Navigating HELOCs: Top Benefits and Drawbacks Explained

Banner image
fact checked icon
Reviewed byTimothy Manni
fact checked icon

Updated: March 22, 2024

Advertising & Editorial Disclosure

If you're a homeowner eyeing major home improvements but wondering how to fund them without breaking the bank, you might want to consider a home equity line of credit. They allow you to leverage your home's equity as a credit line, offering lower interest rates compared to certain products and flexibility in how you utilize the funds. Yet, like any financial product, they have some considerations. Our guide explores the pros and cons of a HELOC, guiding you through its benefits like lower costs and financial flexibility, alongside potential drawbacks such as variable interest rates and the risk of overborrowing. Understanding these aspects equips you to make informed decisions that align with your financial situation.

What Is a HELOC and How Does It Work?

Let's say you're planning major home upgrades but want to avoid draining your savings. A home equity line of credit (HELOC) could be your financial lifeline. It acts as a revolving credit line secured by your home. You can borrow money up to an approved limit while repaying at a variable interest rate. This setup allows you to tap into your funds as needed, making it an excellent option for ongoing projects.

HELOCs have two main phases: the draw period and the repayment period. You can borrow money during the former, often only paying interest on what you've taken out. Once this period ends, the repayment period begins, requiring you to pay back the borrowed principal plus interest.

Lenders determine your credit limit by evaluating your home's equity. To apply, you'll need to provide proof of income, undergo a credit check and get your home appraised, among other steps. Understanding how a HELOC works is crucial in utilizing it effectively for your financial needs.

house icon
HOW TO DETERMINE YOUR HOME EQUITY

Home equity is essentially what your home is worth minus any amount you still owe on your mortgage. To determine how much equity you have, subtract the remaining mortgage balance from your home's current market value. For example, if your home is valued at $450,000 and you owe $200,000 on your mortgage, your home equity is $250,000, or around 56%.

Getting an accurate appraisal of your home is crucial. It reflects your home's current market value, which can fluctuate. Your equity is key in determining if you qualify for a HELOC since lenders often want you to have at least 15% to 20% equity before letting you borrow against it.

Pros of a HELOC

HELOCs are a go-to for many homeowners, with an average balance of $42,139 reported by Experian's 2023 Consumer Credit Review. Their popularity underscores a key benefit of a HELOC: access to substantial funds based on your home's equity. It's a flexible way to finance big projects or consolidate debt. HELOCs also stand out for their interest rates, which can be lower than other financing options. Let's dive deeper into how these and other advantages make HELOCs a smart choice for financial needs.

Lower Interest Rates

As of November 2023, the Federal Reserve reports average interest rates of 21.47% for credit cards and 12.35% for 2-year personal loans. In contrast, HELOC interest rates are typically much lower, offering a more affordable borrowing option. The difference can save borrowers a significant amount both immediately and over time.

Lower HELOC interest rates reduce the cost of borrowing, making it easier to manage monthly payments and pay down the balance faster. When securing a HELOC, compare rates from multiple lenders to ensure you get the most competitive offer. Lower rates mean more of your payment goes towards the principal, speeding up your debt repayment.

Flexibility

HELOCs stand out for their flexibility, letting borrowers tap into funds exactly when and as much as they need. Instead of receiving a lump sum upfront, you can draw from your HELOC over a period of time, which means you only borrow what's necessary for expenses as they come up. It can help you manage debt more effectively since you're not paying interest on money you don't yet need.

To maximize this benefit, plan your spending carefully and only use the HELOC for significant, planned expenses. That way, you control your debt and avoid overspending, ensuring you use the financial flexibility to your advantage.

Possible Tax-Deduction

The interest you pay on a HELOC can be tax-deductible, but not in every case. To qualify for this tax benefit, you must use the funds to buy, build or significantly improve your home, as the Tax Cuts and Jobs Act of 2017 outlines. So, if you use your HELOC for other expenses, like paying off credit card debt, you won't get the deduction.

