What are the Pros & Cons of HELOCs?
A home equity line of credit, or HELOC, is a useful tool for people who want to access the value built up in their homes. If you own a home and it has gone up in value, or you have made significant progress on paying down your mortgage, a home equity loan may be possible for you.
Before you rush and apply, make sure you understand the pros and cons of home equity lines of credit. They make sense for a large number of people, but they are not perfect for everyone. Stick around to learn more about HELOC pros and cons so you can make the best financial decision.
What is a Home Equity Line of Credit?
Before diving into the HELOC pros and cons, here is a quick recap on what a HELOC is and how it works. A home equity line of credit is kind of like a credit card attached to your home equity. You can typically add to the balance multiple times and pay it off over time.
Unlike an installment loan, which is a loan for a fixed amount with consistent monthly payments, a HELOC usually has a variable rate and adjusts the minimum monthly payment based on your balance and current interest rates.
Pros of Home Equity Lines of Credit
1. Low Interest Rate – The biggest benefit of any kind of home equity loan compared to other types of borrowing is the low interest rates. Your home is likely the most valuable thing you own, so lenders are willing to give very low rates to qualifying borrowers when a loan is secured to your home.
The only kind of loan that often has a lower rate is a traditional first home mortgage loan. While it works a lot like a credit card, it charges a lot less than virtually any regular credit card.
2. Add to Balance Repeatedly – Most mortgages, second mortgages (also called a home equity loan), and cash-out refinance options are for a fixed amount. The credit limit of the loan is based on the home’s value and you don’t have much wiggle room if you change your mind on how you want it to work. A lump sum isn’t always the best type of loan.
A line of credit is usually a revolving loan that you can add to when needed. This makes a HELOC very popular to pay for a home remodel, for example, as costs can be above or below estimates. They make it easy to pay various contractors and suppliers with a check that draws directly on the credit line. Some banks may even offer a debit card linked to the account.
3. Long Repayment Periods – Longer payoff periods mean lower monthly payments. HELOC borrowers often have up to 30 years to pay back the entire balance. A common HELOC setup allows you to add to the balance for up to 10 years, sometimes called a draw period, before a 20 year payoff period.
Most lenders recalculate the minimum payment every month using the same formula used for a mortgage. This kind of amortization sets you up to have a zero balance when the last payment is due. But you can always pay it off early to save on interest.
4. Consolidate Other Debts – Many credit cards charge well over 20% APR. With a good credit score and enough home equity, you may be able to find a HELOC that charges less than 5%. Due to the effects of compounding, interest rate savings can be massive. Depending on how much you borrow, you could easily save tens of thousands of dollars by consolidating higher interest debt with a HELOC.
Debts commonly paid off with a HELOC include car loans, private student loans, and credit cards. That can lead to one lower monthly payment instead of a bunch of higher interest payments. Just do the math and make sure that you will really save in the long-run. A short-term focus can be costly.
5. May Be Tax Deductible – Depending on the use of your HELOC proceeds, you could find yourself with an added tax deduction. Under the current tax code, HELOC interest may be tax deductible if you use the loan for home improvement. Some additional restrictions apply, such as a limit of $750,000 in total home loan debt for new loans. Depending on the value of your home and how much you borrow, you can take advantage of these additional savings.
In addition to lower interest rates, this can lead to some significant savings compared to other types of debt. If you are not sure if this is right for your tax return, consult with a licensed tax advisor.
Cons of Home Equity Lines of Credit
1. Secured By Your Home – The biggest downside of a HELOC is that you put your house on the line to use one. Just like any other secured home loan, if you stop making regularly scheduled minimum payments, the lender can foreclose on your home. This is true with an auto loan or any other secured loan as well. If you stop paying, the bank can seize the asset. That isn’t the case with a personal loan or credit card debt.
This is not something to take lightly. Really look at your current monthly income and expenses to ensure you can afford the required payments. Whatever you borrow, you have to pay back. You definitely don’t want to lose your home.
2. Variable Interest Rates – The most popular types of mortgage loans have a fixed interest rate. Borrowers like this because the payments are steady and predictable. You know exactly what you’ll have to pay every month for the entire life of the loan.
Most HELOCs, on the other hand, are variable rate. That means the interest rate can go up or down with market interest rates. The Federal Reserve sets a target interest rate at a quarterly meeting, which usually makes the news. Rates have gone up over the last few years, which means people with HELOCs may find themselves paying more even though they didn’t add to the balance. Fixed-rate loans are more predictable.
3. Some Lenders Charge Fees – If you find the right lender and qualify, you may be able to get a HELOC with no fees and no minimum draw requirements. That makes a HELOC a great emergency backup plan for needs beyond your emergency fund. But not all HELOCs are fee-free. Closing costs alone can be sizeable.
Many lenders charge origination fees and annual fees in addition to any interest accrued. Those fees can add up to a lot of money over the life of a HELOC. Make sure to read the loan details so you know exactly what you’ll have to pay before signing up. Fees should never be a surprise.
4. All Debt is Bad if You Can’t Afford It – Some personal finance experts say that all debt is bad debt no matter what. That view is pretty extreme, but most everyone in the industry would say you should never take out a loan you can’t afford.
To help you avoid getting the wrong loan, lenders review your credit report, credit score, and income to make sure you can afford the loan. The metric used to measure this is called your debt-to-income ratio, or DTI. If you have too many monthly debt payments already, you are not likely to get approved for a new HELOC. But even if you can, it’s important to really review your finances to ensure you can afford the loan and that it aligns with your long-term financial goals.
Should You Get a Home Equity Line of Credit?
If you’ve reviewed the pros and cons of a home equity line of credit, you are in a good position to decide if you should get a HELOC. This kind of loan is popular for a reason. In an era where home values have been on the rise for years, millions of households have a ton of value sitting in their property.
Just make sure you also know the HELOC cons so you can avoid common pitfalls. In the best case, those are fees and slightly higher monthly payments. In the worst case scenario, however, it could be losing your home.
With those risks in mind, you can shop around for the best HELOC for your needs. Finding a low-interest loan from a high-quality lender will set you up for HELOC success.