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- A home equity line of credit, or HELOC, is one way to convert your home equity into cash.
- HELOCs allow you to withdraw funds as you need them and make interest payments on the borrowed funds.
- But a line of credit is secured by your home, and interest rates and monthly payments may change over time.
A home equity line of credit – more commonly called a HELOC – is one option for homeowners who want to leverage the value of their home in exchange for cash.
However, unlike other options, HELOCs offer a line of credit – allowing you to withdraw, repay, and then withdraw more funds as needed over a longer period of time. While this may be the right strategy for some homeowners, it also has drawbacks.
Here are the pros and cons you should consider before taking out your HELOC.
What is HELOC?
HELOCs allow you to turn some of your home equity into a line of credit, which works just like a credit card.
During the draw period (usually 10 to 15 years), you can withdraw and replenish funds as you wish, in most cases making interest-only payments. Then, once you enter the repayment period (usually 10 to 20 years), you will begin making monthly principal and interest payments to the lender.
HELOC pros and cons: in brief
HELOCs offer homeowners a wide range of benefits. But they also have some significant drawbacks. Make sure you take this into account before installing a HELOC in your home.
Here are more details about the benefits of a HELOC.
1. You can withdraw funds for many years
One of the biggest benefits of a HELOC is that it allows for expanded access to cash. You can withdraw $10,000 here, another $30,000 there, pay it back and withdraw even more. This makes a HELOC great for covering recurring expenses (like tuition, for example) or unexpected repairs, medical bills, and other fees that may arise in the future.
“This method can be used repeatedly as the funds are refunded,” says Esther Phillips, senior vice president and chief sales officer at the company Key mortgage services. “This is a good option if you only need funds for a short period of time or you are not sure how much you will need and when.”
2. You only pay interest on what you borrow
Another advantage of a HELOC is that you only pay interest on the funds you actually withdraw. If your line of credit is $50,000, but you only use $20,000, you’ll only be charged interest on that $20,000 – not the full line.
This helps minimize long-term interest costs, especially compared to other loan options that typically charge interest on the full loan amount from day one.
3. You can use the funds however you want
There are no restrictions on how you can use your HELOC account funds. Many homeowners use them for repairs and renovations, while others use them for expenses completely unrelated to the home – like taking a vacation or consolidating credit card debt.
“The main advantage of a HELOC card is that it has the same flexibility as a credit card,” says Deb Gontko Klein, a Chandler, Arizona resident and branch manager Loan reliability at Primary Residential Mortgage Inc. “You only make payments for what you use, and you can pay it back and use it again as needed for home improvements, remodeling, landscaping, your child’s college, or even paying off higher-interest credit cards.”
4. High credit limits
Depending on how much equity you have in your home, HELOCs can potentially offer access to very large sums of money. Some HELOC lenders actually offer up to $500,000 in financing – significantly more than most other financial products can provide.
As Adam Boyd, director of home equity lending at Citizens Bank, explains, “HELOCs typically offer larger loan amounts and lower interest rates than unsecured loans, lines of credit and credit cards.” How much you ultimately qualify for will depend on how much home equity you have and your credit score.
5. Payments start small
Most HELOCs only require interest payments during the draw period, which can keep your monthly cost low. This can be helpful if you’re on a tight budget or want to maintain cash flow. Just remember that once you enter repayment period, your payments will increase by interest and principal.
6. Interest may be a tax deductible expense
In some cases, you can deduct the annual interest costs of a HELOC on your federal tax return. This only happens if you use the borrowed funds to “buy, build or significantly improve your home” according to the tax officeso keep this in mind if you want to get tax relief.
“Interest paid on a home equity loan or HELOC for any other purpose, such as purchasing an investment property or consolidating debt, is not tax deductible,” says Heather Harmon, director of research at Open financeonline mortgage broker.
Disadvantages of HELOC
Here are more details about the disadvantages of HELOCs.
1. Rates are variable
HELOC accounts have a variable interest rate, which means the rate charged may change depending on the current HELOC rate level. Typically, these rates are tied to the base rate. When that rate goes up or down, the rate on your HELOC does too. This can make it difficult to plan your payment budget because it can change frequently.
“Prepare a budget for the worst-case payment scenario,” Klein advises. “Estimate your payment amount by increasing your rates by another 1% to 2% so that you are well prepared when rates go up.”
2. Risk of subsequent payment shock
While HELOCs allow for low, interest-bearing payments during the draw period, this isn’t always a good thing, especially if you’re withdrawing large amounts of cash. In this case, you may face a significant jump in payments once you enter the repayment period.
3. Your house is on the line
HELOCs use your home as collateral. While this can reduce some of the risk for the lender and allow them to offer lower rates and more favorable terms, it is also risky. If you don’t make payments, the lender can foreclose on your home to pay off the debt.
“It’s important to make sure you’re prepared to manage your line of credit responsibly and have room in your budget to change your monthly payments,” Harmon says.
4. Prepayment penalties may apply
Some lenders charge fees if you close your HELOC too soon after opening it. In some cases, the lender may also bill you for closing costs that it paid on your behalf.
“HELOCs are best suited for homeowners who plan to stay in the property for several years, because some lenders will charge prepayment penalties if the loan closes within the first two to three years,” Boyd says.
5. You can pay fixed fees
HELOCs often have annual maintenance fees, transaction fees, and other ongoing costs that you must pay over the life of the loan. You may even be charged inactivity fees if you don’t withdraw funds for too long.
Frequently asked questions about the advantages and disadvantages of a HELOC
A HELOC is a line of credit secured by your home. You can withdraw and repay funds multiple times during the drawing period – usually 10 to 15 years. Home equity loans provide the homeowner with a one-time upfront payment and are not subject to top-up; payments start immediately after. Both allow you to turn equity into cash.
The exact requirements for a HELOC vary by lender, but you can usually expect a credit score in the mid-600s or higher, at least 10% to 15% equity in the home, and a low debt-to-income ratio. which means that existing loan and debt repayments don’t take up too much of your monthly income.
You can get a HELOC through many banks, credit unions, mortgage lenders, and online lenders. You will need to complete an application, agree to a credit check, and submit financial documentation. The lender may also order a home appraisal to confirm the value of your property.
A HELOC is typically a second mortgage. The term “second mortgage” simply means that the lender has a secondary right to the property if you default on the loan (the primary right goes to the primary mortgage lender). If you no longer have a primary mortgage – meaning you own your home – it’s possible that a HELOC will be your first mortgage instead.
Taking money out of your home’s equity is risky, and because HELOCs have variable interest rates, it can become unexpectedly expensive if rates rise. Before closing, find out how much a HELOC might cost you, both on a monthly and total basis.
Taking out a HELOC may be worth it if it ultimately helps you get into a better financial situation. For example, some borrowers use a HELOC to consolidate high-interest debt, making repayment easier and cheaper. Or a HELOC can be used for value-added home improvements, helping to increase the wealth you have in your home.
The amount of your monthly HELOC payment depends on several different factors, including the rate, the length of the term, and whether you are in the drawing or HELOC repayment period. A $50,000 HELOC at current rates could cost anywhere from $300 to $600 per month.