Homeowners have multiple ways to turn their home equity into quick cash. If you own a home that’s worth more than your existing mortgage debt, a home equity line of credit (HELOC) can be a good way to get cash when you need it.
But is a HELOC a good option for you? Here’s what you need to know about HELOCs before you get one.
What is a home equity line of credit (HELOC)?
A line of credit is an opportunity to borrow money when you need it.
Unlike a loan with a fixed payment, a line of credit works like a credit card. You can borrow as much as you need, up to your credit limit, pay it back, and then borrow it again, and so on.
A “line of credit” may also be called a “credit line.” The two terms mean the same thing and can be used interchangeably.
Home equity is the difference between the market value of your home and the amount of mortgage debt that you owe.
For example, if your home is worth $500,000 and your mortgage balance is $350,000, you have $150,000 of home equity. If you obtain a second mortgage for, say, $50,000, your equity will drop to $100,000.
Equity rises when you pay off home equity debt or your home appreciates. Equity falls when you borrow against your home or your home depreciates.
Put the line of credit and your home equity together, and you have a HELOC –– a line of credit that’s backed, or secured, by the equity you have in your home.
What you should know about HELOCs
An asset that secures a credit line (in this case, your home) is known as the “collateral.”
Using your home equity as collateral for a second mortgage or line of credit means you’ll get a lower rate than you would for unsecured debt, which could save you money.
It also means you could lose your home if you borrow against your equity and don’t make the payments when required.
The credit limit on a HELOC depends on how much equity you have, your income, debt, and credit history. Most lenders will allow you to borrow against at least 75% of your equity. Many will push that up to 80%, 85%, or even 90%.
How do HELOCs work?
HELOCs allow you to draw only the cash you need up to your credit limit. HELOCs generally come with a variable rate that is based on a prime rate plus a margin. This means your monthly payments fluctuate with the market. Some HELOCs come with an introductory fixed rate, but these only last for one to six months. (Source)
Usually, borrowers only pay interest on the money they draw for an initial period. Once the draw period ends, say after 10 years, borrowers can no longer withdraw money from their line of credit. They must either repay the debt in full – what is known as a balloon payment – or their monthly payments go up to pay off the principal of the loan.
Monthly payments can increase by as much as 300 percent (Source). For instance, a HELOC with a $270 payment could jump to $1,100 after the draw period. It’s these drastic fluctuations in payments that get some borrowers in trouble. Some HELOCs reduce this payment shock by giving longer repayment periods or requiring borrowers to repay some of the principal during the draw period.
Good and bad ways to use a HELOC
There are many ways to use a HELOC. Some are good. Some are bad. Unfortunately, financial experts don’t agree on which are which.
The truth is how you choose to use your HELOC might be good for you and bad for someone else. It all depends on your financial goals, ability to manage debt, and personal lifestyle.
Examples of how a HELOC can be used include:
- Making home improvements
- Adding square footage to your home
- Paying off credit-card debt or a car loan
- Consolidating other debts
- Taking care of emergency expenses
- Buying a second home as a vacation or rental property
- Investing in stocks, bonds, or other types of assets
- Buying a car or boat
- Paying college tuition for yourself or your children or grandchildren
5 things you should know about HELOCs
1) Draw period
A typical HELOC has a 5-year or 10-year draw period. During the draw period you can use and reuse the credit line as often as you want.
At the end of the draw period, you’ll enter a repayment period. During this time, your lender will expect you to make payments to pay off your HELOC balance.
A 10-year or 20-year repayment period is typical.
Most HELOCs have a variable rate. That means the interest you’ll be charged if you use your HELOC will probably change over time as market rates fluctuate. Your rate could go up or down, and it could change before or after you borrow any money.
Some HELOCs offer a rate discount if you set up automatic monthly payments or make an initial withdrawal when you open your account.
3) Income tax deductibility
The 2017 Tax Cuts and Jobs Act suspended the federal income tax deduction for interest paid for HELOCs and home equity loans from 2018 until 2016.
But there is an exception: if the funds are used to buy, build, or substantially improve the home used to secure the loan, the interest may be deductible. The loan must be secured by your primary home or a second qualified residence.
Also, according a Feb. 21, 2018 IRS memorandum, interest on home equity loans are often still deductible under a new law.
You should ask your tax preparer for details.
4) HELOC-to-equity loan conversion
Some HELOCs allow you to convert all or a portion of your HELOC into a home equity loan during the draw period. Unlike a HELOC, a home equity loan (or second mortgage) has a fixed term and may have a fixed rate and payment.
The option to convert debt from a HELOC to a loan can be nice to have, especially if your HELOC rate goes up and you want to lock in a fixed rate to protect yourself from further increases. Look for this feature or ask about it when you apply.
5) Applying for a HELOC
Many lenders allow homeowners to apply for a HELOC online. The initial application process can take as little as 15 minutes. Keep in mind, some lenders charge fees and closing costs for a HELOC.
Examples of fees you might be charged:
- Application fee
- Annual fee
- Conversion fee (i.e., from a HELOC to a home loan)
- Cancellation fee
- Early account closure fee
You should shop around and compare your options before you decide to get a HELOC. Consider the rate and other terms you’re offered as well as your credit limit.
Getting a HELOC with bad credit
If your credit history isn’t perfect or your credit score is on the low side, a HELOC can be both your best and worst option to borrow money.
If you have equity in your home, it’s relatively easy to get approved for a HELOC, even if your credit is mediocre. And, your rate for a HELOC should be lower than a personal loan or credit card rate. That’s the best part.
The worst part is that, if you don’t make payments on your HELOC when they’re required, you could lose your home. If you’ve struggled with credit in the past, that might not be a smart risk for you to take.
Should you get a HELOC or a home equity loan?
HELOCs and home equity loans have certain important characteristics in common.
- Allow you to borrow against your home equity
- Use your home as collateral
- Put your home at risk if you don’t make payments, when required
Beyond that, though, HELOCs and home equity loans are very different.
HELOC or home equity loan?
Compare the features of HELOCs and Home Equity Loans to make a better decision.
- Low interest rates
- Line of credit
- Draw and repayment period
- Variable rate
- Limit can change
HOME EQUITY LOANS
- Loan is secured by your house
- A fixed term with a monthly payment
- Fixed or variable rate
- Fixed loan amount
A home equity loan and HELOC comparison calculator can help you figure out which option you prefer.
HELOCs can turn upside down
One last point should be made about HELOCs and home equity loans. If the market value of your home drops after you borrow against your home equity, you could get flipped upside down on your home loans.
This situation occurs when you owe more than your home is worth.
If that happens, it could be difficult for you to sell your home for enough money to pay off your home loans and pay your closing costs, leaving you with no equity or in a loss position.
If you have no plans to sell, that might not matter to you. Over time, you could pay off your loans and your home might regain or surpass its former value as housing markets tend to be cyclical.
Still, it’s important to weigh all the risks and rewards when you think about HELOCs and home equity loans.