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You may be considering a home equity line of credit (HELOC) if you've built a substantial amount of equity in your home and need to take out a loan. If you can qualify for a low interest rate and good terms, it may not be a bad idea. But consider alternative financing if you don't want to use your house as collateral. Find out when a HELOC may or may not be a good choice, as well as other options that might make more sense for you.
When It Can Be a Good Idea to Get a HELOC
A HELOC is a second mortgage that provides a credit line you can borrow against up to a certain limit for a certain period of time, usually 10 years. If you have sufficient equity built up in your home, a HELOC can be a good option when you need to borrow money for a large expense or other goals. Here's when getting a HELOC might be advantageous.
Consolidating High-Interest Debt
Because HELOCs use your home as collateral, interest rates are usually significantly lower than credit card interest rates. Using a HELOC to consolidate high-interest debt can help you save money on interest. It can also reduce your monthly expenses, especially if you have a significant amount of debt and are having trouble paying your bills.
Making Home Improvements
One of the most common ways to use a HELOC is for home renovations or improvements. HELOCs allow you to borrow money as you need it, making it suitable for projects that might be completed in stages. Plus, if you use a HELOC to pay for home improvements, the interest may be tax deductible under certain circumstances.
In addition, upgrades to your home can add to its value. You'll enjoy an updated living space, and when you're ready to sell, you may see more interest from potential buyers.
Paying for College
The average tuition and fees at public four-year colleges and universities were $9,400 in 2020-21, and that doesn't count room and board. While federal student loans are the most common and generally the best way to fund a college education when you need to borrow, a HELOC might be an option if you don't qualify for federal loans or you need more than they provide. HELOCs may also offer lower interest rates than private student loans or parent PLUS loans.
If you do qualify for federal student loans, you'll also have access to forbearance, deferment, forgiveness or income-based repayment plans if needed—programs not available with other types of financing—which is why it's usually best to opt for federal student loans when possible. Scholarships and grants are also money-saving options to pay for your or your child's education.
When You Shouldn't Get a HELOC
Although there are times when using a HELOC may make sense, it's not the best option in all cases. This is especially true if there's any risk you won't be able to pay back the loan, since you could lose your home if you miss too many payments.
The times when a HELOC may not make sense include:
Paying for a Wedding or Vacation
Vacations can be expensive, but adding to your overall debt to pay for time away, a wedding or honeymoon with a HELOC is generally not a wise move. If you can't afford a vacation or wedding on your income or what you have tucked away in a savings account, tapping into your home's equity is a risk you may not want to come home to.
Buying a Car
Using a HELOC to buy a car may not be the best idea for several reasons. First, if you have good credit, you may get an auto loan with a lower interest rate than a HELOC.
With an auto loan, you'll pay back the loan plus interest over a set time period, usually three to six years. However, with a HELOC, you're not required to pay the principal until after the draw period ends, which is typically 10 years after your HELOC is approved. That means it's possible you could be paying off your HELOC far longer than the useful life of your vehicle. In addition, a car loan will usually have a fixed interest rate and loan payment, making it easier to budget for than a HELOC, which typically comes with an adjustable interest rate.
Paying for Nonessentials
Building equity in your home is important because it is a long-term way to help strengthen your financial stability. But using that equity to pay for nonessentials, like a flatscreen TV, luxury speedboat or fancy car, puts your home at undue risk. It's also worth noting that HELOCs come with upfront closing costs that can add to the price of that expensive purchase.
What to Consider Before Getting a HELOC
HELOCs can be a good option in some cases, but there are a few things to consider before you set things in motion.
- Your equity: Generally, HELOCs let you borrow up to 85% of your home's value, minus any balance you owe on your current mortgage. If you don't have sufficient equity in your home, you'll likely not qualify for a HELOC.
- Your credit: Credit score requirements vary by lender, but a credit score of 700 or higher is typically preferred. Your credit score is also an important factor in the interest rate you'll receive on your HELOC. Even if you're approved, a lower score may make a HELOC an expensive option.
- The possibility of losing your home: Anytime you use your home as collateral, you risk losing it to foreclosure if you fall behind on your payments.
- Potentially high closing costs: Like with your mortgage, when you take out a HELOC, you'll likely pay closing costs, which could range from 2% to 5% of the amount of your line of credit.
- Adjustable interest rate: HELOCs usually come with variable interest rates, which means your rate and monthly payments could increase or decrease after you draw money from your HELOC. If you're on a tight budget, fluctuating interest rates can make meeting your monthly payments more challenging. However, some HELOCs may allow converting part or all of your balance into a fixed-rate loan.
Alternatives to a HELOC
A HELOC can be an appropriate option for several reasons, but it also comes with risks, like losing your home if you miss payments. If that's a concern, other alternatives may suit your needs better.
If you don't want to use your home as collateral, a personal loan might be a good alternative. They may have higher rates than HELOCs, but some unsecured personal loans have fewer fees than HELOCs, which can lower your overall costs. You can compare your personal loan options and get matched with loans using Experian CreditMatch™.
A credit card acts much like a HELOC: You only borrow money as you need it and pay interest only on what you spend. With credit cards, though, you can avoid paying interest altogether if you pay your balance in full each month. Additionally, you can earn cash back, rewards or miles with some cards. There are also introductory 0% APR credit cards that offer no interest on purchases, balance transfers or both during the intro period. Once the intro period ends, the card's standard rate will kick in and you'll start accruing interest on any unpaid balance that remains.
With a cash-out refinance, your equity allows you to refinance your current mortgage with a new, larger mortgage and receive the difference in cash. By refinancing your current mortgage, you may be able to lower your monthly payments and get better rates and loan terms. But, like a HELOC, a cash-out refinance also uses your home as collateral for the new loan. If you default on your new loan by missing too many payments, you risk losing your house to foreclosure.
Home Equity Loan
Home equity loans are installment loans that, similar to a HELOC and cash-out refinance, use your home as collateral to secure the loan. Another type of second mortgage, a home equity loan can be a good option if you need a lump sum amount upfront and want a fixed interest rate.
The Bottom Line
Whether or not you should take out a HELOC depends on your financial circumstances and needs. It can come in handy in certain situations, but also comes with risks, the biggest of which is the possibility of losing your home.
Keep in mind that your credit score and credit history can impact whether or not you qualify for a HELOC at the best rates and terms. You can check your Experian credit report and credit score for free before deciding whether a HELOC is right for you.