A home equity line of credit, widely referred to as a HELOC, is a type of second mortgage. Lenders base the amount you can borrow on the equity in your home, which is calculated by subtracting your outstanding mortgage balance from your home’s market value.
However, unlike most loans, a HELOC isn’t a lump-sum payment. Instead, a lender sets up an account with the full loan, or principal amount, and you withdraw funds as needed during the HELOC draw period.
You can use HELOC funds for any purpose, such as home improvements, debt consolidation, and medical expenses. This flexibility of use makes this type of loan attractive to many homeowners.
Whether or not a HELOC is the right choice for you depends on your situation. There are myriad more benefits to HELOCs, but there are several downsides and risks. Make the best financial decision for your needs with our in-depth look at HELOC's pros and cons below.
When is a HELOC a good idea?
Benefits of a HELOC
Tapping into the equity in your home through a HELOC can be especially helpful if you’re eligible for some of its many upsides. However, not all these benefits may be available through every HELOC lender or in all financial situations.
HELOC starting interest rates are low compared to annual percentage rates for borrowing options such as credit cards and even the best personal loans. Lenders are more likely to offer the lowest rates to borrowers with excellent credit.
Most HELOC rates are variable, but some lenders allow borrowers to lock a portion of your credit line into a fixed interest rate. This rate won’t increase regardless of market changes.
Interest payments may be tax deductible for borrowers who use their HELOC to “buy, build, or substantially improve” their home. See the IRS website for more details.
Control over borrowing amount
Because HELOCs are like a revolving line of credit rather than a lump-sum payment, you can pull only what you need from the total amount of money approved. This flexibility gives you control over how much debt you ultimately take on.
Smaller payable compound interest
With a HELOC, interest isn’t applied to the entire credit line. During both draw and repayment periods, you only pay interest on the money you’ve withdrawn from your credit line.
Control and flexibility over payments
During the draw period, most lenders require only monthly payments to the interest on funds you’ve pulled from your HELOC. You can also make payments toward your principal balance at any time.
Flexible repayment options
After the draw period, repayment usually begins at 10, 15, or 20 years. However, you also have the option to start repayment during the draw period, which will cut down on the overall interest paid.
Improved credit score
If you make your agreed-upon HELOC payments on time, you’ll likely see an increase in your credit score. You could also use your HELOC funds to consolidate debt, which could also improve your credit score.
You can use your HELOC credit line for any purpose, such as home renovations, debt consolidation, medical expenses and making mortgage payments.
How to know if a HELOC is right for me
If the following applies to you, a HELOC might be the right choice for your borrowing needs.
- You’ve accrued equity in your home - The amount you’re approved for will depend on your home’s appraisal value minus how much you still owe on your mortgage. The more equity you have, the more you can tap into a line of credit from that equity.
- You have good credit - In addition to home equity, lenders also consider your credit score and credit history when applying for a HELOC. Most lenders require a minimum credit score of 620 to qualify.
- Your debt-to-income ratio (DTI) is low - Your DTI is the percentage of your income (before taxes) used for debts, such as payments to your mortgage, credit cards, or loans. Most HELOC lenders require a minimum DTI of 43%.
- You need funds for multiple purposes - The flexibility of use with a HELOC is vast. You aren’t limited to a specific, single use for the funds. However, as we warned above, that interest is only tax-deductible if the funds are used for home-related improvements.
- You need to borrow, but aren’t sure how much - With a HELOC, you’re approved for up to 85% of your home equity. However, you don’t have to use all the funds allotted, which is helpful if you’re not sure how much you’ll ultimately need.
- You’re good at financial planning - HELOCs are best for borrowers who are meticulous about their budgets or have help from a financial planner. Variable interest rates can cause your draw period payments to increase, and in the repayment period, those payments will be significantly greater.
When are HELOCs risky?
Like any kind of loan, HELOCs come with downsides, uncertainties and serious risks.
Disadvantages of a home equity line of credit
Risk of losing your home
Because a HELOC is like a second mortgage loan that uses your home as collateral, late payments or failure to repay what you’ve used from your borrowing limit could lead to foreclosure.
No fixed-rate loans
Most HELOC interest rates are variable, so they’re subject to increases of up to 18%. Locking in the rate for a portion of your HELOC balance may be possible. Depending on the lender, this option is usually available from one year to two months before your repayment plan begins.
Risk of overspending
Some borrowers may be tempted to use the entirety of their HELOC loan credit limit without considering the interest that will be added and their ability to repay. Borrowers shouldn’t use the entirety of their line of credit if they’re not sure they can repay both the debt and the interest accrued.
