In this article:
A home equity line of credit (HELOC) can be a convenient source of cash for big projects such as a home remodel or big bills such as a hospital stay. But because a HELOC is collateralized by your home, you should carefully weigh the pros and cons before using one. How do HELOCs work, and what are the best (and worst) reasons to apply for this type of credit? Read on.
What Is a HELOC?
A HELOC is a revolving credit line that lets you borrow against your home equity, using your home as collateral. (Your equity is your home's assessed value minus your mortgage balance.) You can typically borrow 60% to 85% of your home's equity. Most HELOCs have variable interest rates, usually with a rate cap.
You can draw as much as you need from the HELOC up to the borrowing limit during the draw period (usually 10 years) and make interest-only payments on the amount you borrow. Unlike other types of revolving credit such as credit cards, HELOCs aren't counted as part of your credit utilization ratio by the FICO credit scoring model, so your HELOC balance won't negatively affect your FICO® Score☉ .
After the draw period, you'll have to repay the loan in full, generally over 20 years. (You can also choose to refinance it.) HELOC payments rise substantially at this point, so be sure to budget for the cost. Some HELOCs let you pay down principal during the draw period, making post-draw-period payments more manageable.
Like HELOCs, home equity loans use your home as collateral. Unlike HELOCs, however, they are installment loans: You receive a lump sum and begin making fixed monthly payments immediately. Most home equity loans have a fixed interest rate.
What's a Good Way to Use a HELOC?
HELOC payments can soar when the draw period ends, and you could lose your home if you can't repay the loan. Because of this risk, HELOCs are best used for the following:
- Home improvements: HELOCs are well-suited to finance home improvements that are completed in stages because you can draw money as you need it. If the improvements add to your home's value, interest paid on the HELOC may be tax-deductible.
- Major home repairs: Discovering your home needs a new roof or repiping can put a big dent in your budget if your emergency fund can't cover the cost. A HELOC can help pay for costly repairs, and interest on the HELOC can be tax-deductible if the repairs increase the home's value.
- Financial emergencies: If you lose your job, face a major medical bill or other financial crisis, a HELOC can help you get back on your feet.
- Paying off credit card debt: Using a HELOC to pay off high-interest credit card balances may be a wise move, but only if you have a well-thought-out plan to avoid building up that debt again. Otherwise, you could find yourself with high credit card balances plus HELOC payments.
What Are Bad Ways to Use a HELOC?
Aside from putting your home at risk, HELOCs also eat up precious home equity. During the Great Recession, many borrowers whose home values declined found they owed more than their homes were worth. To protect your equity, avoid using HELOCs for:
- College tuition: HELOCs are often promoted as a way to finance college, but federal student loans are generally a smarter choice. With federal student loans, you may qualify for loan deferment, forbearance, forgiveness or income-based repayment plans if you need it, and interest rates for new undergraduate federal student loans are generally lower than for HELOCs. Students can also apply for scholarships, select a budget-friendly school or start at community college to save money on college costs.
- Vacations or weddings: Rather than go into debt for a dream vacation, wedding or honeymoon, create a budget to save for your goal, or find budget-friendly ways to travel or host your event.
- Buying a car: With good credit, you can probably get an auto loan with a lower interest rate than a HELOC. If you can't repay the loan, you could lose your car, but you won't lose your home.
- Starting a business: Instead of putting your home in peril for an untested business idea, explore financing options such as investments or loans from friends or family, credit cards, crowdfunding or business loans.
- Investing: HELOCs can free up cash to invest in stocks or rental properties, but returns on such investments aren't guaranteed, making them risky bets.
Alternatives to HELOCs
If a HELOC isn't for you, consider these other ways to finance big purchases or unexpected expenses.
- Personal loan: Personal loans are installment loans that typically have fixed interest rates, require no collateral and can be used for any purpose. Interest rates are generally higher than for HELOCs, and interest is not deductible. Personal loans are available for up to $100,000. Experian CreditMatch™ can help you find loans fitting your credit profile.
- Personal line of credit: Borrowers with good credit may qualify for a personal line of credit from their bank or credit union. Most personal lines of credit are unsecured with a draw period of a few years. Unlike HELOCs, these unsecured credit lines count toward your credit utilization ratio, so drawing more than 30% of your limit may hurt your credit score.
- Balance transfer card: If you have good credit, a balance transfer card with a low or 0% introductory annual percentage rate (APR) can help you pay down high-interest credit card balances. Transfer balances to the new card, pay them off before the introductory period ends and you'll pay no interest.
- Cash-out home refinance: This option refinances your mortgage into a new, larger mortgage; you receive the difference in cash. If interest rates have dropped since you got your mortgage, a cash-out refi can also help you save on interest. However, cash-out refis are time-consuming and require starting your mortgage clock all over again, so carefully weigh the costs and benefits.
Keep in mind that borrowing money isn't the only way to pay off debt. Investigate all your options. For instance, if you have medical debt, you can ask about payment plans, negotiate with the medical provider or seek financial assistance. Overwhelmed with credit card debt? A reputable credit counselor can create a debt management plan for you and work with your creditors to lower interest rates, waive fees and reduce your payments.
Is a HELOC Right for You?
While HELOCs do offer lower interest rates and greater flexibility than many other financing options, the tradeoff is putting your home up as collateral. Before choosing a HELOC, carefully consider how it will affect your home equity, how you will pay it back, and whether less risky financing alternatives are a better fit for your needs.
To qualify for a HELOC, you'll need a good credit score plus significant home equity. Before applying for a HELOC or any loan, check your FICO® Score and credit report. If your credit score needs work, you can help improve it by paying down debt, maintaining low credit utilization and not applying for new credit until you're ready to apply for the HELOC. Once you have a HELOC, make payments on time to help boost your credit score.