Homeowners who want to tap into their home’s equity to consolidate high-interest debt or finance home improvement projects often decide to take out a home equity line of credit, or HELOC.
Unlike a home equity loan that lends you a lump sum, a HELOC offers a line of credit you can borrow against when you need to. Like credit cards, HELOCs also come with variable interest rates, and your monthly payment will vary depending on how much you borrow at any given time and your current interest rate.
HELOCs remain popular because they tend to make good financial sense, says Sean Murphy, AVP of equity lending at Navy Federal Credit Union.
“Specifically, if you are someone who is looking for a home improvement or debt consolidation loan with lower interest rates than personal loans or unsecured products, a HELOC may be right for you,” he says.
Before you decide, go over the pros and cons of a HELOC.
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, which means these loans won’t work for consumers who don’t have considerable equity. You also typically need good credit to qualify, and you will need 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. Financial attorney Leslie H. Tayne says HELOCs can have lower interest rates and lower initial costs than credit cards.
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 not deductible “unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.”
Borrow only what you need
JPMorgan Chase Home Lending Representative Keosha Burns says another advantage of HELOCs is that you can “use what you need, when you need it.” Where home equity loans and even personal loans require you to take out a lump sum, you can use a HELOC in spurts if you want, only borrowing the cash you’ll use as you go along.
Tayne also points out that your monthly payment varies based on how much you’re borrowing, so you can wind up with a smaller monthly payment if you wind up needing less cash than you thought.
Choose from flexible repayment options
Finally, don’t forget that HELOCs often provide flexibility in terms of how you pay them off. Joseph Polakovic, owner and CEO of Castle West Financial in San Diego, says that this can include the option to make interest-only payments — at least at first.
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 including a draw period and a repayment period.
Cons of a home equity line of credit
Being able to tap into your home’s equity is definitely a good option to have, but there are some HELOC disadvantages to be aware of. Consider these cons before you move forward with this loan option.
You’re using your home as collateral
First, you’re putting your home up as collateral for the loan, which you’re also required to do with a home equity 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,” Murphy says.
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 your rate can go up or down based on the decisions of the Federal Reserve, which can be good or bad.
As a borrower, it really means more uncertainty for you, particularly since HELOCs can last over a long timeline.
Risky for undisciplined borrowers
Polakovic says that one disadvantage of HELOCs often stems from a lack of borrower discipline because they are so easy to access. Since HELOCs offer the chance to make interest-only payments, it’s also almost too easy to access this 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,” Polakovic says.
You’re reducing the equity you have in your home
Finally, don’t forget that you’re borrowing against home equity you may have worked hard to build up. This could mean spending more time paying off your house in the long run, but also paying more interest over the time you own your home.
If housing prices drop, borrowing against your home equity also means you could wind up owing more than your home is worth.
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
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.
“But if you are looking for a fixed monthly payment and a large sum of cash upfront, a home equity loan is probably the better option,” he says.
Home equity loans come with a fixed monthly payment and a fixed interest rate. This means you’ll know exactly how much you will owe each month, and you never have to worry about your interest rate going up or down.
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.
Finally, don’t forget to consider personal loans. This type of loan comes with a fixed monthly payment and a fixed interest rate, and you get a lump sum of money upfront like you do with a home equity loan. The big difference is 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 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, since personal loans are unsecured.