The deduction for HELOC interest is capped at the interest paid on the first $750,000 of debt, a limit shared with your primary mortgage if the funds are used for eligible home improvements. It applies to loans taken out after December 15, 2017. To maximize this benefit, focus on using your HELOC for projects that enhance your property value within this threshold, ensuring you can deduct as much interest as possible come tax time.

Helps You Boost Credit

Opening a HELOC can be a strategic move because it can potentially boost your credit score. A better credit standing can open doors to more favorable loan terms and interest rates down the line, making future financial moves easier and less costly. Here’s how a HELOC can help improve your credit:

  • Diversifies your credit mix: Adding a HELOC to your credit portfolio introduces a new type of credit, showing lenders you can responsibly manage different kinds of debt.

  • Potential for lower credit utilization: A HELOC can lower your overall credit utilization ratio by providing additional available credit, a key factor in credit scoring models.

  • History of on-time payments: Regular, on-time payments on your HELOC can strengthen your payment history, positively affecting your credit score.

Remember to use your HELOC wisely. Don’t max out the credit line; ensure you make all payments on time. This disciplined approach only helps you manage debt effectively. It lets you build a stronger credit profile, demonstrating your reliability as a borrower to future lenders.

Interest-Only Payment Option

A HELOC's interest-only payment option lets you pay just the interest on the money you've borrowed during the initial phase, known as the draw period. It's a standard feature for HELOCs, but some lenders don't offer it. It can ease your financial burden in the short term, giving you flexibility in managing your budget, especially if you're facing other significant expenses.

If you only pay for interest during the draw period, prepare for larger payments later on. That way, you're not caught off guard when the repayment phase kicks in, requiring payments on both the principal and interest. It's a smart strategy to prepare for the future while enjoying lower payments now.

No Usage Restriction

One of the biggest perks of a HELOC is its flexibility. There are virtually no restrictions on how you can use the funds. Unlike personal loans, which may come with specific usage requirements set by lenders, a HELOC lets you decide whether to invest in home renovations, cover education costs or even consolidate debt.

Plan how to use a HELOC wisely. Consider investing in areas that could increase your home's value or significantly improve your financial standing. Thoughtful spending ensures you leverage the HELOC to your long-term advantage, making each dollar work for you.

High Loan Limit

The amount you can borrow with a HELOC depends on your home's value, and the loan-to-value (LTV) ratio lenders use. LTV is a comparison of your loan amount to your home's value, expressed as a percentage. For instance, if your home is valued at $300,000 and you owe $150,000 on your mortgage, a lender offering an 80% LTV allows you a HELOC up to $90,000 ($300,000 value - $150,000 mortgage = $150,000 equity * 80% LTV).

If you have the equity, a HELOC gives you access to a high borrowing limit, which is beneficial for tackling large projects or consolidating significant debt, offering financial flexibility when you need it most.

Cons of a HELOC

While HELOCs offer flexible and affordable ways to access cash, focusing solely on these benefits can lead you into a financial pitfall. For example, a HELOC's variable interest rate, which can fluctuate and increase your payment amounts unexpectedly, can be a challenge. There's also a real risk of losing your property if you can't keep up with repayments since it's secured by your home. These are reminders that while financial tools are powerful, you must handle them carefully. Let's explore other aspects to fully understand the challenges of a HELOC.

Variable Rates

A HELOC's variable rates mean that the interest you pay can fluctuate over time depending on broader economic conditions. As a result, your monthly payments could increase unexpectedly, making budgeting a challenge. If rates go up, you might find yourself paying more in interest than you planned, which could strain your finances.

Consider locking in a fixed-rate option for a portion of your balance if your lender offers it. Also, staying informed about rate trends and setting aside a buffer in your budget for possible rate increases can help you manage this risk more effectively. Keeping an eye on your spending and borrowing only what you need will minimize the impact of rate changes.

Secured By Your Home

With a HELOC, your house acts as collateral for the loan. You could lose your home to foreclosure if you can't make payments. That introduces an additional layer of risk to your financial stability — it's not just your credit score that's at stake but also your place of residence.

