Home equity lines of credit, or HELOCs, are tempting in today’s environment where rates are low, equity is high and people aren’t moving as frequently as they used to. But what you do after you open a HELOC can make all the difference between a smart money move and a costly mistake.
HELOCs, which are lines of credit lenders issue using your house as collateral, can give you access to tens of thousands of dollars for any purpose.
Since 2011, the first year equity stopped dropping post-housing crisis, borrowers have gained $5.9 trillion in home equity, according to a report by CoreLogic. This means there are a lot of homeowners getting mail for HELOC offers. But before you decide to tap your equity, it’s important to think about how you’ll use that credit after you get the HELOC.
Make a budget and stick to it
Managing your HELOC begins with planning on how you’ll use it. Whether you want to renovate your home or consolidate high-interest debt, having a specific purpose is important. On the other hand, using a HELOC to fund a vacation or float your lifestyle is an unwise way to use it, particularly because your house is on the line if you can’t afford to pay it back.
“We do find cases where a consumer has had a number of short-term emergencies or they used the credit card to pay for renovations,” says Michelle McLellan, product executive at Bank of America. “Another reason is that their debt is at a higher interest rate. In this case, A HELOC can be good for debt consolidation. These are instances when we recommend this line of credit.”
When to use a HELOC
Experts agree that HELOCs can be useful products for certain purposes, such as saving people money on existing debt or making meaningful improvements to their home. Here are a few reasons why you might consider a HELOC.
- Increase your quality of life or ability to live in the home or
- Provide a return on your investment.
- Lower your interest rate by consolidating expensive debt.
- HELOCs can be helpful for medical bills or other sudden emergencies.
Avoid using HELOCs as a way to supplement income over the long-term or buy things that are outside of your budget. One financial rule to consider is to match the source of debt with the use of debt.
“Short-term uses, like going out to eat, or shopping, should be paid with short-term debt like a credit card, and paid off quickly. Long-term uses, like home renovations or investments like education, can be paid by long-term debt like home equity,” says John Sweeney, head of wealth and asset management at Figure Technologies.
If you consolidate your debt and thus save money by lowering your interest rate, avoid getting back on the debt merry-go-round. It doesn’t make sense to get a HELOC to pay off debt if you rack it up again later (minus emergencies or other necessary expenditures). Here’s where having a budget and solid long-term strategy is key.
Keep in mind that moving unsecured debt like medical bills and credit card balances to a home equity loan means you are securing that debt against your house. If you don’t pay Visa or the doctor, they can’t take your home. If you don’t pay a HELOC, the lender can foreclose.
Make additional payments toward principal
- Minimize interest by paying off your debt asap
A HELOC repayment plan usually consists of two phases: the draw period and the repayment period.
The draw period (which is when you have access to the credit) is typically five to 10 years and, during that time, you’re only making interest payments. After that expires you move into the repayment period, which is typically 20 years (at this point you no longer have access to your credit) and now you’re paying both the interest and the principal, so your monthly payments will be higher. (Though some HELOCs do require both principal and interest repayments during the draw period.)
If possible, make extra payments on the principal during the draw period. This will accomplish a few things:
- You’ll reduce the amount of interest you pay and
- You’ll avoid sticker shock when the draw period ends.
- And if you can afford to make additional payments today, don’t wait because you don’t know what might happen in the future. This can keep you from getting behind on payments should your income drop.
Avoid penalties for paying off your HELOC early
- Get a loan with no prepayment or early closure fees
If you plan to pay off your HELOC early, be sure to avoid lenders that charge early closure fees. Bank of America, for instance, does not charge customers for paying down their entire HELOC balance early while keeping the line open. However, Bank of America borrowers are charged $450 if the HELOC is paid off and closed within 36 months of opening it.
Be aware that you’ll already pay fees to get a HELOC, including closing costs, so avoiding any additional fees is a good idea if you’re keen on saving money.
Before you decide on a HELOC, talk with a financial adviser about your goals and needs. A HELOC might be the best solution, but there could be other options that are better-suited for your particular circumstances.