Is a HELOC a good idea?
A HELOC can be a good idea if you have ongoing expenses you want to finance at a low interest rate, such as home renovations, college tuition, or even an investment property. Home equity lines of credit (HELOCs) allow homeowners to tap their home’s equity when they need cash quickly for something important.
Unlike a cash-out refinance or a home equity loan, which pay a lump sum, a HELOC lets you borrow from a credit line over time as needed. During the first few years, you pay interest only on what you borrow. Better yet, a HELOC lets you leverage the value of your home without refinancing.
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Current HELOC rates
As you might suspect, home equity line of credit rates vary widely by lender and product type. Just like mortgage rates on a traditional mortgage, your HELOC rate will also depend on factors such as your credit score, debt levels, and the amount you request to borrow.
To ensure you don’t miss out on the best HELOC rates, compare quotes from various lenders when shopping around. Look for the lowest rate and the best combination of interest rate and upfront fees.
How do HELOCs work?
A HELOC is a revolving line of credit that can borrow against and repay as needed, much like a credit card. It’s a type of loan that allows you to borrow money against the equity in your home.
Here’s how a HELOC works:
- You apply for a HELOC. You’ll need to fill out an application with a lender and provide information about your income, credit score, and the value of your home
- Your lender determines your credit limit. Your lender will review your application and determine how much you can borrow based on your credit score, income, and the equity in your home
- You access funds as needed. Once you’re approved, you can access funds from your HELOC as needed, up to your credit limit. You can withdraw funds using a check, credit card, or electronic transfer
- You pay interest on the amount you borrow. You’ll only pay interest on the amount you borrow from your HELOC, not the entire credit limit. The interest rate may be variable or fixed, and may be based on the prime rate or another benchmark rate
- You make monthly payments. You’ll need to make monthly payments on your HELOC, including principal and interest. The length of the repayment period may vary, but is typically between 10 and 20 years
- You can use the funds for any purpose. Unlike a traditional mortgage, you can use the funds from your HELOC for any purpose, such as home improvements, debt consolidation, or to pay for education expenses
It’s important to note that a HELOC is secured by your home, so if you’re unable to make payments on the loan, your lender may foreclose on your property. Additionally, taking out a HELOC can be risky if you’re unable to make payments or if the value of your home decreases, as you could end up owing more than your home is worth.
How HELOC repayment works
A HELOC has two phases:
- The draw period: Often lasts for 10 years, during which you are allowed to borrow from the credit line at any time up to your credit limit. During the draw phase, you are only obligated to make interest payments on the money borrowed. If you borrow no money, you typically owe nothing.
- The repayment period: Next comes the “repayment” period, a 10- to 20-year phase during which you’ll need to repay your loan balance owed. You are not permitted to borrow additional funds during this time unless the lender approves the renewal of your HELOC
Note that some HELOCs require you to repay the entire balance in full as soon as the repayment period begins. Some borrowers can convert their HELOC to a fully amortizing fixed-rate second mortgage during the loan’s term if their lender allows it. Ask your lender about its repayment structure before signing on.
HELOC pros and cons
As with any type of financing, a HELOC has both benefits and drawbacks. It’s important to understand how a HELOC can help you and the potential risks, before obtaining this type of loan.
|HELOC Pros||HELOC Cons|
|Borrow up to 85% of home value*||HELOC rates are higher than mortgage rates|
|Money can be used for any purpose||Charges closing costs|
|Offers a flexible credit line for ongoing expenses||Possibility of overspending|
|Tax-deductible in some cases|
Lower interest rates than credit cards
|Your home is used as collateral|
Variable interest rates
*Maximum loan amounts vary by lender and depend on borrower eligibility.
Pros of a HELOC
Most lenders that offer home equity lines of credit will allow you to borrow up to 85% of your home’s appraised value. In other words, you can enjoy a fairly high borrowing limit if you qualify.
So long as you’ve accrued enough equity in your home (more than 15% to 20%) and have good credit, you will likely be eligible for a HELOC, too. Here are some of the notable benefits of a HELOC.
1. Low interest rates
HELOCs generally offer lower interest rates than home equity loans, personal loans, and credit cards. Getting a lower HELOC rate can save you thousands of dollars over the life of your loan.
