A home equity line of credit (HELOC) is a second mortgage that operates similarly to a credit card. It allows you to tap the equity in your home on an as-needed basis. Since this line of credit is secured by your home, it usually comes with a lower interest rate than personal loans and credit cards.
Although using a HELOC comes with many benefits, it also comes with risks. Read ahead to learn the pros and cons and how a HELOC works so you can decide if taking one out makes sense for you.
How does a home equity line of credit work?
A HELOC is a revolving line of credit that typically has a variable interest rate. It comes with a draw period that usually lasts 10 years. During the draw period, you’re allowed to withdraw money as you need it, using a credit card or checks. After the draw period ends, you can no longer withdraw money and the repayment period begins, unless the lender allows you to renew your credit line.
There are two types of home equity lines of credit: an interest-only HELOC and a principal-and-interest HELOC. The interest-only option requires you to pay interest only during the draw period. When the draw period ends, you’re responsible for repaying the principal and interest. The principal-and-interest option requires you to make a minimum monthly payment that includes a small percentage of the principal.
When you take out a HELOC, your home is used as collateral to secure the loan. This puts your home at risk; if you default on the loan, a lender can foreclose on your home.
Why get a HELOC or second mortgage?
Many people like HELOCs or other types of second mortgages because the interest rate on them is usually lower than unsecured lines of credit. As a result, a HELOC is commonly used for purposes such as:
- Refinancing high-interest debt: Since home equity loans usually have lower rates, you can use them to refinance more expensive debt. This can help you save money and eliminate debt faster.
- Funding home improvement projects: When you use a home equity loan to fund a home improvement project, the interest on your loan may be tax-deductible.
- Refinancing your home: To lower your monthly mortgage payment, you could use HELOC funds to refinance or pay off your home.
- Investment property: If you use a HELOC to make a down payment on an investment property, you can expand your real estate portfolio.
Before you use a HELOC for those reasons, make sure you understand the pros and cons of taking out a home equity line of credit.
Pros and cons of a HELOC
How much can you borrow with a HELOC?
The amount of money you can borrow with a HELOC depends on the amount of equity you have in your home and the percentage of equity a lender allows you to borrow. It also depends on your remaining balance — a lender subtracts that amount from the loan amount.
For example, let’s say a lender lets you borrow 85% of your home’s value, your home is worth $100,000, and your outstanding balance is $50,000. To calculate how much you could borrow with a HELOC, you’d first multiply the home’s value by 85%, which gives you a total of $85,000. Next, you’d subtract your outstanding mortgage balance from that amount, giving you a maximum HELOC amount of $35,000.
Once you understand how much you can borrow, use a home equity loan calculator to estimate how much your payments would be.
How do HELOC rates compare?
HELOC rates and home equity loan rates are typically lower than those for unsecured debt, such as personal loans and credit cards. However, the rate you receive will vary based on your credit and income.
Since HELOCs come with variable interest rates, the rate you receive will rise or fall based on an index benchmark. The interest rate on a HELOC is calculated by adding the index and margin together. The margin is a set amount that’s locked in at time of closing. Meanwhile, the index rate varies and is based on the federal funds rate, which is determined by the Federal Reserve.
Who qualifies for a home equity line of credit?
To qualify for a HELOC, you need to have a certain percentage of equity in your home, usually 15% to 20%. Some lenders may require just 5% to 10% equity in some cases. This means that if your home is worth $100,000, you’ll need to have $15,000 to $20,000 equity in your home. In addition, you need to meet the lender’s income, debt-to-income (DTI) ratio, and credit score requirements. These ratios vary by lender.
If you want to increase your odds of being approved for a HELOC and chances of securing a better rate, work on boosting your credit score. The two most important factors are your payment history and amount of debt you owe, so make sure you pay your bills on time and pay down any debt, if possible.
HELOC vs. other types of second mortgages
HELOCs aren’t the only avenue you have to tap home equity. Other options include home equity loans and cash-out refinancing. Both options operate differently from HELOCs.
HELOCS vs. home equity loans
Unlike a HELOC, a home equity loan operates similarly to a personal loan. When you take out a home equity loan, the lender issues you a lump-sum payment and you repay the loan in fixed monthly installments. Interest rates for home equity loans are usually fixed, instead of variable.
If you need to borrow a set amount of money for a home improvement project or other expense, using a home equity loan can be a better option than a HELOC. Also, you may prefer using this type of loan if you prefer having predictable monthly payments. This can make it easier for you to budget.
HELOCs vs. cash-out refinancing
When you do a cash-out refinance, you take out a new, larger mortgage with new terms to pay off your existing mortgage. The lender pays you the difference between the new and old mortgage in a lump-sum cash payment. Once you get the cash, you can use it for anything.
If you prefer making one monthly payment instead of two, doing a cash-out refinance can make more sense than taking out a HELOC. Also, it could make sense if you want a longer repayment period. By taking out a new loan with a longer repayment period, you’ll have more time to pay back the loan than a HELOC typically allows.
Home equity line of credit FAQs
Is interest on my HELOC tax-deductible?
According to the IRS, the interest on your HELOC may be tax-deductible if it’s used to “buy, build, or substantially improve the home.” You can deduct interest on the first $750,000 of your mortgage if you’re single or married filing jointly. If you’re married and file separately, you can deduct interest paid on the first $375,000 of your mortgage. To qualify, your HELOC must be secured by your primary residence or a qualifying second residence.
How does a HELOC affect your credit score?
Using a HELOC can have a positive or negative impact on your credit. When you first take out a HELOC, a hard credit inquiry can lower your score slightly, typically by less than five points. As time passes by, its impact will lessen. If you repay your HELOC on time, your score may benefit from the positive payment history. However, if you make late payments or default on your HELOC, your score could suffer major damage.
Do you pay on a HELOC if you don’t use it?
With a HELOC, you only have to pay if you borrow money from it. Although some lenders have minimum draw requirements on a HELOC, you can ask for a waiver.
To learn more about your HELOC options, contact a local Finance of America Mortgage Advisor today.