To reduce this risk, only borrow what you need and can afford to repay. Make a solid repayment plan and stick to it. It's also wise to build an emergency fund to be prepared for unexpected expenses without relying heavily on your HELOC.

Further Lowers Your Equity

A HELOC lowers your equity because you're borrowing against the value of your home. Every dollar you draw from a HELOC is a dollar less in home equity, the portion of your property you truly "own." If home values drop, you could end up owing more than your home is worth.

To mitigate this, borrow wisely. Use HELOC funds for investments that could increase your home's value, like renovations or repairs, rather than for everyday expenses. Also, regularly pay more than the interest-only payments to rebuild your equity faster.

Potential of Overspending

A HELOC gives you access to a large sum of money, which can tempt you to spend more than you need, leading to a high balance that's tough to pay off. It can result in debt that grows over time, making it harder to manage your finances and possibly putting your home at risk.

To avoid overspending, create a budget for how you'll use the HELOC funds, focusing on necessary expenses or investments that add value to your home. Treat it like any other loan by monitoring your spending and setting limits for yourself. Also, plan to repay what you borrow as soon as possible rather than just covering the interest. This discipline helps you use a HELOC wisely without falling into a debt trap.

Ongoing Fees

Having a HELOC can come with ongoing fees, adding to the cost of borrowing. These include:

  • Annual fees to keep the credit line open.
  • Transaction fees for each time you draw funds.
  • Inactivity fees if you don't use the HELOC for a certain period.

These fees mean you're paying extra just to have access to funds, whether you use them or not, which can make a HELOC more expensive over time.

To lessen these costs, shop around and compare different lenders' fees before choosing a HELOC. Ask about fee waivers or discounts, and plan your withdrawals to minimize transaction fees. Also, utilize your HELOC actively but wisely to steer clear of inactivity fees. Understanding and managing these fees can help you keep the cost of your HELOC in check.

Possible Payment Shock

After the HELOC draw period, where you only pay interest, you enter the repayment period. You must start paying back the interest and the principal amount borrowed. The shift can significantly increase your monthly payments, a phenomenon known as payment shock. It can suddenly strain your budget, especially if you're not prepared for the higher payments.

Start paying towards the principal during the draw period; you can reduce the amount you owe later. Also, budget for the future by understanding the potential increase in payments and saving accordingly.

excellentCredit icon
DOES A HELOC IMPACT YOUR CREDIT SCORE?

A HELOC can impact your credit score in both positive and negative ways. If you borrow too much or miss payments, it might drop because lenders see you as a higher risk. However, if you manage your HELOC responsibly, it can help improve your credit. Responsible management shows lenders you're good at handling debt, which can increase your credit score. A HELOC allows you to prove your creditworthiness but also requires careful financial management.

Is a HELOC Your Best Choice?

Opening a HELOC is a major financial decision that could impact your life significantly. Taking the time to consider whether a HELOC suits your needs is crucial. Failing to manage one properly could lead to financial strain or even the loss of your home. Before jumping in, it’s wise to ask yourself some essential questions to guide your loan decision:

1

How stable is my income?

If you have a stable and reliable income, you're in a better position to handle the variable payments that come with a HELOC. Conversely, if your income is unpredictable, the fluctuating payments could pose a financial risk, indicating that a HELOC might not be the best option.

2

What’s my plan for using the funds?

Planning to invest in home improvements that increase your property's value or consolidate high-interest debt can make a HELOC a smart financial tool. However, if the funds go towards everyday expenses or non-essential purchases, the risk of unnecessary debt increases and a HELOC may not be advisable.

3

Can I handle the financial responsibility?

Evaluate your financial habits critically. A disciplined approach to spending and repayment indicates a HELOC could work well for you. Conversely, if you're likely to succumb to the temptation of accessible funds, the potential for debt accumulation suggests a HELOC might not suit your financial behavior.

4

What are my long-term financial goals?

