A home equity line of credit, or HELOC, is a type of secured loan that gives you access to cash based on the equity in your home. You draw from a HELOC as needed and repay some or all of it monthly, somewhat like a credit card.
When applying for a HELOC, a lender will usually evaluate if you have enough equity in your home—the difference between your home's current value and what you owe on your mortgage—for the amount you want to borrow.
Although a HELOC can be a flexible and often inexpensive way to borrow money, it doesn't come without risks. Take a look at the pros and cons of a HELOC to see if it's a good choice for you.
Pros of a HELOC
A HELOC can be a convenient way to tap into the equity in your home to pay for a large renovation, consolidate debt, cover the cost of college and more. A HELOC also comes with a few other advantages.
Lower Interest Rates Than Unsecured Loans
A HELOC is secured by your home as collateral for the loan. For that reason, lenders typically consider HELOCs less risky than some other types of financing, like unsecured personal loans or high-interest credit cards. As a result, lenders can often offer lower interest rates and initial closing costs. However, because HELOCs are often adjustable-rate loans, your HELOC's interest rates can increase or decrease over time.
Only Borrow What You Need
Unlike a loan where you get one lump sum to be paid back in equal installments, with a HELOC, you can choose to borrow only what you need up to your credit limit. HELOCs typically give you a 10-year "draw period" during which you can borrow money. You'll make low, often interest-only monthly payments during this time.
When the draw period closes, the HELOC must be paid back in full, typically over 20 years. At this time, you can also opt to refinance.
Flexible Repayment Terms
Depending on the lender and how much you borrow, you may have flexibility in terms of how you pay off your HELOC. Some lenders offer a discounted interest rate for a short time, called an introductory rate, which can temporarily make your monthly payments more manageable.
During the draw period, you may only have to make interest payments based on your balance, but you might also be able to pay toward your principal if your lender allows it. Keep in mind that if you make interest-only payments during the draw period and borrow a large amount, say $50,000, you will have much higher monthly payments once the draw period ends and you begin repaying the principal amount.
Cons of a HELOC
Although HELOCs offer many benefits, including lower interest rates than on unsecured loans and flexible repayment terms, there are a few drawbacks.
Risks Your Home as Collateral
With a HELOC, you use your home as collateral for the loan. Anytime you put up collateral, you risk losing it if you cannot make your payments. Because losing your home is a very real possibility if you fall behind on HELOC payments, consider your ability to repay carefully.
Also, if the value of your property falls significantly below the appraised value, or if your lender no longer feels you can make your payments because of a change in your finances, your lender may reduce or freeze your line of credit. Should this happen, you can no longer draw funds from your HELOC.
Interest Rate Is Usually Variable
Most HELOCs come with variable interest rates, which can rise and fall with market rates. Although in some cases a variable-rate loan can be a better option than a fixed-rate loan, especially if interest rates are dropping, a HELOC with a variable interest rate runs the risk of costing you more over time if market rates rise.
Lowers Your Home Equity
When you take out a HELOC, you shrink the equity in your home that you've worked so hard to build up. If the housing market in your area slows, you could end up owing more on your loan than your home is worth, meaning you are underwater on your mortgage. This may also be true if you bought high and property values have fallen significantly since then.
Depending on how much the value of your property has decreased since you purchased your home, you may also have little equity or even negative equity, where the value of your home is less than the original mortgage principal.
Should You Get a HELOC?
Because your home is used as collateral for the HELOC, your lender may be more willing to lend you the money, even if your credit is less than stellar. However, it's common for lenders to want to see a credit score of at least 680 or higher. Although not the only determining factor in getting a HELOC, if your credit is on the low end, having significant equity in your home may tip the scale in your favor.
Since lenders typically let you borrow between 60% and 85% of your property's current appraised value (minus your remaining mortgage balance), a HELOC can be a less expensive option than credit cards or unsecured personal loans, particularly if you're using it for a large expense such as a home remodel.
Keep in mind that closing costs on a HELOC can range from 2% to 5% of the line of credit amount, so factor in that amount when deciding whether a HELOC is right for you. However, some lenders charge no closing costs at all.
Alternatives to a HELOC
When you need an influx of cash to pay for a large expense or consolidate debt, a HELOC isn't your only option. Here are others.
Home Equity Loan
With a home equity loan, you borrow against the equity in your home, just like a HELOC. But home equity loans are installment loans, so you receive the total amount upfront and make fixed monthly payments over the loan's term. Because a home equity loan usually offers a fixed interest rate, your payments are predictable and remain the same over the life of your loan. That can make it easier to budget your month-to-month expenses. Keep in mind that just as your first mortgage is secured by your home, so is a home equity loan—and the same risks apply.
Unsecured Personal Loan
An unsecured personal loan does not require collateral. That's good news since you won't risk losing your home if you can't make your fixed monthly payments. However, anytime you miss payments on a loan or another type of financing, your credit score can take a hit.
Many personal loans have shorter repayment periods than home equity loans and are best if you need to borrow a smaller amount. Because the loan is unsecured, it can be more challenging to get a loan if you have poor credit and you may pay higher interest rates on a personal loan than with a HELOC.
If you have substantial equity in your home, a cash-out refinance may be an option. A cash-out refinance is a new, larger loan that pays off the balance on your original mortgage and lets you take what is left over as cash to be used for most any purpose.
The catch? You lose a portion of the equity you've built up, have a larger loan balance, may have to pay closing costs and are not guaranteed a lower interest rate than what you're already paying or that you might pay with a HELOC or home equity loan. However, if you are in a better financial position now than when you took out your first mortgage, you could possibly reduce your loan term and interest rate (lowering your total costs) and still get the cash you need.
The Bottom Line
In certain circumstances, a HELOC can be a good option. HELOCs often come with lower interest rates than unsecured loans and many credit cards, but the rate is variable, meaning it can go up or down. Your house is also used as collateral, providing less risk for lenders but more risk for you if you can't make the monthly payments.
Before applying for a HELOC (or any other type of financing), get your free credit report and credit score to see where you stand. It can often be better to sit tight and work to improve your score before you apply. That way, you get the most competitive terms when you're ready to proceed.