Your home is very likely your most valuable asset. If you put a large amount of money down, have paid your mortgage for several years, or seen home values significantly rise in your neighborhood, chances are that you’ve built up a tiny amount of equity in your property—the difference between what you owe on your mortgage and what your house is worth if you sold it now.
That can add up to a sizable amount of money. If you purchased a $250,000 home 10 years ago with 20% down and a 30-year, 5% mortgage, the equity on your loan would be nearly $88,000 today. And that’s not counting any increase in property value, which averages 3 – 5% annually, depending on where you live.
That’s a nice chunk of cash, but there’s one problem—it’s all tied up in your house. If you have a medical emergency, need to replace your roof or need to access your home’s value for any other reason, pulling that money out can mean selling or refinancing the house, which is expensive and time-consuming. Financial experts call such assets, “illiquid” because it’s hard to easily tap that cash flow.
Meet the HELOC
The alternative is a home equity line of credit. A home equity line of credit, or HELOC, is a loan based on the value of your home beyond what you owe that, once approved, can be accessed with a check or even a debit card. Interest rates for HELOCs tend to be lower than other forms of credit, since the loan is secured by your home. Even better, the interest is deductible if you itemize your taxes. Typically, you can borrow up to 85% of your home’s value, minus your remaining loan balance, although some lenders limit your maximum to 60% of your available equity. In the example used above, that means you could borrow up to about $50,000 for any purpose you like.
Home equity lines are different from home equity loans, which are based on the same idea. Loans, however, are made for one fixed sum over a fixed number of years at a fixed payment and rate of interest, while a line of credit works like a credit card—you’ve got a credit limit, but you choose when and how much to borrow, with the interest rate fluctuating over time. Most equity lines of credit are interest-only loans for the first 10 years, called the “draw period,” when you can access that money. At the end of 10 years, the line is closed and you have to make regular payments on the balance, or refinance the loan.
How to Get a HELOC
Like any other loan, the quality of your credit history is going to influence what rate of interest you’ll pay and whether you qualify for a line of credit at all. After the housing meltdown in 2007 triggered the great recession, equity lines were hard to get at all. They’re available now, but lenders still want to see good or very good credit. While credit scores typically range from 300 to 850, HELOC lenders will want to see a score of at least 680, with some lenders requiring a score of 720 or better. In addition lenders also will review your debt-to-income ratio, which is your total of outstanding debt vs. your income. Most lenders want to see no more than 45%, meaning someone with a $5,000 monthly income could have total debt—car payments, mortgage, credit cards, student loans and so on – where the payments totaled no more than $2,250 a month. Additional credit concerns will include factors such as your length of employment and whether you have any bankruptcies, foreclosures or real estate short-sales in the past.
Applying for a home equity line of credit is a lot like applying for a mortgage —lenders will need an application, will want to check your credit, appraise the property, conduct a title search and so on. The fees for those items and other application requirements make it important to shop around—rates and costs can vary widely. In addition, some lenders charge an annual fee to maintain a credit line or a fee for each withdrawal. In some cases, lenders will waive all or most fees if you immediately borrow a set minimum amount—usually $10,000 or more— for a minimum amount of time. In those cases, you’re like to face a penalty if you pay off the line of credit early.
What’s Your Rate?
Beyond loan fees, you’ll also pay interest, which averaged around 5.5% during July, August and September, according to Bankrate.com. That rate will fluctuate based on an index, such as the prime rate, with the lender adding a margin. With the prime rate at 4.25%, a HELOC with a margin of 1.5 percentage points would charge 5.75% on your outstanding balance.
The good news is that, just like a first mortgage, you’ll be able to deduct home equity interest on your federal income tax, if you itemize deductions. That helps lower your overall cost, but just because you can write-off some of the cost doesn’t mean you should borrow more than you need—after all, you’ll still be the one paying the bulk of the interest. If you’re in the 25% tax bracket, the IRS may give you back 25 cents for each dollar of interest, but the other 75 cents is still coming from you.
Overall, you’ll want to compare what lenders charge for total fees, margins and costs over time before finalizing a loan. Because HELOCs are variable-rate loans, check out how high your rate can go if broader interest rates rise.
Advantages of Home Equity Lines
The advantage of equity lines of credit is the flexibility in when and how much you can borrow, lower interest rates compared with other types of borrowing, tax deductibility and the interest-only payments available for the draw period. HELOCs often are used to fix up or repair a home, finance college education, pay off other debts or even to start a business.
In general, financial advisors will recommend tapping home equity when you need to repair your home since the home will be securing the debt. For example, using a HELOC to add on a room or convert a basement your home could allow you to avoid the much larger expense of moving to a larger home, and at least some of that investment in your home will add to what you’ll get when you eventually sell the house.
Disadvantages of HELOCs
The big disadvantage of a home equity line of credit is that you can be adding significant debt, putting your home at risk if you don’t keep up with the payments. In addition, it’s easy to be lulled into a false sense of safety during the draw period, when you’re allowed to make interest-only payments, then get hit by the balance at the end. If interest rates rise rapidly, you’ll also see your payments increase.
While some people keep a line of credit open for emergencies, your HELOC can be frozen by the lender if the value of your home declines. During the great recession, many homeowners found their lines cut off after home prices plummeted.
The other downside to a HELOC is the temptation to over-spend, thanks to what’s called the “wealth effect:” the knowledge that you have an asset that’s worth a lot of money on paper, but that you haven’t converted into cash. This can cause people to draw down equity lines for vacations and other luxury spending.
Using a line of credit to pay off accumulated debts in one fell swoop also is a dangerous strategy, because you may not address the situation that caused you to have excess credit card or other debt in the first place. In many cases, homeowners wipe out a pile of credit card debt but continue to run up their balances, resulting in more debt on their home in addition to even more credit-card debt. Finally, any money that you use to pay off your HELOC is cash that could be saved and invested but, instead, is going toward debt.
All in all, a home equity line of credit can be a good tool to handle big, temporary expenses in a flexible way but, like all debt can be abused. Before taking out a loan, consider alternatives such as a cash-out refinance, borrowing from savings or taking out a home equity loan, where you won’t be exposed to a balloon payment and the threat of rising interest rates. If you do borrow, aim to pay more than the minimum during you draw period and give yourself a schedule to pay off the loan. Before you sign, make sure to understand all the terms and conditions, including your margin, rate caps and any minimum borrowing requirements.