What Is a Home Equity Line of Credit (HELOC)? Here's How to Know if One Makes Sense For You.

When you buy a house using a mortgage, the amount of equity you own in your home initially depends on the size of your down payment. If you put 20 percent down on your home, for example, you own 20 percent of your home at the start of your loan.

Over time, the amount of equity you have in your home increases as you make your monthly payments and reduce your mortgage balance. At some point, you may consider using the equity in your home to help you accomplish other financial goals. For many people, that involves opening a home equity line of credit (HELOC).

But what exactly is a HELOC and how does it work? When does it make sense to tap into a HELOC and what are the pros and cons of doing so? Perhaps most importantly: When is a HELOC a bad idea? We’ll help you answer all of these questions to determine whether it might make sense for you.

What is a HELOC?

A home equity line of credit, or HELOC, is a line of credit that homeowners can use to access the equity they’ve built in their home and use it for other purposes. Because HELOCs are backed by your home, they typically carry lower interest rates than other forms of debt, which makes them very attractive to homeowners who are looking to put their equity to work.

How does a HELOC work?

When you are approved for a HELOC, you are given a set credit limit that you can borrow against, similar to revolving credit on a credit card. As you draw on your line of credit to make purchases, the balance on the HELOC goes up. As you repay the debt, your available credit is replenished and you are allowed to tap it again. Any balance you carry will accrue interest as set by your lender.

Because your HELOC is backed by the equity you have in your home, it’s known as secured debt. This collateral reduces the lender’s risk that you won’t repay your debt, which allows them to charge lower interest rates compared to many other types of credit. Unfortunately, it also means in a worst-case scenario, if you default on your HELOC, your lender could foreclose on your home and take it from you.

What is a draw period?

A draw period is a specified period when you can borrow money from your HELOC. During this period, you must make minimum monthly payments as set by your lender. These are often interest-only payments, but this can vary. When the draw period ends, you can no longer borrow against the HELOC, and you’re required to pay back your balance—often over a certain period of time (usually between five and 10 years) or all at once.

Who qualifies for a HELOC?

Lenders generally require borrowers to have a minimum credit score to qualify. The minimum score varies from lender to lender, but generally speaking, a higher credit score will translate into greater likelihood of approval as well as a more favorable interest rate.

Another factor a lender considers is a borrower’s debt-to-income (DTI) ratio: how much they owe in debt obligations (like credit cards and mortgage payments) divided by their total income (including anything from salary to income-producing assets).

How much can you borrow with a HELOC?

How much you can borrow through a HELOC will depend on how much equity you have in your home. Some lenders may let you borrow up to 85 percent of your home’s value or higher depending on your credit score and debt-to-income ratio. But typically, a lender will allow you to borrow up to 80 percent of your home’s appraised value less what you still owe on it.

So let’s say your house is worth $200,000 and you owe $70,000 on your mortgage. If you take 80 percent of your home’s value, or $160,000 and subtract the $70,000 you owe on it, you’d be left with $90,000—meaning you’d qualify for a line of credit of $90,000.

What is the average interest rate on a HEOC?

Just as interest rates on mortgages can fluctuate depending on the market, HELOC interest rates can also vary greatly. And as with a mortgage, the interest rate you’re eligible for will also depend on your credit score. In 2023, average HELOC rates sit somewhere around 9 percent, according to data from Bankrate.

When it might make sense to use a HELOC

Though a HELOC can be used for almost anything, there are some situations in which using a HELOC is particularly advantageous, such as:

When interest rates are low or declining

Most HELOCs have variable interest rates, which means that they fluctuate depending on the underlying federal funds rate. This makes HELOCs particularly beneficial during periods of low or declining rates. But low rates today don’t necessarily mean low rates throughout the life of the HELOC. It’s important to think about how rising interest rates might impact your ability to repay the debt. It’s a good idea to consider the maximum possible interest rate (which should be disclosed in your paperwork) before borrowing.

In the event of an emergency

An emergency fund that holds six months’ worth of expenses should be your first line of defense against an unexpected cost that can throw your budget out of whack. But if you’ve depleted your emergency savings and are considering using a credit card, a HELOC may be a better alternative because it’ll most likely charge a lower interest rate than a credit card. Just make sure you have a plan to pay off the debt.