If a HELOC aligns with your goals, such as enhancing home value or efficiently managing debt, it could be a beneficial move. But if taking on more debt contradicts your financial objectives, like saving for retirement or maintaining a low debt-to-income ratio, reconsidering a HELOC would be wise.

5

How will a HELOC impact my overall debt situation?

Adding a HELOC could be a strategic way to streamline debt at a lower interest rate, especially if you're consolidating higher-interest loans. However, if it merely adds to your debt burden without a clear payoff strategy, the impact on your financial health could be negative, suggesting alternative financing might be better.

Deciding on a HELOC requires a deep dive into your financial situation and goals. If, after asking these questions, you feel confident in your ability to manage the loan and that it aligns with your financial strategy, a HELOC could be a beneficial tool. However, if doubts arise, exploring alternatives might be a better route.

MONEYGEEK EXPERT TIP

When mortgage rates are high, and homeowners aren't interested in refinancing and trading their existing low rate for a higher one, home equity lines of credit are worth even more consideration. HELOCs are best for homeowners with a track record of responsible debt management. HELOCs are a long-term financial commitment. The most successful borrowers only borrow what they need; they follow the markets, understand where interest rates are headed and utilize their credit line to further their home's value or improve their finances. — Timothy Manni, Mortgage and Real Estate Consultant

When to Get a HELOC

Deciding to get a home equity line of credit (HELOC) isn't a one-size-fits-all decision — it's about matching your specific needs and financial situation with the right tool. By considering different scenarios where a HELOC shines, you can better assess if it aligns with your goals. Whether you're making smart investments in your home, managing debt or funding major life events, understanding when a HELOC serves you best can lead to more informed, confident financial decisions. Let's explore some situations that might signal a HELOC is a good fit for you.

Home Improvement or Renovations

Meet Alex, a homeowner with a growing family, looking to add a bedroom and update the kitchen in their 20-year-old home. He needed to find a flexible, cost-effective way to finance these renovations without depleting their savings. After researching various options, Alex considered a HELOC because of the project's substantial cost and the desire to complete it in phases.

Alex weighed several factors before deciding on a HELOC: the competitive interest rates compared to personal loans and credit cards, the flexibility to draw funds as needed over time and the potential for the home improvements to increase the property's value, which could further enhance their home equity.

bigHouseRent icon
WHY WAS A HELOC A SMART MOVE?

Choosing a HELOC was wise for Alex for several reasons. The renovations aimed to increase the home's value, making good use of the borrowed equity. The flexibility to borrow only what was needed helped Alex manage costs more effectively, avoiding the trap of overspending. By enhancing his home, Alex improved his living conditions and invested in his property's future marketability.

Consolidating High-Interest Debt

Jordan found herself struggling with several high-interest credit card debts after a few years of unexpected expenses and emergency situations. The mounting interest made it seem like her balances barely budged despite having made regular payments. Seeking a more manageable and cost-effective solution, Jordan considered a HELOC to consolidate her debts into a single, lower-interest option.

Before deciding on a HELOC, Jordan evaluated her home equity, confirming she had enough to cover her debts. She also considered the HELOC's variable interest rate but found it significantly lower than her credit cards' rates. Additionally, the prospect of simplifying multiple debt payments into one was highly appealing. Jordan was particularly drawn to the potential for lower costs and the chance to improve her credit score over time by maintaining consistent, on-time payments.

debtConsolidation icon
WHY WAS A HELOC A SMART MOVE?

In Jordan's scenario, a HELOC was a smart choice due to several key factors. The lower interest rate offered by the HELOC compared to credit cards meant significant savings on interest payments, making it financially sensible. Consolidating debts into a single payment also simplified Jordan's finances, reducing the chance of missed payments and improving her credit score. Furthermore, the discipline required to use a HELOC effectively for debt consolidation could help Jordan develop better financial habits.

Covering Educational Expenses

Sam, a single parent, faced the challenge of funding her child's education at a prestigious university. With tuition, books and living expenses adding up, Sam needed a financial solution beyond her savings and the daunting prospect of high-interest student loans. She considered a HELOC because she had built up significant equity in her home. Its lower interest rates (compared to personal loans and credit cards) made it an attractive option for covering the costs.

