Homeowners who need money for major expenses such as medical bills or a kitchen renovation often decide to take out a home equity line of credit, or HELOC.
Like any loan that uses your home as collateral, a HELOC is not to be regarded lightly. Failure to repay according to the loan terms will severely damage your credit score and result in you losing your home through foreclosure.
Use Bankrate’s calculator to help you decide whether a HELOC is right for you.
Here are some pros and cons of HELOC.
The pros of a HELOC
A HELOC is fairly easy to get if you have enough equity in your home and a decent credit history.
It is similar to a credit card in that you pay interest on the amount you withdraw from your credit line. But the typical interest rate on a HELOC is far lower than it is on a credit card.
A HELOC is also typically less expensive than a personal loan.
The cons of a HELOC
A home equity line of credit does have some disadvantages. For one, the interest rate is variable so monthly payments can be unpredictable, especially when rates are on the rise.
HELOC rates currently are slightly higher than interest rates on conventional mortgages. This is unfortunate for homeowners with a super-low-rate first mortgage who would like to tap their equity. Bankrate’s interest rate survey from May 22 showed the average 30-year fixed-rate mortgage rate to be only 4.27 percent.
Many lenders also charge an annual fee to keep the HELOC open, even if you don’t withdraw any of the money.
A new wrinkle in the home equity landscape is the federal tax law, which limits the deductibility of the interest you pay on a HELOC. The law eliminates the interest deduction for equity loans unless the money is spent on improvements that will raise the property value.
An even bigger drawback of a HELOC is that if your home value falls, you could end up owing more than your home is worth. This situation, known as being “upside down” or “underwater,” means you won’t be able to refinance your mortgage, and selling your home will be difficult.
Alternatives to a HELOC
If the idea of taking out a HELOC seems less than appealing, there are a couple of other options to consider.
1. Home equity loans
Home equity loans are similar to HELOCs, but rather than receiving a line of credit, you get one lump sum. The amount you receive could be up to 85 percent of the equity in your property.
2. Cash-out refinance
A cash-out refinance removes your existing mortgage loan and provides you with a new one. This new loan is more than what your house is worth. The difference is what you get in cash. If your home is worth $400,000, and you owe $200,000 on the mortgage, you can refinance your loan for $275,000. The $75,000 will be what you will receive in cash.