before you borrow. Will you be able to afford the monthly payments if they go up later? How much of an increase can you stomach? Will the things you want to purchase with your HELOC money still be worth it at a higher interest rate and possibly with no tax deduction for the interest?
You should also think about how you plan to use the money and your past borrowing behavior to decide whether a HELOC is likely to help or hurt your finances in the long run. If you have a habit of abusing credit and do not really trust yourself to change your ways, you may be better off leaving your home equity intact and keeping your debt on your credit cards.
Finally, be vigilant and check your HELOC statement regularly. Identity theft is increasingly common, and there are unscrupulous people out there who will steal yours and use it to drain the funds from your HELOC while you’re not looking.
If you understand how credit cards work, you already have a basic understanding of how HELOCs do too. With a credit card, the bank establishes a credit limit based on your household income, assets, and credit score. In each billing cycle, you can spend as much or as little as you want, as long as you stay under that limit. When you pay your bill, your available credit increases by the amount of your payment.
A HELOC functions similarly, but your credit limit is also based on how much equity you have in your home. There is a “draw” period, typically of five to 10 years, during which time you have access to funds in your credit limit, and then a “repayment” period, generally of 10 to 20 years after, when you can no longer get money but must instead pay any outstanding balance back with interest.1
While the basic concept of a HELOC resembles that of a credit card, there are a number of important differences between them. Borrowers should thoroughly understand these features before applying for a HELOC.
Underwriting Standards
HELOCs are subject to underwriting standards from lenders, which means that you will need to document your income and employment status as you would if you were refinancing your home mortgage.
When you apply for a credit card, you are asked to provide information about your income and employment, but you do not typically have to document it. Note that not all borrowers will qualify for a HELOC, and that qualifying for a credit card may be easier in general.
Collateral
As a HELOC is secured by your home's value; if you don’t repay it, you could end up in foreclosure.
A credit card, on the other hand, is a form of unsecured credit so you are significantly less likely to lose your home if you cannot repay what you borrow. With credit card default, even if your creditors sued you and you had to declare bankruptcy you might be able to keep your home.
Interest Rates
HELOCs, like most credit cards, have variable interest rates that change over time with rates in the economy. With a credit card, your interest rate is based on a benchmark interest rate, such as the prime rate or the London InterBank Offered Rate (LIBOR), plus a margin or mark-up that is based on your credit score, repayment history, and how much the lender needs to charge to potentially earn a profit.
HELOC interest rates are priced similarly. However, HELOCs often have significantly lower interest rates than credit cards due to the collateral giving the lender a cushion if you default. That being said, when interest rates increase, people who thought they were borrowing money cheaply could find themselves stuck with HELOCs whose interest rates are comparable to credit card rates.
There is also the possibility of getting a HELOC with a fixed-rate option. In this case, the loan will often have a variable interest rate during the initial draw period, and then converts to a fixed interest rate for the repayment period.
Interest Deductibility
Unlike credit card interest, HELOC interest can sometimes be tax-deductible, but only if the loan is “used to buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service (IRS).2 This provision was made law starting in 2018 by the Tax Cuts and Jobs Act (TCJA) of 2017, and it is currently slated to go away in 2026, when the previous situation of tax-deductible interest for any loan purpose is slated to be reinstated.
The TCJA also nearly doubled the standard deduction, making it less likely that most taxpayers will find it advantageous to itemize their deductions.3 Still, the tax-deductible interest option may make a HELOC additionally attractive in some cases.
High-Interest Debt Refinancing
If the interest rate on a HELOC is, say, 5.5% and the interest payments are tax-deductible—while the interest rate on your credit card debt is perhaps 29.9% and the interest payments are not tax-deductible—it is easy to see how a HELOC can save you a ton of money and help you get out of debt faster by consolidating your debt and using the HELOC proceeds to pay off your credit card balances. In effect, you will have swapped a high-interest loan for a low-interest loan.
However, some people will use a HELOC to pay off higher-interest debt, but then use their newly replenished credit card limits to accumulate even more high-interest debt. This is a practice known as “reloading,” and it often doesn’t end well. Indeed, remember, if you default on a HELOC you could lose your home, but going bust on a credit card often does not bring such consequences.
The Bottom Line
If you want to borrow against the equity in your home using a HELOC, make sure you understand how it works. In particular, you need to know when and by how much your interest rate might change before you borrow. Will you be able to afford the monthly payments if they go up later? How much of an increase can you stomach? Will the things you want to purchase with your HELOC money still be worth it at a higher interest rate and possibly with no tax deduction for the interest?
You should also think about how you plan to use the money and your past borrowing behavior to decide whether a HELOC is likely to help or hurt your finances in the long run. If you have a habit of abusing credit and do not really trust yourself to change your ways, you may be better off leaving your home equity intact and keeping your debt on your credit cards.
Finally, be vigilant and check your HELOC statement regularly. Identity theft is increasingly common, and there are unscrupulous people out there who will steal yours and use it to drain the funds from your HELOC while you’re not looking.