Before making a decision, Sam weighed the potential risks of using their home as collateral against the financial flexibility a HELOC could provide. She thought about the long-term impact on their financial security and the fact that, unlike student loans, the interest on a HELOC used for education wouldn't be tax-deductible. Despite this, the immediate need for a lower-cost borrowing option led Sam to prioritize the HELOC's lower interest rates and repayment flexibility.

graduationCap icon
WHY WAS A HELOC A SMART MOVE?

Choosing a HELOC was ultimately a practical decision for Sam. It allowed her to access the needed funds without the higher interest rates associated with other types of loans. Even though the HELOC didn't offer a tax benefit for educational expenses, its cost-effectiveness in the short term provided a viable solution for supporting their child's academic aspirations. This scenario highlights the importance of carefully considering all financial options and implications when planning for significant educational expenses.

When Not to Get a HELOC

Like any financial tool, a HELOC is not always the perfect fit for every situation. Knowing the scenarios where it could do more harm than good can save you from potential financial stress and complications. It can help you make informed decisions, protecting your home and financial future. Let’s dive into some specific situations where opting for a HELOC might not be in your best interest.

Financing Daily Expenses or Non-Essential Luxuries

Taylor, a graphic designer, found herself frequently dipping into her savings for daily expenses and the occasional splurge on tech gadgets and vacations. With savings dwindling, Taylor considered a HELOC to keep her lifestyle afloat, attracted by the seemingly easy access to funds. However, upon reflection, she realized that using a HELOC for such purposes could jeopardize her home and lead to unsustainable debt, given the non-essential nature of her spending.

Taylor recognized that the root issue was budget management, not a lack of funds. The temporary relief a HELOC could provide would come with long-term risks, including the potential loss of her home if she couldn't keep up with payments. This scenario was a wake-up call to reassess financial priorities and explore safer, more appropriate ways to manage spending.

shoppingBag icon
WHY WAS A HELOC NOT THE RIGHT MOVE?

In this context, a HELOC was not a wise choice due to the risk of securing debt with Taylor's home for non-essential spending. A better option would be a personal loan or a credit card with a low-interest promotional period, ideally coupled with a solid plan to improve budgeting and savings habits. These offer a way to manage expenses without risking valuable assets, providing a more fitting solution for Taylor's needs while encouraging healthier financial practices.

Uncertain Income in the Future

As a freelance photographer, Mia enjoyed her career's freedom and variety but faced fluctuating incomes, which is common in gig-based professions. With dreams of expanding her studio and upgrading equipment, Mia considered tapping into her home equity through a HELOC for the financial boost she needed. However, the unpredictable nature of her income made her pause. The risk of not being able to meet monthly payments during lean periods could endanger her home.

After careful consideration, Mia realized that a HELOC's variable rates and repayment structure, coupled with her uncertain income, could lead to financial instability. The commitment to a HELOC felt too risky without a steady paycheck to rely on, highlighting the need for a financial buffer to protect against income fluctuations.

photoCamera icon
WHY WAS A HELOC NOT THE RIGHT MOVE?

In Mia's scenario, a HELOC wasn't the right fit due to the financial unpredictability inherent in freelance work. Instead, a more suitable financial product for Mia could be a business credit line designed for small businesses or freelancers, offering more flexibility and potentially lower risk than a HELOC. This alternative, along with building a more substantial emergency fund, could provide Mia with the financial support she needs while accommodating the ups and downs of freelance income, ensuring she can pursue her business goals without jeopardizing her home.

Short-Term Ownership Plans

Chris, a software developer, purchased a house in a rapidly growing city with the intention of residing there for only a few years before relocating for work. As home values in the area increased, Chris considered a HELOC to finance a few home improvements, thinking it would boost the house's value even further. However, realizing that he planned to sell the home in the short term made Chris reconsider. The costs associated with setting up a HELOC, including appraisal fees and closing costs, not to mention the potential for interest rates to rise, could actually diminish the profit from the sale of the home.