Reduces the home’s equity
Home equity is calculated by subtracting any liens or loans attached to your home from the appraised value of your home. A HELOC is a kind of second lien on your home and will be considered, along with your mortgage and any other loans attached to the property, in assessing how much equity you have.
Minimum withdrawal requirements
Your HELOC lender may set a minimum amount for each withdrawal, which may be higher than how much you need. Depending on contract terms, you may also be charged a fee per withdrawal.
Longer application period
From prequalification to funding, getting a HELOC can take anywhere from a few weeks to a couple of months. Steps affecting this timeline include the documents required, the underwriting process and whether or not an appraisal is required. Additionally, some states require an attorney to be present at loan closing.
Additional HELOC costs
Beyond typical fees like loan origination and closing costs, annual fees for account maintenance or inactivity fees may be applied to your account. Your HELOC could also include a prepayment penalty for paying off the line of credit before the term ends.
Mortgage refinance restrictions
Approval from your HELOC lender may be necessary if you want to refinance your first mortgage while the line of credit remains open. Some lenders won’t allow any refinancing of the original mortgage.
How to know if a HELOC is not the best option for me
Consider these factors before applying for a HELOC.
- Equity in your home - If your outstanding mortgage balance is too close to your home’s market value, you won’t be approved for much funding, if at all. In other words, if you still owe about as much as your home’s real estate market value, you’ll only be approved for what you’ve already paid back.
- Credit health - Good credit will help a lender lean toward a bigger HELOC loan. If your credit isn’t great currently, you might not want to apply for a HELOC now.
- Debt-to-income ratio - Your DTI percentage will affect how much a lender will offer. Use a DTI calculator to find out where you stand.
- Personal finance - While you’ll only make interest payments during the draw period, a HELOC is still a debt that must eventually be repaid. Ensure you can afford later payments to the outstanding balance during the repayment period.
- Funds desired - A HELOC probably isn’t the appropriate borrowing choice if you only need a small sum of money.
- Speed of funding - If you need access to funds quickly, the lengthy application process for a HELOC may be a problem.
Alternatives to a HELOC
Homeowners looking for other options that also tap into their home equity can consider the following:
- Home equity loan - This is a lump-sum, secured loan borrowed against the equity in your home and repaid monthly over five to 30 years. Home equity loans offer lower interest rates than credit cards or personal loans.
- Reverse mortgage - Older homeowners (usually aged 62 and up) may be eligible to borrow from a portion of their home’s equity through a reverse mortgage. Rates may be fixed or adjustable, and funds may be delivered in a lump sum, a line of credit or monthly installments.
Borrowers looking for alternatives to using home equity for a loan could consider the following:
- Personal loans - This is a fixed-rate loan typically unsecured and repaid in fixed monthly installments, usually over one to seven years.
- Home improvement loans - Home improvement loans, which can be either lump-sum payments or lines of credit, are used for home repairs, remodels and upgrades.
- Credit cards - We’ve reviewed several credit card products based on rewards and perks in our Best Credit Cards guide.
Finally, if you’re looking to lower your current mortgage payments, the following options could work for you:
- Mortgage refinance - Depending on your creditworthiness and a lender’s opinion of your ability to repay, refinancing your current mortgage with a new home loan could lower your monthly payment.
- Cash-out refinance - This type of refinancing replaces your existing mortgage with a bigger mortgage, and the difference is paid out to you. With excellent credit, your monthly payment could be lower than with your original loan.
Summary of HELOC Pros and Cons
Borrowing against the equity in your home with a HELOC has plenty of benefits. HELOCs are a boon to many thanks to their typically low interest rates. Additionally, funds aren’t restricted to home improvements; you can use the loan amount for any purpose.
However, no two homeowners are alike, and the downsides to HELOCs present serious risks.
It’s standard that only interest payments on tapped funds are required during the five or 10-year draw period. But most HELOCs have variable interest rates, so they’re subject to fluctuations, and an unanticipated bump to a higher interest rate could hurt you financially. Missed payments could cause a drop in your credit score. Failure to repay could result in the foreclosure of your home.
The amount of equity in your home and the lender’s opinion of your ability to repay will determine how much money you qualify for. From there, your personal finance savvy will play a significant role. You’ll have to make consistent, on-time payments as laid out in your HELOC terms and avoid the temptation of withdrawing more money than you need.
Whether or not a HELOC is right for you will depend on all these factors. Consider them carefully before you choose to apply. You can further educate yourself on HELOCs by reading about how to get a home equity loan.