Homeowners who want to tap into their home equity to consolidate high-interest debt or finance home improvement projects often decide to take out a home equity line of credit (HELOC). One advantage of a HELOC is that you can borrow only the amount that you need, which can keep your monthly payment lower. However, the variable payment amounts can make a HELOC riskier for less disciplined borrowers.
What is a home equity line of credit (HELOC)?
Unlike a home equity loan, which lends you a lump sum, a HELOC offers a line of credit you can borrow against when you need to. Like credit cards, HELOCs come with variable interest rates, and your monthly payment will vary depending on your current interest rate and how much you borrow at any given time.
With a HELOC, you are typically given a maximum amount that you can borrow based on the equity you have in your home. You can choose to use some or all of your line, and you are charged interest based on only the amount that you’ve actually borrowed. So if you haven’t used any of your line of credit, you won’t owe any principal or interest.
Pros of a home equity line of credit
Home equity lines of credit normally let you borrow up to 85 percent of your home’s value, minus outstanding mortgage payments, which means that these loans won’t work for consumers who don’t have considerable equity. You also typically need good credit to qualify, as well as provable income to repay your loan.
If you’re a candidate for a HELOC, here are some of the biggest advantages.
Qualify for a low APR
Interest rates have been at or near all-time lows for several years now, and home equity lines of credit let you take advantage of that fact. HELOCs can have lower interest rates and lower initial costs than credit cards, which makes them attractive for debt consolidation or ongoing projects.
Interest may be tax deductible
Even after the Tax Cuts and Jobs Act of 2017, you can still deduct interest paid on a home equity line of credit (or home equity loan) if you use the money for home improvements.
Specifically, the IRS says that interest payments on home equity products are deductible if they are used to “buy, build or substantially improve the taxpayer’s home that secures the loan.”
Borrow only what you need
Another advantage of HELOCs is that you can use funds as you need them. Where home equity loans and even personal loans require you to take out a lump sum, you can use a HELOC in bursts if you want, only borrowing the cash you’ll use as you go along. If you wind up needing less cash than you thought, you’ll have a smaller monthly payment.
Choose from flexible repayment options
HELOCs often provide flexibility in terms of how you pay them off. The timeline for your HELOC can vary depending on how much you want to borrow and the lender you go with, but HELOCs can last for up to 30 years. You’ll typically have to make only interest payments during the draw period, or the initial 10 years, but you have the option to make principal payments as well to lower the balance remaining when you enter the repayment period.
Some HELOC lenders have also begun offering fixed-rate options, which let you lock in a portion of your HELOC balance at a fixed interest rate for a period of time.
Raise your credit score
Two of the most important components of your credit score are your payment history and the different types of credit you have. Adding a HELOC to your credit portfolio and making on-time and regular monthly payments can boost your credit score since it shows a streak of good financial habits.
Few restrictions on how you use the funds
With a HELOC, there are very few restrictions on how you can use the funds. Although your HELOC is secured by your home, you don’t have to use the funds from a HELOC on home improvements. You can use it for higher education expenses, travel or debt consolidation.
Cons of a home equity line of credit
Being able to tap into your home’s equity is a good option to have, but there are some HELOC disadvantages to be aware of. Consider these drawbacks before you move forward with this loan option.
You’re using your home as collateral
A HELOC is a secured loan, meaning you put your home up as collateral for the loan. While having a secured loan can help you secure a lower interest rate, you’re taking on some additional risk.
“Because you are borrowing against your home, if you can’t make your monthly payments, you risk foreclosure,” says Sean Murphy, assistant vice president of equity lending at Navy Federal Credit Union.
You’ll have a variable interest rate
Where home equity loans offer a fixed interest rate that will never change, home equity lines of credit come with variable rates. This means that your rate can go up or down based on the decisions of the Federal Reserve — so even if you take out a HELOC with a low rate, you could face high rates when it comes time to pay.
There’s a risk of overspending
One disadvantage of HELOCs often stems from a borrower’s lack of discipline. Since HELOCs let you make interest-only payments during the draw period, it’s also almost too easy to access cash without feeling the pain of your decisions right away.
“If the borrower is not returning funds to this line of credit, then the loan eventually begins to amortize and the payments go up significantly,” says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. If you’re not expecting or accounting for the increase in monthly payments at the end of the draw period, it can be an unwelcome surprise.
You’re reducing the equity you have in your home
When you borrow through a HELOC, you’re borrowing against home equity you worked hard to build up. If housing prices drop, you could wind up owing more than your home is worth. Having an outstanding HELOC also limits your additional opportunities to borrow from your equity.
Alternatives to a home equity line of credit
HELOCs can be extremely useful, but they’re not exactly perfect — at least not for everyone. Here are some loan alternatives to consider in place of a HELOC.
Home equity loan
A home equity loan is very similar to a HELOC, but instead of a credit line, it gives you a lump sum of cash. You’ll have a set repayment period and a fixed interest rate, meaning your monthly payment will never change.
Murphy says that if you’re looking to spend as you go — and only pay for what you’ve borrowed, when you’ve borrowed it — a HELOC is probably a better option. If you know exactly how much you need up front, a home equity loan could be a better option than a HELOC.
A cash-out refinance replaces your existing mortgage with a new loan with a higher balance. Many lenders will let you refinance and borrow up to 80 percent of your home’s value, letting you receive the difference in cash.
If your home is worth $400,000 and you owe $200,000, for example, you could potentially do a cash-out refinance with a new loan for $320,000 and get $120,000 in cash, minus closing costs and other refinancing fees.
Like home equity loans, personal loans come with a fixed monthly payment, a fixed interest rate and a lump sum of money up front. The big difference between personal loans and home equity loans and HELOCs is that personal loans are unsecured, so you don’t have to put your home up as collateral.
Personal loans can also be easier to apply for, since you can often fill out an application online and you don’t have to prove how much your home is worth. They do tend to come with higher interest rates than home equity products, however.
The bottom line
Home equity lines of credit can be an attractive option if you have sufficient equity in your home, since you have more flexibility in what you borrow and when you pay it off. However, you will have to put your home up as collateral, and HELOCs come with variable interest rates. Before applying for one, consider your financial habits, as well as what you want to use your funds for.