Buying a home is often considered superior to renting one because mortgage payments build home equity, an asset you can convert back to cash in various ways. One popular way to tap into your home equity is to borrow against it using a HELOC, short for home equity line of credit.
If you’re a homeowner, here’s everything you need to know about this form of financing.
What are HELOCs?
HELOCs are a form of home equity financing. They let you tap into the equity you’ve built up in your home and use it as collateral for your credit account.
The primary difference between home equity loans and HELOCs is their structures. A home equity loan is an installment account like a mortgage, while a HELOC is a revolving line of credit that functions more like a credit card.
Because HELOCs require that you use your house as collateral, they often come with relatively generous terms, including lower than average interest rates.
👉 For example: The average HELOC interest rate at the end of 2021 was 4.27%[1]. Meanwhile, personal loan interest rates averaged 10.28%, and those with less than excellent credit paid even more[2].
How Does a HELOC Work?
HELOCs are generally considered a form of revolving debt like credit cards. Your HELOC lender gives you a credit limit that you can borrow against whenever you need it. Once you pay back what you owe, you can reuse the funds.
However, unlike credit cards, HELOCs have a finite lifespan, and they don’t remain a revolving credit account the whole time. Instead, they have two distinct phases: a drawdown phase and a repayment phase.
The drawdown phase often lasts around ten years, during which the account functions as explained above, and you usually only have to make variable interest payments. However, you’ll have to repay the principal if you want to reuse the funds.
Once you enter the repayment phase, you no longer have the ability to borrow against the account. In addition, your lender will require that you start making fixed monthly payments to pay back whatever outstanding balance remains.
👉 For example
Say you take out a $40,000 HELOC with a 5% interest rate and a 10-year drawdown phase, during which you spend the whole balance on home improvements.
You make $166 interest-only payments each month for a year, then pay the balance off in full to reduce your costs, which takes you another three years.
You’re now four years into your 10-year drawdown phase with a paid-off balance when your interest rate drops to 3.5%. As a result, you decide to make more improvements to your house and max out the account once more.
This time, you make $116 interest-only payments monthly until the drawdown phase ends. Finally, your lender increases your minimum monthly payment to $480 to include principal paydown, and you eliminate the balance over the next 10 years.
For more information on HELOCs, see this useful brochure from the Consumer Financial Protection Bureau.
👉 Home equity loans are another popular form of home equity financing. The primary difference between home equity loans and HELOCs is their structures. A home equity loan is an installment account like a mortgage, while a HELOC is a revolving line of credit that functions more like a credit card.
How Much Can You Borrow with a HELOC?
Like a home equity loan, a HELOC typically lets you borrow up to around 80% or 85% of your home’s current market value when combined with your outstanding mortgage balance.
However, because you can withdraw and repay your HELOC as much as you want during the drawdown phase, you can potentially receive more capital using a HELOC than a home equity loan.
HELOC Pros and Cons
Like home equity loans, HELOCs are significant credit accounts that you shouldn’t take out on a whim. Though they can be powerful, borrowing against your home equity is always risky. Here are the factors to consider before doing so.
✔️ Pros
- Loan interest is an itemized tax deduction if used to improve the home
- Interest-only payments during the drawdown phase
- Potentially lower interest rate than other lines of credit
- Use the funds for many different purposes
- Loan interest is an itemized tax deduction if used to improve the home
❌ Cons
- Interest rates are typically variable
- Closing costs can be high, reducing interest savings
- Market fluctuations can cause you to owe more than your house is worth
- Lenders can foreclose on your house if you default on your debt
Unsurprisingly, the pros and cons of HELOCs are similar to those of home equity loans. The two financing options have a lot in common, with the most significant differences being their respective structures and interest rate behaviors.
Generally, they make sense when they’re well within your ability to repay, you’re using them for something financially responsible, and the risk of you being underwater is low.
👉 For example, it might be beneficial to take out a modest HELOC or home equity loan to convert a small storage space in a long-term home into an additional bedroom.
It should drive up the property value, and your interest might be tax-deductible. In addition, because you’re not planning to leave anytime soon, there’s not much risk of getting trapped by a debt that exceeds your property value.
📗 Learn More: Have you ever thought about renting out one of your spare bedrooms for some extra cash? Take a look at our analysis of the strategy: What is House Hacking and Should You Try It?
Where to Get a HELOC
If you’re interested in home equity financing, a great place to start your search is with the lender holding your existing mortgage if you have a good relationship.
However, that shouldn’t be your only stop. Like with mortgages, it’s essential to shop around with multiple lenders to get the best HELOC. Try reaching out to other banks, credit unions, and mortgage companies.
A good rule of thumb is to get between three and five offers. That will ensure that you have an accurate understanding of the options available and helps you negotiate from a position of strength.
Finally, make sure you review the offers in detail. Don’t just go for the one with the lowest interest rate on the sticker. Details like closing costs, ongoing fees, and repayment terms significantly impact your total borrowing expenses.
If you want help, it may be worth working with a mortgage broker to guide you through the process and explain the specifics of each option’s terms.
