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Home equity lines of credit (HELOCs) are an option for homeowners looking to take advantage of the value of the ownership stake they have in their residence. Unlike home equity loans, which pay you a lump sum, HELOCs allow you to borrow lesser amounts over time, so that you’re only taking the funds you need when you need them.
Borrowing only what you need can keep your monthly payments lower and help avoid unnecessary debt (and interest payments). However, a fluctuating interest rate and the sense of a seemingly limitless credit line could make HELOCs risky for less-disciplined borrowers.
Pros and cons of a HELOC
- Lower APRs than credit cards
- Tax-deductible interest
- Flexible withdrawals and repayments
- Potential boost to credit history
- Home becomes collateral for the loan
- Borrower’s home equity stake is reduced
- Interest rate could rise
- Potential to run up big balance quickly
What is a home equity line of credit (HELOC)?
A home equity line of credit (HELOC) offers a line of credit you can borrow against when you need to. Like credit cards, HELOCs come with variable interest rates, and for a period of time, 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 — similar to the credit limit on a credit card — 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
With a HELOC, you can typically borrow up to 85 percent of your home’s value, minus the outstanding mortgage balance, which means that these loans won’t work for borrowers who don’t have considerable equity built up in their home — that is, they don’t own a substantial percentage of it outright. You also need good credit to qualify, as well as verifiable income to repay your loan.
If you’re a candidate for a HELOC, here are some of the biggest advantages.
You could qualify for a low APR
While mortgage interest rates overall have risen dramatically since 2022, some of the best HELOC rates still tend to have lower interest rates and lower initial costs than credit cards, which makes them attractive for debt consolidation or ongoing renovation projects.
Interest might 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 renovations.
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.” You can only take the deduction up to a certain threshold, however, based on the combined interest of the first and second mortgage. You must also itemize deductions.
You can borrow only what you need
Another advantage of HELOCs is that you can use funds as you need them. Where home equity loans and 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.
This makes them ideal when you don’t know exactly how much that roof replacement or kitchen renovation might end up costing. If you wind up needing less cash than you thought, you’ll have a smaller monthly payment.
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.
Potential to 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.
Cons of a home equity line of credit
Being able to tap your home’s equity is a good option to have, but HELOCs do have some disadvantages. Consider these drawbacks.
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 obtain 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 mortgage operations, closing at Navy Federal Credit Union.
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 much higher interest rates when it comes time to pay.
This happened in 2022, as the Fed began a series of interest rate hikes to combat inflation.
One disadvantage of HELOCs often stems from a borrower’s lack of discipline. Because HELOCs allow you to make interest-only payments during the draw period, it is easy to access cash impulsively without considering the potential financial ramifications.
“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.
How does HELOC repayment work?
HELOC repayment is unusual in that not only will your required payments change over time, the method used to calculate those payments will also change.
Typically, a HELOC has two distinct stages: a draw period and a repayment period. The draw period is the first stage, usually lasting between five and 10 years. During this period, your minimum monthly payments will be equal to the amount of interest that accrued that month. That means the interest rate of the HELOC and its current balance will determine the payment.
As you draw more funds from the line of credit, the amount of the minimum payment will rise (even though it only covers accrued interest, that interest is applying to a larger balance). Changes in the interest rate will also change your required payment. You can also opt, with most HELOCs, to pay more, to lower outstanding the balance during the draw period.
Once the draw period ends, you’ll enter the repayment period. During this phase, which can be as long as 20 years, you’ll have to make payments that cover interest and a portion of the loan’s principal. That means your payment will increase when the draw period ends and the repayment period begins.
Although it’s getting less common, some HELOCs have a balloon payment requirement. That means that you must pay the loan off in-full immediately at the end of the draw period. That can be a massive bill to handle if you aren’t ready for it, so read the fine print of your loan carefully.
Alternatives to a HELOC
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 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. Conversely, if you know exactly how much you need upfront, a home equity loan could be a better option than a HELOC.
- Cash-out refinance – 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, with you receiving 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.
- Personal loan – Like home equity loans, personal loans come with a fixed monthly payment, a fixed interest rate and a lump sum of money upfront. 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 because 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.
Bottom line on HELOC pros and cons
Home equity lines of credit (HELOCs) are an option for disciplined borrowers who want to take advantage of their home’s equity. HELOCs have the most flexibility in terms of what you can borrow and when you can pay it off.
However, HELOCs also come with risks. You must put your home up as collateral and interest rates are variable. When considering a HELOC, think honestly about your financial habits, the potential risks, and the nature of your funding needs. HELOCs work best if you require an indefinite sum, or need funds for an extended period of time.