2. Flexible financing
One of the biggest advantages of a HELOC is that you can use the funds for virtually any purpose. A HELOC can be useful to finance home improvements, cover medical costs, debt consolidation, or any other expense inline with your personal financial situation.
“HELOCs are arguably more flexible than a traditional cash-out refinance of your home loan... you can access a line of credit as needed, as opposed to having cash from a refi sitting in a savings account.”—David Friedman, CEO, Knox Financial
“HELOCs are arguably more flexible than a traditional cash-out refinance of your home loan. Once approved for a HELOC, you can access a line of credit as needed, as opposed to having cash from a refi sitting in a savings account,” notes David Friedman, CEO of investment property platform Knox Financial. “With a cash-out refi, you are committed to paying the new principal and interest balance for the duration of the home loan — likely 15 to 30 years.”
3. Borrow only what you need
Another HELOC benefit is the ability to only borrow money that you need. You can borrow as much as you like during the draw period, pay down the loan balance, and then borrow again. In this way, HELOCs are similar to credit cards. Cash-out refinancing, personal loans, and home equity loans all require you to borrow one lump sum of money.
“Your available credit is restored whenever you pay down your outstanding HELOC balance,” explains Dino DiNenna, broker/Realtor with Southern Lifestyle Properties in South Carolina. “This implies that you can borrow against your HELOC again and again if necessary and that you can borrow up to the credit limit you set at closing for the duration of your draw period.”
Note, that some HELOCs impose an early payoff fee if you pay off the balance before a certain amount of time has passed. Ask your lender about its prepayment policies before taking the loan out.
4. Interest may be tax deductible
You might also be eligible for a tax break if you utilize a HELOC to buy or renovate a home.
“Any interest paid on a HELOC or home equity loan that is used to purchase, construct, or enhance the property that serves as security for the loan is tax-deductible,” says Sep Niakan, managing broker for CondoBlackBook.com.
Cons of a HELOC
Although HELOCs allow you to tap your home’s equity, there are considerable disadvantages to this type of loan. It’s important to understand a HELOC’s risks before choosing one.
1. Your home is collateral
Perhaps the biggest drawback to a HELOC is that you must use your home as collateral. That means you could lose your home to foreclosure if you cannot repay your HELOC per the agreed-upon terms.
2. Variable interest rates
While home equity loans offer fixed interest rates that will not change, HELOC rates are variable. This means that the rates rise and fall with the broader rate market. So even though your HELOC had a lower interest rate when you first took out the loan, the rates will increase (or decrease) over time.
Additionally, HELOC interest rates can be higher than rates for a traditional mortgage loan — including a cash-out refinance. At the time of this writing in March 2023, the average interest rate charged for a HELOC was around 7.8% compared to around 6.7% for a cash-out refinance.
3. Risk of overspending
Some homeowners risk overspending with a HELOC, especially if they’re awarded a generous credit limit.
“A borrower’s lack of discipline is frequently a drawback of HELOCs,” cautions Shad Elia, CEO/founder of New England Home Buyers in Massachusetts.
“It’s simple to access cash quickly without thinking about the possible financial consequences because HELOCs allow you to make interest-only payments during the draw period.”–Shad Elia, CEO/founder, New England Home Buyers
Elia continues, “Remember that the loan eventually starts to amortize, and the payments dramatically increase if you do not refill this line of credit by paying it off. The increase in monthly payments at the end of the draw period may be an unpleasant surprise if you aren’t prepared for it.”
4. Closing costs
Lastly, consider that you may pay closing costs on a HELOC ranging from 2% to 5% of the line of credit. Although some lenders are willing to waive closing costs.
When is a HELOC a good idea?
A HELOC is a good idea when you’re making home renovations that will increase the market value of your home.
A HELOC provides an affordable credit line to finance ongoing expenses, with much lower rates than other forms of borrowing like credit cards and personal loans. In addition, you’re allowed to use the funds for any purpose, such as student loans, credit card debt, or real estate investments. But the best use of a HELOC is to increase your home’s value.
