A home equity line of credit (HELOC) is a type of second mortgage that provides a line of credit that is secured using your home for collateral. Unlike a personal loan, a HELOC functions more like a credit card, providing access to funds as you need them rather than you receiving the full amount in a lump sum.
Many borrowers use a HELOC to make expensive repairs and home improvements that would be cost-prohibitive otherwise.
Let’s take a closer look at how home equity lines of credit work, the pros and cons of using a HELOC, and what to expect during the application process.
How a Home Equity Line of Credit Works
A HELOC provides revolving credit that allows you to borrow money against a percentage of the available equity in your home. Like a credit card, when you pay down the balance on the line of credit, your available credit increases, so you can borrow as much or as little money as you need up to your credit limit.
You can use the funds from your HELOC for a defined period of time, known as the draw period. After this time, you enter the repayment period, during which you can’t borrow any more money and must repay the loan at a variable interest rate. Typically, the draw period lasts 10 years, and the repayment period lasts 20 years.
During the draw period, you will be required to make minimum monthly payments. These payments often only cover the interest, so you may want to make additional payments toward the principal to avoid a high monthly bill during the repayment period.
Pros and Cons of a Home Equity Line of Credit
Defaulting on any type of loan can devastate your credit and finances, but with a HELOC, your home is also at stake. If you are considering applying for a HELOC, understanding the benefits and drawbacks of this type of loan can help you decide if it’s the right choice for you.
Pros
You can use the money for anything (but that doesn’t mean you should).
Unlike other types of loans, there are no restrictions on how you use your home equity line of credit. However, it’s important to remember that you must repay the money, and you are borrowing against your home’s equity.
To minimize the risks and maximize the benefits of the loan, most borrowers use their HELOC to pay for things that have long-term value and don’t depreciate, such as repairs or renovations that increase the value of their homes.
You get access to cash without the commitment of a lump sum loan.
Most people don’t have tens of thousands of dollars in savings, and if they do, they probably don’t want to spend it all on a new kitchen. A HELOC is a great way to access a large amount of money without wiping out your savings.
With a HELOC, you can spend as much or as little of your approved limit as you need. This means you only pay interest on the money you spend rather than being responsible for paying off a large loan balance.
The interest may be tax-deductible.
If you use your HELOC to pay for repairs or improvements to your home, you can deduct the interest you pay on those funds at tax time. According to the IRS, the interest is deductible only if the funds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan.”
Cons
Your home is used as collateral.
Borrowing money with your house as collateral is risky. If you are unable to repay the loan, you could go into foreclosure and eventually lose your home.
There are significant up-front costs.
During the application process, your lender may charge an application fee, an annual fee, or an early closure fee. These fees are in addition to the appraisal, title search, and attorney fees you will be required to pay at closing.
Rates and payments can fluctuate.
HELOC interest rates are variable and fluctuate with the market. This can make it difficult to budget for your monthly payment because your billing amount may change and can increase significantly over time.
You’re borrowing against the equity in your home.
If you don’t plan to stay in your house for very long, a home equity line of credit may not be the best option. Every dollar you spend with your line of credit is subtracted from your home’s equity, which will reduce your cash on hand when you sell the house.
How a HELOC Compares to Other Types of Credit and Loans
A HELOC isn’t the only credit option for homeowners who want to make home improvements. Here are three types of loans often used for renovations, repairs, and other home-related expenses and how they compare with a HELOC:
1. Home equity loan
A home equity loan is a lump sum payment to the borrower with a fixed interest rate for the life of the loan. Like a HELOC, a home equity loan is considered a second mortgage, so you will make monthly payments on the loan as well as your regular mortgage.
2. Home improvement loan
A home improvement loan is an unsecured personal loan. Normally, the loan amounts are less than those of home equity loans, and interest rates are higher. Home improvement loans are a good option for smaller, less expensive projects, but for more extensive renovations, a HELOC or home equity loan will have better terms and rates.
3. Cash-out refinance
A cash-out refinance loan replaces your original mortgage with a new mortgage for more than you owe on the house. The difference between the amount owed and the new mortgage is the amount that can be cashed out and used for home improvements. A cash-out refinance loan often has a lower interest rate than a HELOC or a home equity loan; however, the closing costs are generally higher.
Applying for a HELOC
Equity
Before you apply for a HELOC, you need to have an idea of your home’s value and whether you have enough equity to qualify. Most lenders require 15-20 percent equity and will let you borrow up to 85 percent of the value of your home minus the amount you owe.
A HELOC calculator will help you quickly determine the amount of equity in your home and provide an estimate of how much you may be able to borrow.
Qualifications
The qualifications for a home equity line of credit are similar to those needed to refinance a home. Lenders will review your credit score, credit history, employment history, monthly income, and monthly debts. Most lenders require a credit score greater than 700 and a low debt-to-income ratio to qualify.
Interest rates and fees
Because a HELOC is technically a second mortgage, the interest rate will be higher than the rate for your first mortgage. However, interest rates and fees can vary considerably between lenders. Be sure to shop around for the best deal.
Home Equity Is a Valuable Tool for Homeowners
Every loan comes with some level of risk, but when used responsibly, a home equity line of credit can help homeowners achieve goals that otherwise would be financially out of reach.
But a HELOC is just one of the ways you can convert your home’s equity into cash that you can use for other high-value expenses. Download The Smart Homeowner’s Guide to Refinancing to learn more ways to use equity to reach your financial goals.
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