HELOCs can be a path to increased cash flow or help you cover large expenses.
You need equity in your home to take out a HELOC.
HELOCs are revolving credit, not an installment loan, so they can offer flexibility.
HELOCs are tied to your home, which can be a risk for borrowers.
Home equity lines of credit, or HELOCs, let you convert the equity in your home to a line of credit you can draw on. HELOC funds can be used to cover emergencies, large expenses, or even experiences, such as a family vacation.
Discover how a home equity line of credit works, as well as the pros and cons, so you can make an educated financial choice for your family.
A HELOC is a revolving credit account similar to a credit card. However, it’s secured by equity in your home.
How Does a Home Equity Line of Credit Work?
A HELOC is a form of second mortgage. If you have equity in your home and meet other requirements, such as having a good credit score and income high enough, you may be able to get approved for a HELOC. It’s a line of credit, which means you can draw on it as you need. Since it’s revolving, you pay back what you borrow and then you can use the funds again—similar to how you might use a credit card.
You don’t need a down payment to take out a HELOC. You do, however, need to meet the requirements of your lender. Those vary from lender to lender, but common requirements can include the following:
A decent debt-to-income ratio—lenders may not offer you a HELOC if you have a lot of debt compared to your income
Here’s a more detailed breakdown of how HELOCs work.
You need equity in your home. This means the home is worth more than you owe on it. For example, if your home is worth $200,000 and you owe $80,000, you have $120,000 in equity. You may be able to get a HELOC for part of that amount. Most lenders won’t approve a HELOC for 100% of your equity.
Equity secures your home equity line of credit in the same way your home secures your first mortgage. The HELOC doesn’t transfer if you sell the home, which means it all has to be paid back with proceeds from the home sale if that happens. The bank might also be able to force the sale of the home to get its money back if you don’t make appropriate payments.
You can use the HELOC funds as you like for the most part. Depending on the structure of your home equity line of credit, you may be given checks you can write to draw on the funds. In some cases, you may be given a debit card you can use a lot like a credit card.
You pay back the funds you use with interest, similar to how you pay for a credit card. HELOCs sometimes come with adjustable rates, so the interest might fluctuate. You only pay interest on the amount you actually borrow. You don’t pay interest on the portion of the line of credit that you don’t use.
As you pay back funds you’ve used, they become available again. If you have a HELOC with a credit limit of $50,000 and you use $10,000, then you have $40,000 left that you can access. If you pay back $5,000 (plus interest) of the $10,000 you used, you have $45,000 in available credit again.
HELOCs are limited by a draw period. During the draw period, you can continue to borrow against the line of credit. Once the draw period is over, you can only repay any outstanding balance with monthly payments as agreed. Typical draw periods are between 5 and 10 years, with repayment lasting as long as 20 to 25 years.
Home Equity Loan vs a HELOC
A home equity line of credit is not the same as a home equity loan. Here’s a breakdown of ways they’re the same and how they’re different.
Home Equity Line of Credit
Home Equity Loan
Secured by equity in your home
Secured by equity in your home
Acts as a second mortgage
Acts as a second mortgage
Funds are available as you need them during the draw period
Funds are provided as a single lump-sum payment
You make a monthly payment and can reborrow what you pay back during the draw period
You make a monthly payment but cannot reborrow what you pay back
Interest is typically adjustable, so it may fluctuate over time
Interest may be fixed or adjustable, depending on the terms of the loan
Home equity lines of credit come with benefits and disadvantages. It’s important to understand both to decide if getting a HELOC is a good financial move for you. Review these pros and cons and discuss your options with a financial advisor.
Benefits of HELOCs
Flexibility. You decide when and how to use the funds, and you can draw from a HELOC at any time during the draw period. As long as you make the required minimum payments, you can also manage how you pay the debt off.
Lower interest rates. In many cases, HELOCs come with lower interest rates than some other types of credit. That’s because they’re secured by your home value, so there’s less risk for the lender.
Tax-deductible interest. Some or all of the interest you pay on your HELOC debt could be tax deductible. That can help lower your tax burden at the end of the year. These rules can be a bit complex, though, so talk to a tax professional about your options to avoid mistakes on your tax returns.
Disadvantages of HELOCs
Diminished equity. The more you use your HELOC, the lower your equity is. Put simply, using your HELOC means you owe more on your home, and it reduces other options for leveraging your equity.
Your HELOC is tied to your home ownership. If you default on minimum HELOC payments, you could end up losing your home to foreclosure. And that’s true even if your original mortgage is in good standing.
Temptation to overspend. Some HELOCs can provide lines of credit much bigger than average credit card limits. That access to cash can make it tempting to make big purchases even when you shouldn’t—and you’ll eventually have to pay for all those purchases. If you’re not good with money management, a HELOC can be a door to a debt spiral.
COVID-19 and Home Equity Lines of Credit
The coronavirus pandemic and the subsequent economic uncertainties have caused some banks to discontinue offering HELOCs, at least temporarily. Banks that stopped accepting HELOC applications include JP Morgan Chase, Wells Fargo, and Citi. While many larger banks have put a hold on HELOCs, home equity lines of credit may still be an option for borrowers working with smaller banks or other lenders.
Alternatives to HELOCs
HELOCs have a lot of benefits, but they aren’t right for everyone. And if you don’t have equity in a home, they aren’t even an option. Here are some alternatives to consider.
Personal loans. Personal loans provide a lump-sum amount you can usually use for almost any legal purpose.
Mortgage refinancing. Refinancing your mortgage at a lower rate or for longer terms can help reduce how much you pay each month. That can help you stabilize cash flow or free up some of your income for other purposes.
Credit cards. Credit cards can be a way to cover immediate expenses, especially if you can get approved for a card with a 0% introductory APR offer. These offers let you make purchases and pay them off without any interest for the duration of the introductory offer.
HELOCs are a great financial tool, but they’re just one option. When taking on debt, make sure you consider all your options so you can make the best decision for yourself and your family. Review your credit report and credit score regularly so you know your financial standing.