However, remember that if you get in over your head by overborrowing, you risk losing your home. HELOCs are secured by the property and failure to make payments can lead to foreclosure. By contrast, personal loans and credit cards have higher interest rates but are not tied to your home. They are less risky in the event of a default.
HELOC requirements can vary depending on the lender, so it’s a good idea to shop around and compare offers from different lenders before making a decision.
Here are some common HELOC requirements.
- Sufficient equity in your home: To qualify for a HELOC, you need to have enough equity in your home. Typically, lenders require you to have at least 15-20% equity in your home, although some may require more
- Good credit score: Lenders want to see that you have a good credit score, typically above 620. A higher credit score may help you qualify for a better interest rate
- Steady income: You need to show that you have a steady source of income to repay the HELOC. Lenders may look at your employment history, income level, and other sources of income, such as investments or rental properties
- Debt-to-income ratio: Your debt-to-income ratio, which is the amount of debt you have compared to your income, may be considered by lenders when evaluating your application. A lower debt-to-income ratio may improve your chances of getting approved for a HELOC
- Appraisal and title search: Lenders may require an appraisal of your home to determine its value, and a title search to ensure that there are no liens or other issues with the title
- Ability to make payments: Lenders will want to see that you can make the monthly payments on the HELOC, so they may ask for documentation of your expenses and income
- Homeowner's insurance: You may need to show proof of homeowner’s insurance to protect your property in case of damage or other losses
Alternatives to a HELOC
Home equity lines of credit can be useful for the right type of borrower. But many homeowners may want to consider other financing solutions.
- Home equity loan: A home equity loan helps you leverage the equity in your home. The loan amount is issued in a lump sum and repaid in monthly installments. Both the interest rate and monthly payments are fixed. But your home is used as collateral to secure the loan
- Cash-out refinance: A cash-out refinance replaces your existing mortgage with a new, larger loan. You receive the cash difference between the new loan balance and your old mortgage balance as a lump sum. However, your entire mortgage is reset
- Personal loan: This is an unsecured loan from a bank, credit union or online lender that you pay back in fixed monthly payments. Because your home is not used as collateral for the loan, you will pay a higher interest rate
Regardless of the loan option you choose, be sure to compare rates and costs with several lenders to ensure you’re getting the best deal.
Using a HELOC as a down payment on a second property is risky, but allowed. Not only will you have two mortgage payments, but you’ll also have to repay the HELOC at the same time. However, if you have the cash flow, then a HELOC can be a down payment option for a second home or real estate investment.
Homeowners must qualify for a HELOC based on sufficient income, job security, good credit, and a positive financial history. You must have built up more than 15-20 percent equity in your home to have enough to fund a HELOC. If you don’t have that much home equity yet, then you may not be eligible for a HELOC. This is often the case with first-time buyers and recent purchasers.
You are not required to draw funds from a HELOC during the draw period. However, your lender may charge you an inactivity fee if you incur no transactions over a particular period. Most lenders will allow a HELOC to remain open indefinitely if it has not been used. Still, some lenders may have a clause requiring some activity to prevent the HELOC from being closed.
In a market crash, your HELOC would remain open with the funds available unless there is language in your agreement that says otherwise.
A HELOC cannot trigger PMI (private mortgage insurance), which is assessed only on your primary mortgage if your lender or loan program requires it. Even if your HELOC is the only loan you currently have against your home and you have a loan-to-value balance over 80 percent, it will not require PMI. Note that you cannot use the funds from a HELOC to pay off your primary first mortgage in order to get rid of PMI.
Yes. You can pay off the principal owed on a HELOC at any time during the draw period, either partially or in full. Although, some lenders may impose an early payoff fee if you start paying off the balance before a certain amount of time has passed. During the draw period, you must at least make interest payments on anything you borrow. Once you enter the HELOC’s repayment period, you will be required to pay off your balance in full immediately or over time.
If you have a HELOC open, you can sell your home and use the sale proceeds to pay off the HELOC balance at closing.
You may already qualify for a HELOC
Many homeowners have built equity quickly due to rising home prices. If this is your situation, then you may easily qualify for a HELOC. Get a few quotes from different lenders. They’ll each review your personal finances and determine how much money you can borrow. You can get started with the link below.