As you make your mortgage payment every month, you are gradually building up the equity that you own in your home. In addition to the obvious benefits you will gain once you sell your house, there are other ways to access this equity while still remaining in your home. A home equity line of credit–also known as a HELOC–can be a relatively cheap source of financing for homeowners. Understanding the ins and outs of this financial arrangement can help you decide if a HELOC is right for you.
Because they are dependent on the amount of equity that you have accumulated, HELOCs share a number of similarities with home equity loans. They can be one option to consider if you need to gain access to financing.
What Is a HELOC and How Does It Work?
A HELOC is an arrangement that you enter into with a financial institution that allows you to borrow against a percentage of the equity that you have accumulated in your home.
In a standard arrangement, you can gain access to up to 85% of your home equity for a predefined time frame, known as the draw period (generally five to 10 years). In other words, if your house is worth $200,000 and you have paid off 50% of your mortgage, you could gain access to a revolving line of credit of $85,000 (i.e. 85% of $100,000) that you can continuously borrow over the predefined draw period.
Whatever amount you and your financial institution agree upon for your HELOC, this figure will represent the maximum debt that you can take at any given time. Similar to a credit card balance, as you repay the principal that you owe during the draw period, you will be able to withdraw more financing. For instance, let’s say you have a HELOC for $50,000 and borrow the entire amount in the first year. If you repay $15,000 of this amount in year two, you will be able to borrow an additional $15,000 once again.
For most HELOC arrangements, during the draw period, you will only be responsible for making interest payments. Once the draw period ends, a repayment period (typically 10-20 years) will commence. You will be responsible for repaying both principal and interest during this timeframe.
A HELOC will usually have a variable interest rate, which is linked to an index. These rates could go up or down, depending on the overall conditions in the market. Some lenders will offer a fixed-rate HELOC, though these tend to have higher initial interest rates, as well as a requirement to take a minimum withdrawal at the beginning of the draw period.
Is It a Good Idea to Get a HELOC?
There are a few advantages of a HELOC, including the following:
(1) Flexibility: The HELOC gives you the ability to access a predefined amount of funds throughout the life of the draw period. If your plans change, you do not need to borrow the full amount. You will only owe interest on the amount you borrow, cutting down on unnecessary costs.
(2) Cheaper financing: Because a HELOC is a type of secured loan, your bank is taking less of a risk when offering you this debt. Therefore, the interest rates tend to be lower than for other types of financing, especially credit cards.
(3) Freedom to choose: You can put the HELOC funds towards a variety of uses. These include home improvements (see below), medical bills, or debt consolidation, among other reasons. Paying off higher-interest, compounding credit card debt can serve as one way to escape from the cycle of consumer debt.
(4) Tax benefits: If you use the funds to make home improvements or fixes, you may be eligible to deduct your interest payments from your annual tax obligation.
What Are the Disadvantages of a HELOC?
There are a number of reasons to be wary about taking a HELOC, however.
Like any source of financing, there will be fees and interest payments. In addition to the application and appraisal fees, your financial institution could also charge you for the early termination of the HELOC. Additionally, variable interest rates can drive the cost of the financing upward.
Another drawback of a HELOC is that it could lead to “reloading.” This is the phenomenon of falling right back into the overspending trap after you have addressed your credit card debt, and you once again have the ability to run up your credit card spending.
However, perhaps most concerning, you are opening yourself up to the risk of foreclosure if you are unable to repay your debts during the repayment period. This could cause you to lose your home.
Deciding if a HELOC Is Right for You?
Determining if a HELOC is right for you should come down to both your personal finances and circumstances. The first item to consider is whether you truly need to borrow money. If the purpose of the loan aligns with an important objective, such as the cost of education, home improvements, or escaping from debt, it can be worthwhile. If it is for a more short-term desire, such as going on your dream vacation, it probably does not make sense.
Second, you should factor in your financials, and whether you have a secure, predictable revenue stream that will enable you to repay your debt. The amount of equity you have accrued and your credit score also will influence the lending terms, so having a good sense of these and how they will impact your potential HELOC is vital.
Beyond the financial particulars, before signing on a HELOC you should make sure that you have a strong awareness of your relationship with money. If you have legitimate concerns that a HELOC would encourage bad spending habits, then it is definitely a financial agreement that you should avoid. If, however, you are confident in your abilities to act responsibly with this line of credit, it could be a good fit.
Conclusion: Understanding Your Options
HELOCs can be a potential avenue to borrow money. They can be a cheaper, flexible source of financing, though using your home to secure any debt could ultimately place this asset at risk.
Understanding your options–along with the relative benefits and pitfalls–is a key part of any personal finance decision. This certainly holds true when it comes to borrowing funds.
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