Pros and Cons of a Home Equity Line of Credit (HELOC)

Pros and Cons of a HELOC

Pros of a HELOC

A HELOC is a convenient way to tap into the equity you've accumulated in your home for various expenses and comes with several benefits.

Lower Interest Rate

Lenders assume less risk with a HELOC because your home serves as collateral to secure the line of credit. As a result, HELOCs generally have lower interest rates than unsecured loans or credit cards. However, rates on HELOCs are variable, so they may increase over time.

Flexibility

Unlike a home equity loan where you borrow a lump sum of cash upfront, HELOCs typically have a 10-year draw period, during which time you can borrow money as needed up to the credit limit. As you pay down your balance, your available credit increases, and you can continue borrowing against the line until the repayment period begins.

Some lenders allow borrowers to make interest-only payments during the draw period. However, when the draw period ends, you must make principal and interest payments, and you can no longer borrow from the line.

With a HELOC, you only pay interest on what you borrow, not the full line of credit.

Multiple Ways to Access to Funds

Many HELOC lenders allow borrowers to access funds in multiple ways, including checks, credit cards, debit cards, withdrawals from a local branch, ATM withdrawals and online transfers, making it easy to use the money as needed.

Long Repayment Timeline

HELOCs generally have long repayment timelines, typically ranging from five to 25 years, which can help make monthly payments more affordable.

Potential Tax Deduction

If you use the funds from your HELOC to make home improvements or renovate your home, the interest may be tax deductible if you itemize deductions. You won't be able to deduct interest payments if you take the standard deduction. Because tax laws change frequently, it's a good idea to speak with a tax professional.

Learn more: Tax Breaks for Homeowners

Cons of a HELOC

While a HELOC offers a flexible way to borrow cash when you need it, it's not without risk. Here are some potential downsides to keep in mind with a HELOC.

Variable Interest Rate

HELOCs typically have variable interest rates, although some lenders may allow you to convert part of your credit line to a fixed rate during the draw period. With a variable rate, your payments likely won't be the same every month, which can make it more challenging to factor in to your budget.

If interest rates are decreasing, having a variable rate may work in your favor. But when rates are increasing, your payments may become unaffordable, especially if you made interest-only payments during the draw period.

Foreclosure Risk

Because your home secures a HELOC, if you're unable to make your payments, the lender has the right to foreclose, and you could lose your home.

Lowers Your Home Equity

Borrowing against the equity in your home is convenient, but it also shrinks the amount of equity you have. If the value of your home decreases after borrowing against the line of credit, you might become underwater on your mortgage.

Additionally, if the value of your property falls significantly below the appraised value or your lender no longer feels like you can make your payments because of a change to your finances, the lender may reduce or freeze your line of credit.

If this happens, you won't be able to draw funds from your HELOC, but you'll still need to repay what you borrowed.

Learn more: Why Is Building Home Equity Important?

Fees

You may have to pay several fees to get and keep a HELOC, including closing costs. Many HELOCs have an annual fee you must pay to keep the line of credit open. Some lenders may also charge an inactivity fee if you don't make enough withdrawals or an early cancellation fee if you close the line early.

You need to have enough cash on hand to cover these costs.

Learn more: How Much Are Home Equity Loan or HELOC Closing Costs?

Credit Requirements

Borrowers generally need a strong credit profile to qualify. Although requirements vary by lender, some may want to see credit scores of at least 660 to approve a HELOC application.

Credit Score Impact

A HELOC can impact your credit scores when you apply, open and use the line of credit. Your credit scores can decrease slightly after submitting an application, but this is temporary. A HELOC has the potential to hurt your credit score if you fall behind on payments.

When Should You Get a HELOC?

To decide whether a HELOC may be a good option for you, there are several things to consider. That includes the amount of equity you have in your home, how you plan to use the money and your financial health. Getting a HELOC may make sense if:

• You have significant equity. You usually need to have accumulated at least 15% to 20% equity to qualify for a HELOC.
• You're planning to use the money for home renovations or improvements. A HELOC may be a good option if you plan to use the funds for projects that will increase the value of your home.
• You can cover fees. You'll need to have enough cash to pay closing costs upfront, and ongoing fees that may be associated with maintaining and using the credit line.
• You need flexibility. A HELOC could be a better option than a home equity loan when you need to cover multiple expenses over time rather than a single large expense.
• You're comfortable in your ability to repay what you borrow. Because your house is on the line when you open a HELOC, it's crucial that your financial health is in good shape. Having a financial cushion can put you in a position to continue making your payments on time if you experience a financial hardship.

When Should You Avoid a HELOC?

While a HELOC can provide access to significant sums of cash, it may not be your best option if:

• You need to finance a one-time expense. A traditional installment loan such as a personal loan may be a better option than a line of credit to make a single purchase.
• Your financial health is questionable. If you're struggling to pay your bills every month and don't have a healthy emergency fund saved up, tapping your home's equity isn't a good idea.
• You want to make a discretionary purchase. Using your house as collateral for a nonessential item like a dream vacation isn't a good idea.

Alternatives to a HELOC

If you're not sure whether a HELOC is right for you, here are some alternative ways you may be able to get the cash you need.

Home Equity Loan

A home equity loan also lets you borrow against the equity you've accumulated, but it's an installment loan rather than a line of credit. Its lump-sum nature can make it a better alternative if you need cash to cover a one-time expense.

Home equity loans have fixed interest rates and predictable monthly payments that remain the same throughout the life of the loan, making it easy to budget.

However, because a home equity loan is secured by your house like a HELOC, you still risk foreclosure if you can't repay what you borrow.

Learn more: Pros and Cons of Home Equity Loans

Cash-Out Refinance

A cash-out refinance offers a third way to tap your home's equity by replacing your current mortgage with a new, larger one. The new loan pays off your original mortgage and allows you to keep what's left as cash to use for almost any purpose.

Like a HELOC, a cash-out refinance will reduce the equity you have in your home and put your house on the line if you're unable to make your payments. Plus, you'll have to pay closing costs like you did when you purchased your home.

Because you're getting a new loan, your interest rate may change. If interest rates have gone up since you purchased your home, your monthly payments could be much higher than they were before. Additionally, your loan term will start over, which may extend your repayment timeline.

Tip: A cash-out refi may be a good option if interest rates have decreased or your credit has improved because you might be able to get a lower rate. However, they aren't usually a great option if rates have risen since you took out your original loan.

Personal Loan

Personal loans are generally unsecured and don't require you to put your home at risk, but if you're unable to make your payments, your credit will still take a hit.

You may not be able to borrow as much with a personal loan as you would with a HELOC, and loan terms tend to be shorter. Since they're generally unsecured, personal loans are riskier for lenders, so they tend to have higher interest rates than HELOCs.

Learn more: What Can a Personal Loan Be Used For?

Student Loan

A student loan may be a good option if you need cash for educational expenses, such as college tuition. Student loans are unsecured, and federal student loan programs may have graduated repayment plans, assistance if you're unable to make your payments and the potential for loan forgiveness.

The Bottom Line

A HELOC may be a good option for borrowers with a strong credit profile, steady income, financial cushion and clear repayment plan. Because HELOC payments can be unpredictable and may be higher than anticipated depending on the interest rate environment, having a financial cushion can help you stay on track.

Before applying, check your credit to see how likely you are to qualify. You can check your credit reports from all three consumer credit bureaus (Experian, Transunion and Equifax) for free once a week at AnnualCreditReport.com, and you can check your FICO^® Score^☉ for free from Experian at any time.