How a Home Equity Loan and a HELOC Actually Work
Both products tap your home equity, but the mechanics are fundamentally different. Understanding the mechanics -- not just the rate -- is what lets you compare them honestly.
Home Equity Loan Mechanics
A home equity loan is a second mortgage. You apply, get approved, sign closing documents, and receive a lump sum wired to your bank account (or paid directly to a contractor or title company). The rate is fixed at closing for the life of the loan.
Origination Flow
Application: submit income documentation, tax returns (last 2 years), and property information. The lender runs a hard credit inquiry (expect a 5-10 point temporary dip). They order an appraisal ($400-700 for a full appraisal; some digital lenders use an automated valuation model (AVM) at $150-300). After underwriting review -- typically 2-4 weeks -- you sign closing documents, often with a notary. Closing costs of 2-5% of the loan amount apply. Funds are disbursed 3 business days after closing (federal right of rescission for primary residences).
Rate and Payment Structure
The interest rate is fixed at closing. Whether prime rises 2% over the next decade or falls back to 3%, your rate does not change. Monthly payments are principal plus interest, fixed for the term. Typical terms: 5, 10, 15, 20, or occasionally 30 years. Shorter terms mean a lower rate but higher monthly payment; longer terms spread payments out but accumulate more total interest.
Worked Example
$50,000 HEL at 7.37% over 15 years. Monthly payment: $459/mo. Total interest over life of loan: $32,620. Total repaid: $82,620. The payment is the same on month 1 and month 180.
Prepayment and Annual Reporting
Most HEL lenders allow prepayment without penalty. A minority -- typically regional credit unions and some community banks -- charge a prepayment penalty of 1-3% if you pay off within the first 24-36 months. Ask explicitly before signing. Your lender will send an annual Form 1098 showing interest paid in Box 1; this is your documentation if you are claiming the deduction on Schedule A.
HELOC Mechanics
A HELOC (Home Equity Line of Credit) is a revolving second mortgage. Like a credit card with your home as collateral: you are approved for a maximum credit limit, and you draw what you need, when you need it, during the draw period.
Rate Calculation: Prime Plus Margin
HELOC rate = prime rate + your margin. The margin is set at origination based on your credit profile, LTV, and the lender's pricing. As of April 17 2026, prime is 6.75% (lowered from 7.00% on December 10, 2025, following the Federal Reserve's December 2025 rate cut). The fed funds target range is 3.50-3.75%; prime historically equals fed funds upper bound plus approximately 3%.
Rate Chain
Fed funds upper: 3.75%
+ spread: +3.00%
= Prime: 6.75%
+ your margin: +0.50%
= Your HELOC rate: 7.25%
If the Fed cuts 25bp, your rate drops 25bp the next billing cycle. If prime rises to 8.00%, your rate rises proportionally.
Rate Floor and Lifetime Cap
Many HELOCs include a rate floor -- typically 3.99-4.99% or the starting rate -- meaning your rate cannot drop below this level even if prime falls further. The lifetime cap is typically 18% APR by state law. These are buried in your Truth in Lending disclosures; ask your lender to confirm the floor before signing.
Draw Period
Typically 5-10 years (10 most common). During the draw period, your minimum required payment is interest-only on the drawn balance. You can also pay principal, which reduces the balance and future interest. You can draw, repay, and re-draw up to your credit limit, similar to a credit card. Some lenders charge a draw fee ($0-50 per transaction) or an annual fee ($0-99) even on undrawn balances.
Draw Period Example
$50,000 HELOC, $30,000 drawn, rate 8.50%. Interest-only minimum: $30,000 x 8.50% / 12 = $212.50/mo. If you draw the full $50,000: $354.17/mo.
Repayment Period: The Payment Jump
When the draw period ends, the line closes and the outstanding balance converts to a fully amortising loan. Repayment periods are typically 10-20 years. The monthly payment jumps significantly because you are now paying principal and interest on the full outstanding balance. This is payment shock. See the detailed modelling on our risks page.
Payment Shock Example
$50,000 HELOC, fully drawn, 8.50% rate.
During 10-year draw (interest-only): $354/mo
15-year repayment begins: $492/mo (+39%)
If rate rises to 10.00% at repayment: $537/mo (+52%)
Fixed-Rate Conversion Option
Some lenders (Third Federal, Citizens, Bank of America) allow you to lock a portion of your HELOC balance at a fixed rate, converting it to a HEL-like payment mid-flight. This is a useful hedge if rates rise during your draw period. Typically you can have 1-3 fixed-rate sub-accounts at a time.
Second-Home and Investment-Property Rules
Both HEL and HELOC products are available on second homes and (with fewer lenders) investment properties, but expect tighter underwriting and higher rates.
| Property Type | LTV Cap | Rate Premium | Lender Availability |
|---|---|---|---|
| Primary residence | 85% CLTV | Base rate | All major lenders |
| Second/vacation home | 70-80% CLTV | +25-100bp | Most major lenders |
| Investment property | 65-75% CLTV | +100-300bp | Fewer lenders; specialist required |
For investment property, check lenders like SoFi, PenFed, or local portfolio lenders. Most national banks will not write a HELOC on a non-owner-occupied property.