Home equity is a valuable resource. As it grows, you can capitalize on it by selling it to turn a sizable profit. Or, if you’re not planning to move soon, you can convert a portion of it into cash. A home equity line of credit (HELOC) is one way to leverage your home equity, and this guide explores the pros and cons of this product.
It also examines scenarios in which taking out a HELOC is a good idea or when it makes more sense to hold off and explore alternatives.
Introduction to HELOCs
Here’s an overview of HELOCs and what to expect should you take out one.
What Is a HELOC?
A home equity line of credit (HELOC) is a revolving line of credit that operates like a credit card. It acts as a second mortgage and uses your home as collateral to secure the line.
Most lenders cap HELOCs at 85% of your home equity. So, if your home is worth $275,000 and you owe $150,000 on your mortgage, you could potentially get a HELOC of up to $83,750 ($275,000 * .85 – $150,000).
How Does a HELOC Work?
If you’re approved for a HELOC, you get access to a pool of cash to withdraw from as needed during the draw period. The latter usually spans 5 to 10 years, and you make interest-only payments during this time frame. You can borrow, repay and borrow again as the line replenishes.
When the draw period ends, the principal balance becomes repayable over a period of up to 20 years. The monthly payments also increase as they are adjusted to include both principal and interest.
It’s worth noting that HELOCs usually have variable interest rates. Thus, the monthly payment amounts and borrowing costs will fluctuate with market conditions over time.
Common Uses for HELOCs
There are no spending restrictions on the funds you pull from a HELOC. That said, homeowners commonly use the loan proceeds for these purposes:
- Home improvement: Many homeowners use a HELOC to finance home improvement projects. Whether it’s a kitchen remodel or a new roof, using your home’s equity can be a smart way to cover these costs.
- Debt consolidation: You can use a HELOC to consolidate high-interest debts like credit cards. Doing so can help you save money on interest and simplify your monthly payments.
- Big-ticket purchases: If you’re planning a major purchase like a wedding or family vacation, a HELOC can help you cover these large-scale events.
- Higher education expenses: Funding education isn’t cheap. A HELOC can provide the money you need for tuition, books and other school-related expenses.
- Investment properties: Some use a HELOC to invest in additional property or real estate, which can grow their investment portfolio.
- Emergency funds: Unexpected expenses like medical bills or car repairs can strain your finances. A HELOC can serve as a backup to cover these costs.
- New business ventures: If you’re starting a business, you can use your HELOC to cover initial startup costs. This can provide the lump sum needed for equipment, supplies or office space.
Pros of Using a HELOC
HELOCs come with a host of key benefits that make them worth considering.
Flexible Access to Funds
HELOCs provide access to cash whenever you need it. You can also control borrowing costs, as you’ll only pay interest on the amount of cash you withdraw.
Lower Interest Rates Compared to Other Loans
Since your home is used to secure a HELOC, lenders have recourse if you default on the loan payments and can extend lower interest rates to you. However, more traditional unsecured loan products don’t come with this level of protection for lenders, and you could pay more to access funding.
Possible Tax Benefits
You could be eligible for a tax deduction on the interest paid on a HELOC. If you use the loan proceeds to make home improvements that substantially boost your home’s value, this perk may be available to you. Consult with a tax professional to learn more about the specifics of this benefit.
Use for Home Improvement and Increasing Home Value
Home renovations can make your home more visually appealing and livable. The right upgrades can also improve your home’s value and help you turn a bigger profit when it’s time to sell. Home improvement projects aren’t cheap, though, so you can use a HELOC to cover the costs.
Cons of Using a HELOC
As with any home equity product, there are also drawbacks to keep in mind.
Risk of Losing Your Home
As previously mentioned, lenders use your home as collateral to secure HELOCs. This puts you at risk of foreclosure if you encounter financial hardship and can’t afford to make the loan payments.
Variable Interest Rates
The variable interest rate on HELOCs makes it challenging to budget for monthly loan payments and compute borrowing costs. The fluctuating rates could also mean steeper loan payments over time that stretch your budget thin.
Potential for Over-Borrowing
It can be tempting to borrow far more than you need, especially if you’re approved for a rather large HELOC. Unfortunately, pulling out a hefty sum of funds could lead to financial stress from unaffordable payments and hefty borrowing costs.
Impact on Credit Score
When you apply for a HELOC, the lender will conduct a hard credit check that could temporarily dip your credit score by a few points. The way you manage your HELOC also impacts your credit score. Your credit utilization rate accounts for 30% of your credit score, so maxing out your HELOC or drawing large amounts close to the limit could ding your score.
Financial Considerations in Getting a HELOC
Below are some additional factors to consider before applying for a HELOC.
Comparing HELOCs to Other Financing Options
HELOCs are an attractive option because they afford borrowers the luxury of withdrawing funds as needed and only paying interest on the funds they pull. They also typically come with much lower interest rates than credit cards.
That said, you need a reasonable amount of home equity and a good or excellent credit score to qualify for a HELOC with competitive terms. However, a traditional loan or credit card product may be accessible without collateral and with less-than-perfect credit.
Understanding Fees and Costs Associated with HELOCs
HELOCs aren’t free—you’ll typically pay closing costs between 2% and 5% to cover the loan’s processing. Some lenders also charge administrative fees and maintenance fees over the life of the loan. Interest costs should also be considered when deciding if a HELOC is right for you.
The Long-Term Financial Impact
Before getting a HELOC, consider how it will affect your finances in the long run. Variable interest rates can lead to higher payments if rates rise, which means you need a plan to cover increasing monthly HELOC payments.
It’s equally important to understand the repayment structure. During the draw period, most lenders require interest-only payments. But when this period ends, you’ll start repaying the principal amount, too, and monthly payments will significantly increase if a hefty principal balance remains.
Furthermore, missing payments on your HELOC can put your home at risk since it’s secured by your property’s equity. So, you want to assess whether you can sustain the potential financial burden of an added monthly payment during the life of the HELOC to protect your home from foreclosure.
When a HELOC Might Be a Good Idea
A HELOC could be a smart financial move in these scenarios:
For Those with Significant Home Equity
If you have built up substantial equity in your home, a HELOC can provide convenient access to funds at a relatively low interest rate. Doing so also means you can tap into your home’s value without selling it.
When Financing Large Home Improvement Projects
A HELOC is often used for large home improvements, such as kitchen remodels or adding a new room. These projects can increase the value of your home over time and help you turn a greater profit if you decide to sell.
As a Tool for Debt Consolidation
HELOCs can be a smart choice for consolidating high-interest debt, such as credit card balances. By paying off those debts with a HELOC, you could lower your overall interest rate and streamline the debt-management process by combining several monthly debt payments into one.
When a HELOC Might Not Be a Good Idea
You may want to look beyond HELOCs if any of these situations apply to you:
In Times of Financial Uncertainty
Taking out a HELOC during financial uncertainty can be risky. If your income is unstable or you’re facing job loss, it might be challenging to make regular payments. Again, falling behind on payments can lead to hefty penalties and possibly losing your home.
For Those with Irregular Income
If your income fluctuates greatly, a HELOC may not be suitable. An irregular income can make it hard to predict if you’ll have enough money to cover the payments each month. Missing even one payment can damage your credit score and negatively affect your ability to obtain other debt products in the future.
If Planning to Sell Your Home Soon
A HELOC is not ideal if you plan to sell your home in the near future. You’ll be required to pay back the full amount borrowed, which could complicate the sale process.
