Is a HELOC a good idea?
If you own a home and need funds for something important — such as a renovation project, college tuition, or an investment property — you can tap into your home’s equity and get funding quickly with a home equity line of credit (HELOC).
A HELOC can be a great idea if you have ongoing expenses you want to finance at a low rate. You can borrow from the credit line over time as needed, and during the first few years, you pay interest only on what you borrow.
Perhaps best of all — at least in the current rate environment — is that a HELOC lets you tap equity without refinancing your mortgage.
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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, as well as the potential risks, before signing on.
|HELOC Pros||HELOC Cons|
|Borrow up to 85% of home value*||HELOC rates 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||Your home is used as collateral|
*Maximum loan amounts vary by lender and depend on borrower eligibility
One of the biggest advantages of a HELOC is that you can use the funds for virtually any purpose — from paying for home improvements, covering medical costs, or consolidating debt to financing a wedding or launching a business.
“In addition, most lenders that offer HELOCs will allow you to borrow up to 85% of your home’s appraised value,” says Eric Jeanette, owner of Dream Home Financing. In other words, you can enjoy a pretty 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.
“HELOCs are arguably more flexible than a traditional cash-out refinance of your mortgage... 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 mortgage. 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 mortgage — likely 15 to 30 years.”
Also, similar to a credit card, “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, however, that some HELOCs impose an early payoff fee if you start paying off the balance before a certain amount of time has passed. Ask your lender about its prepayment policies before taking the loan out.
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.
On the downside, you must use your home as collateral for a HELOC. That means you could lose your home to foreclosure if you cannot repay your HELOC per the agreed-upon terms.
In addition, 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.”
“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.”
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 (August 2022), the average interest rate charged for a 10-year HELOC was around 5.5% compared to around 7.25% for a 20-year HELOC. Although HELOC rates are variable and will also depend on the amount you borrow and your loan’s terms.
Lastly, consider that you may pay closing costs on a HELOC ranging from 2% to 5% of the line of credit, although some lenders waive the closing costs.
Who should get a HELOC?
Applying and being approved for a HELOC can be a smart move. 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. And even if you don’t have an immediate financial need, a HELOC can serve as a safety net.
“Pursuing a HELOC simply to have as a safety net to access funds [is] a good idea,” recommends Jeanette. “But it should never be used like a credit card to pay for frivolous items. At a minimum, you can use it to pay down higher interest consumer debt as a smart way to save thousands per year in interest payments.”
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 and are less risky in the event of a default.
How HELOCs work
A HELOC is a revolving line of credit that you can borrow against and repay as needed, much like a credit card. However, a HELOC is secured by your home’s value. A HELOC lender will approve you for a specific credit limit based on your credit score, earnings, and the amount of home equity you’ve accrued.
Draw period and repayment period
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 (although an inactivity fee may be charged). If you want to pay off your principal and interest during the draw period, you can do so
- The repayment period: Next comes the “repayment” period, a 10- to 20-year phase during which you’ll need to repay your balance owed. You are not permitted to borrow additional funds during this time unless the lender approves renewal of your HELOC
Note that some HELOCs require you to repay the entire balance in full as soon as the repayment period begins. Ask your lender about its repayment structure before signing on.
HELOC interest rates
HELOCs typically charge variable rates, based on the current Prime or LABOR rate in addition to a margin, that can increase or decrease over time.
During the HELOC draw period, interest is charged only on the credit amount you’re utilizing — not on the full credit limit. “For example, if you secure a HELOC for $50,000, and in your first month you draw $5,000 from that line of credit, you will only be required to pay interest the next month on the $5,000 borrowed,” says Jeanette.
After the draw period, you can no longer borrow against your HELOC and must repay it in full via monthly installments. Some borrowers can convert their HELOC to a fully amortizing fixed-rate second mortgage during the loan’s term if their lender allows it.
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 — which is often the case with first-time buyers and recent purchasers — you may not be eligible for a HELOC.
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, per Eric Jeanette with Dream Home Financing.
In a market crash, your HELOC would remain open with the funds available unless there is language in your mortgage agreement that says otherwise, according to Eric Jeanette with Dream Home Financing.
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.