Upon reflection, Chris recognized that the short-term ownership plan didn't align well with the nature of a HELOC. The time and expense of setting up a HELOC and the uncertainty of recouping those costs in a sale made it an unattractive option.

travel icon
WHY WAS A HELOC NOT THE RIGHT MOVE?

A personal loan emerged as a more suitable financial product for Chris. Unlike a HELOC, it offered a fixed interest rate and a predictable repayment schedule, which better suited his short-term horizon without risking the home's equity. A personal loan can allow Chris to make the necessary home improvements without a HELOC's long-term commitment or upfront costs, aligning more closely with his financial and life plans.

Alternatives to a HELOC

Sometimes, a HELOC might not align with your financial situation or goals due to its variable interest rates and the potential risk to your home if you can’t keep up with payments. Thankfully, several HELOC alternatives can suit different needs without these drawbacks. Knowing your options allows you to make smarter, more secure financial decisions that fit your long-term plans. Let’s explore some alternatives to a HELOC:

Loading...

Each HELOC alternative has advantages, depending on your financial needs and risk tolerance. Whether you’re looking for stability in your repayments, don’t want to use your home as collateral or need a short-term financing solution, there’s an option out there for you. Making an informed choice can lead to a more financially secure future.

FAQ: Pros and Cons of a HELOC

Our FAQ section can shed light on some of the most common inquiries borrowers might have about HELOCs. Whether you're considering applying for a HELOC, curious about how it works or weighing the pros and cons, these answers aim to provide you with a deeper understanding.

A HELOC is a revolving credit line that allows homeowners to borrow against the equity in their home. Unlike a traditional loan, which provides a lump sum upfront, a HELOC gives you access to a set amount of funds you can draw from as needed, similar to a credit card.

A HELOC is often considered a type of second mortgage because it is a loan secured by your property, standing behind your primary mortgage in priority on your home's title.

To qualify for a HELOC, most lenders look for you to have a certain amount of equity in your home (usually at least 15% to 20%), a reliable income, a good credit score (often 680 or higher) and a low debt-to-income ratio. Lenders will also appraise your home to determine its current market value.

The draw period is the time during which you can actively borrow from your HELOC, typically lasting five to 10 years. During this time, you may only need to make payments on the interest. The repayment period follows, usually lasting 10 to 20 years, during which you must pay back the borrowed principal amount plus interest.

Taking out a HELOC can be financially prudent if you use it to enhance your financial position by making home improvements that increase property value or consolidating high-interest debt. However, it's essential to consider the potential risks, including the variable interest rates and the possibility of losing your home if you cannot make payments.

Funds from a HELOC can be used for almost anything, including home renovations, education expenses, debt consolidation or covering significant life events. Flexibility is one of the key advantages of HELOC.

A HELOC can impact your credit score in several ways. Initially, applying for a HELOC might cause a slight dip in your score due to the hard inquiry. However, responsible use of a HELOC, such as making timely payments, can help improve your credit score over time. Conversely, borrowing too much or missing payments can harm your credit score.

The benefits of a HELOC include access to flexible funds, lower interest rates than credit cards or personal loans and the possibility of tax deductions on interest. The risks involve variable interest rates, the potential for overspending and the risk of foreclosure if you cannot repay the loan.

A HELOC offers a line of credit allowing you to borrow against your home equity with flexibility in withdrawals and repayments. On the other hand, mortgage refinancing entails replacing your current mortgage with a new one, potentially featuring different terms and interest rates. Refinancing is best for securing a lower interest rate across the entire mortgage, whereas a HELOC is more suitable for specific, shorter-term financial needs.

If the housing market crashes and your home's value decreases significantly, you could end up owing more on your HELOC than your home is worth. Additionally, if your lender believes the value of your home has fallen below the owed amount, they may freeze or reduce your HELOC limit.

Loading...
sources