Home Equity Line of Credit (HELOC): Meaning, and Examples

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit (HELOC) is a line of credit that uses the equity you have in your home as collateral. The amount of credit available to you is dependent on the equity in your home, your credit score, and your debt-to-income (DTI) ratio. Because HELOCs are secured by an asset, they tend to have higher credit limits and much better interest rates than credit cards or personal loans. While HELOCs usually have variable interest rates, there are some fixed-rate options available.

How a Home Equity Line of Credit (HELOC) Works

Home equity lines of credit (HELOCs) are based on the amount of equity you have in your home. To calculate the equity you have in your home, you would take the estimated value of your home less the total balance of any existing mortgages, HELOCs, home equity loans, etc., to get your equity.

Most well-qualified borrowers are able to take out up to 80% of the equity they have in their home. For example, someone with a good credit score and DTI ratio with a home valued at $300,000 with a loan balance of $100,000 could get approved for a HELOC up to $170,000 ($300,000 - $100,000 = $200,000 x 0.85% = $170,000).

HELOC rates vary but are generally significantly lower than the interest rates for credit cards or personal loans but slightly higher than the rates on a mortgage. HELOC rates are usually variable, which means that they can fluctuate with the market. HELOCs tend to have very low or no origination fees and are relatively simple to get, which makes them a more attractive option than a refinance or cash-out refinance for many borrowers.

The terms of every HELOC vary but they most commonly have a draw period of 10 years and a repayment period of around 15 years. During the draw period, borrowers have the option to use up to their credit line limit on their HELOC and make minimal interest-only payments. Once the draw period is up, borrowers have to make substantially bigger payments to pay back the balance owed on the credit line they used during the draw period.

Debt Reloading Risk

HELOCs come with a high risk of debt reloading specifically because they are easy to obtain and because of their draw and repayment periods. Over the last decades as home values have continued to rise substantially, borrowers have found themselves with ever-increasing equity in their homes and access to cheap credit through their HELOCs.

Many borrowers get used to the low interest-only payments on their HELOC during the draw period and aren't prepared to pay back their HELOC during the repayment period, so they take out another HELOC or home equity loan to pay off the first one. They may then continue this cycle as long as their home's value continues to rise. During the financial crisis when home values plummeted, many borrowers who used this method found their homes in foreclosure.

An Example of HELOC Debt Reloading

There is no real limit to how many HELOCs a borrower can take out as long as they continue to have decent credit and increased equity in their home. The downside is that continuing to take out HELOCs could lead them to spiral into substantial debt if they aren't careful.

Let's say a borrower in 2010 had a mortgage balance of $100,000 on a $200,000 home. That would enable them to take out a HELOC for up to $85,000. In this example, they take out this maximum amount. In 2012, they had the mortgage and HELOC No. 1—given some payments on the mortgage, the outstanding balance is now $150,000—but their house is now worth $300,000, allowing them to take out another HELOC for up to $112,500. That brings their balance to $262,500.

Eight years later, the combination of the two HELOCs plus their mortgage gives them a balance of $250,000, and the house is now valued at $600,000. This means they can take out yet another HELOC for up to $297,500. The homeowner is now in the repayment period for that first HELOC, and in two years, the repayment period for the second HELOC will begin.

The major risk for this borrower would be using that third HELOC not to pay off the first two but to make minimal payments on all three while spending the rest frivolously. In 2022, their second HELOC will go into the repayment period. If their home value hasn't increased at all, then they cannot open another HELOC to help cover the increased payments, they will be used to a substantially inflated lifestyle, and they will be in debt for more than $500,000 for a house they owed $100,000 on just 12 years earlier.

The Bottom Line

HELOCs, when used conscientiously, can be an excellent tool for borrowers to consolidate high-interest debt at a lower rate, make substantial improvements to their home, invest in real estate, and so on. However, they come with significant risks, and borrowers should be aware of those issues before signing up for a product that erodes their ability to build wealth through the equity in their home.