If you have equity on your home, you might be able to convert it to cash. This can help you cover a big expense or emergency financial needs. One way to do that is by taking out a home equity line of credit, or HELOC. How does a home equity line of credit work, and is it a good idea for you? Get some information below and make an informed decision for yourself and your family. Talk to your preferred lender or trusted financial advisor to find out what choice is right for you.
What Is a Home Equity Line of Credit?
A HELOC is a revolving credit account similar to a credit card. However, it’s secured by the value of your home.
How Do Home Equity Lines of Credit Work?
HELOCs work a lot like credit cards. You have to apply, and if you’re approved, you get a total credit line. The credit line is secured by your home equity, which means the value of your home is used as collateral for your line of credit.
Whether or not you can get a HELOC, how much your interest rate will be and the total credit limit depend a lot on your credit score, as well as other financial factors. Before you apply for any line of credit, make sure to check your credit score.
If you’re approved for a HELOC, you gain access to an account with the funds. Typically, you can write a check or use a debit card to borrow cash from those funds. And just like a credit card, you’ll pay back the funds with interest. So you could make just the minimum payment, but you could choose to pay back what you borrowed that month in full. Many of these types of accounts have an expiration date, leaving you a large balance to pay or refinance at the end of the term. Keep that in mind when choosing your payment amount.
As you pay back funds you’ve used, they become available again. So, if you have a HELOC with a credit limit of $50,000 and you use $10,000 to cover a major expense, then you have $40,000 left that you can access. However, if you pay back $5,000 plus interest of the $10,000, you have $45,000 in available credit again.
HELOCs vs. a Home Equity Loan
While they both utilize your home as collateral, a HELOC is not the same as a home equity loan. A home equity loan is an installment loan, like a mortgage or car loan. You borrow a certain amount of money and make a fixed payment for a set period of time to pay it back.
The Benefits and Disadvantages of HELOCs
HELOCs come with benefits and disadvantages. It’s important to understand both to decide if getting a HELOC is a good financial move. Here’s a quick look at some of the pros and cons of HELOCs.
What Are the Benefits of HELOCs?
- Flexibility. You decide when and how to use the funds, and you can draw from a HELOC at any time. And as long as you make minimum payments, you can also manage how you pay the debt off. That makes a HELOC more flexible than a home equity loan, which locks you into a specific monthly payment.
- Lower interest rates. In many cases, HELOCs come with lower interest rates than other types of credit. That’s because they’re secured by your home value, so there’s less risk for the lender. You can use your HELOC to pay off higher-interest debt or to fund a large purchase without a higher-interest loan.
- Tax-deductible interest. Some or all of the interest you pay on your HELOC debt can be tax deductible. That can help lower your tax burden at the end of the year.
What Are the Disadvantages of HELOCS?
- Diminished equity. The more you use your HELOC, the lower your equity will be. Put simply, using your HELOC means you owe more on your home—maybe even as much as the home is worth.
- 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.
Alternatives to HELOCs
HELOCs can be a great way to access cash for emergency needs or big purchases. But they might not be right for everyone. Plus, you also need home equity to get a HELOC. So if you aren’t a homeowner, a HELOC isn’t an option. If you’d prefer a more traditional option or don’t have home equity, here are a few other options to consider.
- Personal loans. Personal loans can be used for a variety of expenses. To get approved for personal loans, lenders typically look at your credit history and income.
- Mortgage refinancing. Refinancing your mortgage at a lower rate or longer terms can help reduce how much you pay each month. That can help you stabilize cash flow or use your income for other needs.
- 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.
Is a HELOC a Good Idea?
Whether or not a HELOC is a good idea depends on your financial situation. During a recession or emergency, such as the COVID-19 crisis, a HELOC might be the help you need to cover expenses while waiting for an upturn in the economy. However, remember that you can lose your home if you can’t make minimum payments. Consult a financial advisor and look at the big picture of your own finances before you opt to dive into a HELOC.