Do you have large upcoming expenses which you’re not entirely sure how to finance? You may lean instinctively toward a personal loan—or worse, carrying a balance on a credit card.
If you’re a homeowner, you may have another option. A home equity line of credit (HELOC) can be a convenient way to borrow against the value of your home. There are several advantages to this method of financing, but it also comes with significant risk. Here’s what you need to know about taking out a HELOC.
What is a HELOC?
A home equity line of credit is a type of loan that allows you to borrow from the equity you’ve built in your property. Equity is simply the value of your home minus the amount you owe on your loan.
A HELOC is a secured loan that uses your home as collateral. Secured loans often benefit from lower interest rates—but they can also result in forfeiting your collateral if you default on your loan. In other words, you could lose your home if you fail to repay your HELOC.
To take out a HELOC, you typically need to have built more than 15% equity in your home. Most lenders require that you keep between 15% and 20% equity in your home. For example, if your home is worth $400,000 and you owe $200,000, you’ve built 50% equity. A lender requiring you to keep 20% equity in your property would hypothetically allow you to borrow up to 30% of your equity, or $120,000.
Depending on the amount of equity you’ve got, taking out a HELOC can be a good option when you need more funds than would be offered with a traditional personal loan (often capped at $100,000).
How does a HELOC work?
A HELOC is a revolving line of credit—it works similar to a credit card.
Instead of receiving a lump sum of cash as is the case with a standard personal loan, you receive access to a credit line that increases and decreases as you spend and repay your balance. You’ll only pay interest on your balance; the money you don’t spend won’t cost you as it sits and waits to be deployed.
A HELOC often consists of two phases:
The “draw” period. Depending on the specific terms, you may get up to 10 years to use your line of credit.
The “repayment” period. After the draw period, you’ll no longer be able to spend on your credit line and you must repay what you currently owe. You can pay it all back at once or begin a monthly installment plan. You’ll often receive up to 20 years to repay what you owe.
If you’d like to keep your HELOC after the draw period, you may be able to refinance it for another 10 years.
Taking out a HELOC isn’t free. You’ll often pay closing costs like an origination fee, home appraisal fee, title search fee, and more. You could pay up to 5% of your loan amount in fees.
When does a HELOC make sense?
First and foremost, if you suspect for a second that you’ll have trouble repaying your HELOC, it’s not a good idea. Again, this loan is backed by your home—so defaulting can mean losing your property to the lender.
A HELOC can be a smart move for those with larger ongoing purchases that can’t be paid off within a few months. For example, if you’re renovating your home in increments and find yourself making large purchases a handful of times each year, you may choose to finance it with a low-APR HELOC instead of a high-APR credit card.
Other justifiable uses include:
- Emergency expenses
- Car repairs
- Health expenses
A HELOC may not make sense for impulse buyers. If you’re considering a HELOC for a recreational purchase that you don’t currently have the funds to afford—think vacations, jewelry, electronics, etc.—a HELOC isn’t a good idea. Don’t allow a HELOC to enable overspending.
Pros and cons of a HELOC
Pros:
- Potentially borrow more than you’ll get from a traditional personal loan
- Only pay interest on the funds you use
- Typically lower APR than credit cards and personal loans
Cons:
- Defaulting on your loan can result in losing your home
- Interest rates are often variable (unlike a traditional personal loan)
- Lowers your home equity until repaid
How to qualify for a HELOC
Qualifying for a HELOC is a bit more involved than, say, the average credit card or personal loan requirements. In addition to details like potential home appraisal, notary involvement, and title searches, you’ll need a good credit profile and debt-to-income ratio (below 40% is ideal). You’ll also need to have built more than 15% or 20% equity in your home.
When opening a HELOC, be prepared to show proof of employment and income. Lacking either of these can disqualify you, as well.
HELOC vs. home equity loan
A home equity line of credit differs from a home equity loan in one major way: One is a revolving line of credit and the other is an installment loan:
A home equity loan dumps a sum of cash into your bank account and enrolls you in equal monthly payments until the money is paid back—including interest.
A HELOC provides no cash upfront. You’ll get a credit limit that you can spend and repay as you choose.
A home equity loan is likely a better choice if you need a lot of money upfront for an expense and you don’t want to be subject to fluctuating interest rates. It’s also ideal if you don’t foresee continually needing to draw from your equity. For example, consolidating existing high-interest debts from other accounts is oftentimes a good use of a home equity loan.
On the other hand, a HELOC is better if you plan to (or suspect you might) frequently make large purchases and pay them off. A HELOC also functions as a better emergency tool than a home equity loan, as you won’t pay interest unless you spend it.
Alternatives to a HELOC
A HELOC isn’t the only way to finance your large (or small) purchases. Here are other common options that may better suit your needs in some situations:
- Personal loan: Unsecured personal loans generally come with higher APYs than HELOCs, but at least you aren’t putting your home up as collateral. If you need a lump sum totaling less than $100,000, it could be a fair option.
- Credit card: If you’re seeking a revolving credit line for daily purchases that you can easily pay back each month—generally avoiding interest charges if you pay in full each statement cycle—a credit card is a better choice. Many earn rewards on purchases and come with purchase insurance. Some even offer a 0% introductory APR for a year or two.
- Cash-out refinance: If mortgage interest rates have decreased considerably since you took out your loan, you may benefit from refinancing your mortgage for more than you owe. You can put the difference in your pocket.
Frequently asked questions
How much can I borrow with a HELOC?
Many lenders allow you to borrow between 80% and 85% of your home equity when taking out a HELOC.
Can I convert my HELOC to a fixed rate?
Some financial institutions allow you to convert a portion of your HELOC to a fixed interest rate.
How does a HELOC affect my credit score?
When taking out a HELOC, your credit report will sustain a hard credit inquiry. This will temporarily ding your credit score. However, your credit score will likely bounce back and even increase with responsible credit usage.
Does a HELOC have annual fees?
Some (but not all) HELOCs charge annual fees.
How do I calculate my home equity?
To calculate your home equity, simply subtract your loan amount from the current value of your home. For example, if your home is worth $250,000 and you owe $200,000, you have $50,000 (or 20%) in equity.