A home equity line of credit, or HELOC, is one of the cheapest sources of credit available. Even people with poor credit can get large loans with low interest rates. What’s more, the interest you pay is tax-deductible. The downside is that a HELOC uses your home as collateral. If you don’t repay the loan plus interest, you could lose your home.
Are you considering a HELOC? This guide shows what to look for when shopping for a HELOC, such as the hidden costs of setting up and maintaining a home equity line. You’ll also get pro tips to help you find the best deals.
What is a HELOC?
A home equity line of credit is like a credit card that uses your home as security. Your credit limit is based on a percentage of your home’s equity.
Equity is the difference between what your home could realistically sell for and what you owe on your mortgage. For example, if you own a house that is valued at $400,000, but you still have a $100,000 mortgage on it, your equity is $300,000.
A typical HELOC is to 75-80 percent of your home’s equity, but some lenders may give you up to 125 percent.
In the example mentioned above, a 75 percent HELOC would give you a credit limit of $225,000 ($300,000 x 0.75).
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.
Advantages and disadvantages
HELOCs can be a great way to finance large expenses that occur intermittently, such as home improvements or your children’s college education. However, there are risks you should consider.
The main issue borrowers have with HELOCs is underestimating the cost of maintaining and repaying the line of credit. We have already mentioned the risk of teaser rates, interest hikes, and balloon payments, but lender and third-party fees can also get expensive fast. For example, you may have to pay an annual fee, application fee, points, or even a cancellation fee, if you decide to close the account. The key is to ask your lender for a detailed list of origination, maintenance, and closing fees before you get a line of credit.
Another thing to consider with HELOCs is that your line of credit is linked to the market value of your home. If housing prices drop, your lender can reduce or freeze your credit limit. (Source)
Here’s a rundown of the main advantages and disadvantages of getting a HELOC.
Compare the pros and cons to make a better decision.
- Low interest rates
- You only draw what you need
- Interest is tax deductible
- Even consumers with not-so-great credit can qualify
- Low-cost consolidation loan
- Loan is secured by your house
- Adjustable rates
- Balloon payments
- Teaser rates
- Hidden fees
- Credit limit fluctuates with housing market
Who should consider HELOC?
A home equity line of credit is a good option for people who want flexible access to a reserve of cash, but only want to pay interest on the money they spend. Homeowners with a lot of equity in their home, reliable sources of income, and who live in stable housing markets are the best candidates.
How to get the best rates on a HELOC
Follow these steps to improve your chances of getting a good deal on your HELOC.
Find out the market value of your home
Don’t assume the market value of your home is the same or higher than when you bought. Free sites like Trulia and Zillow are a good starting place.
Ask for rates, terms, and closing costs from at least three lenders. Check SuperMoney’s home loans database for user reviews and ratings of the best online lenders.
Consider all charges and costs
Although the interest rate is the main cost component of a HELOC, don’t forget to include origination, maintenance, and closing fees when calculating the cost. HELOCs come with many of the fees that come with a mortgage, such as property appraisals, application fees, points, title search fees, and taxes.
Compare and negotiate
Once you work out the best offer, try to get the other lenders to improve on it.
Pro Tips for HELOC borrowers
Ask your lender if the HELOC has a minimum draw. If the minimum draw is high, it may force you to borrow more than you want.
Federal law gives you the right to cancel a HELOC agreement without penalty for any reason within a three-day period. Notice this only applies if you are using your main home as collateral. It does not work with vacation or investment properties.
Don’t put much stock, if any, on the start rate of your HELOC. Some lenders use it as a bait-and-switch marketing trick. Focus on the margin rate and the prime rate. Don’t be fooled by the current historically low prime rates. They could rise. In 1981, prime rate hit 21 percent. (Source)
If you know exactly how much money you need for a single purchase or expense, go for a conventional home equity loan, also known as a second mortgage. Although rates are generally higher, equity loans have fixed interest rates. This makes it easier to budget for monthly payments.
Don’t compare the APR of a HELOC with the APR of a traditional equity home loans or mortgages. The APR of a HELOC only reflects the interest rate. It does not account for closing costs, points, or any other fees. (Source)
The bottom line
HELOCs are a flexible, relatively inexpensive, and tax-efficient source of credit. They are particularly useful for financing intermittent purchases, such as home improvements and tuition fees. However, borrowers are at risk of losing their home if they don’t make payments.
It is important to understand that monthly payments on a HELOC can vary drastically over the life of the loan. Many borrowers get themselves in financial trouble when monthly payments rise once the initial draw period ends.
SuperMoney offers consumers a convenient way to compare lenders and products. Click here to read expert reviews and user comments on leading HELOC lenders.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.