If you’re using the money to make home improvements

Tapping a HELOC to improve your home in some way—like paying for a renovation or necessary repair—can be a smart way to utilize your home equity because these expenses have the potential to increase the value in your home.

As an added bonus, you may be able to write off all or a portion of the interest you pay toward your HELOC come tax season if you used the money to “buy, build or substantially” improve your home, according to the IRS. You’ll want to speak to a tax professional to confirm whether your home improvement project qualifies for a tax break.

When it might not make sense to use a HELOC

Here are some situations in which you’d probably want to avoid using a HELOC if possible:

When you’re trying to consolidate unsecured debts

Because HELOCs typically come with lower interest rates than credit cards, many people find it tempting to use a HELOC to consolidate the more expensive, unsecured forms of debt they’ve accumulated from credit cards or personal loans.

This can be risky. Paying off a large amount of unsecured debt using a HELOC means you are essentially putting up your home as collateral for that debt. If you’re unable to make your payments, you risk losing your home. If you’ve got good credit card habits and a plan for paying off debt, you may be in okay shape, but if you’re unsure about your ability to pay down debts, you may not want to go this route.

When you need to cover everyday expenses

If you are tempted to tap into your home equity to cover everyday expenses, think twice. If you’re having trouble making ends meet, the last thing you want is to put your home at risk by leveraging a HELOC to cover living costs. Instead, reevaluate your budget and find opportunities to cut costs or bring in additional income so that you don’t need to rely on debt for your basic expenses.

To fund a large expense or purchase not related to your home

Using a HELOC to make large purchases that you would not otherwise be able to afford—like a vacation, new car or educational expenses for your child—isn’t a great idea. These aren't increasing your wealth or the value of your home, so you’re ultimately risking your home to cover costs that you should be budgeting for instead. Often, there are other financing options, such as a car loan or student loans, that would be better suited for those types of purchases. If you have bigger financial goals you’re trying to meet, instead consider talking to a financial advisor to discuss how you can save for those goals without having to go into debt.

What are the pros and cons of a HELOC?

While your home equity can be a great way to access funds, it’s important to consider your complete financial picture before borrowing against your house.

What are some benefits of a HELOC?

Here are some of the potential benefits of using a HELOC:

Relatively low interest rates

Because the line of credit is secured with your home, HELOCs tend to offer lower interest rates than other similar types of loans.

Flexibility to spend

You can use your HELOC to pay for anything you want. There are no restrictions, and you don’t need approval from your lender.

Increased liquidity

Just because you get a $40,000 HELOC doesn’t mean to you need to use all $40,000 at the same time. You could decide to borrow $2,000 now and use the rest later. You’ll owe interest only on the amount that you actually borrow, not the limit you’re approved for.

Low payments

During your draw period, your payments are interest-only, meaning you only need to repay the interest on what you borrowed, though you can pay back some or all of your balance if you wish.

Added tax deductions

If you use your HELOC to pay for home improvements, the interest you pay on those improvements may be tax deductible and can help lower your overall tax bill.

Is there a downside to having a HELOC?

There are some potential drawbacks of HELOCs you want to be aware of, like:

Upfront fees

Before you’re approved for a HELOC, you’ll often need to pay a number of fees upfront, just like with a mortgage. These can include an origination fee, appraisal fee, title search fee, notary fee and more. As a rule of thumb, HELOC closing costs usually fall between two and five percent of the loan amount. If you only need a small line of credit, these fees may not be worth it.

Variable interest rates

HELOCs typically carry variable interest rates, which means that, just like the interest rate on your credit card, your HELOC’s rate could go up (or down) in the future.

Risk to your home

Your HELOC is backed by your home, so if you can’t repay your loan, your lender could force a foreclosure on your house.

Sensitivity to fluctuations in the real estate market

If the value of your home decreases after your HELOC has been approved, you could see your credit limit decrease or even freeze altogether.

Is a HELOC right for you?

Under the right circumstances, a home equity line of credit can be a powerful tool offering affordable liquidity that you can use to reach various financial goals. But, a HELOC doesn’t come without risks and it isn’t right for every situation.

If you’re not sure whether a HELOC belongs in your financial plan, a Northwestern Mutual financial advisor can help you look at your entire financial picture and show you how the individual pieces—like tapping into your home’s equity—can fit with the rest of your financial plan.

This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.