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HELOCs offer low initial rates and financial flexibility, but are more unpredictable than a standard home equity loan. So are they the right choice for you?
What is a HELOC?
HELOC stands for Home Equity Line of Credit. It is a secondary mortgage loan based on the equity that is in a person’s home. These loans offer high limits with low-interest rates because you are putting up your home as collateral.
This type of loan is different from your primary mortgage in that you don’t get a lump sum payment. Instead, the loan acts as a credit card or checkbook and you can take out sums at any time during a 5-10 year withdrawal period.
During that withdrawal period, the user is only required to pay interest. In the end, you only owe on what you take out. During the following repayment period, which is generally 10-20 years, the borrower is required to repay the principal as well as interest payments.
The amount of credit available is determined by subtracting the balance that the owner owes on his or her first mortgage by a percentage of the appraised value of the home, which is usually 80%.
Say you purchased your home for $400,000, and you currently owe $300,000 on the loan. If your home is appraised at $600,000, you should be able to get a line of credit worth about $180,000 (up to a total amount of $480,000 or 80% of $600,000).
Another big difference between a HELOC and most other loans is that the interest rate is almost always variable. Fluctuations in interest rates can lead to changes in your monthly payments.
HELOC vs Home Equity Loan: Key Differences
HELOCs and home equity loans both allow you to borrow against the equity in your home, but there are some key differences between them.
A home equity loan, also known as a second mortgage, is a lump-sum loan. After receiving the loan, the borrower is required to make regular payments over a set term, typically 5-20 years.
With a HELOC, you have access to a credit line and can borrow as much or as little as you need, up to your approved credit limit. When you opt for a home equity loan, you receive the entire loan amount upfront.
You cannot access additional funds from the loan beyond the original borrowed sum. If you need more money, you would have to apply for a new loan or refinance.
When you take out a home equity loan, you start making regular payments immediately on both the principal and interest. These loans normally come with fixed interest rates that remain constant over the duration of the loan.
This feature provides borrowers with stable and predictable monthly payments.
» MORE: See today’s refinance rates
What can you use a HELOC for?
There are lots of ways to utilize a HELOC, but here are some things that people commonly use them for.
- Home renovations: You can use it to actually raise the value of your home by sinking the money into home improvements.
- For emergency savings: Take out all of the money available to you and put it in a bank that gives you a higher interest rate than you are paying on it already, and you will have it in store to use for an emergency.
- For education: When parents come up short on college, they can use the money to pay for tuition.
- For medical bills: In emergency situations, a HELOC can be cheaper than racking up credit card debt.
What are the benefits?
The interest that you pay is typically deductible under federal and many state income tax laws. This can greatly reduce the cost of borrowing funds compared to other methods of borrowing.
HELOCs are flexible both in what you can take out and how you pay them back. Maybe you took out a HELOC loan for $80,000 but only ended up needing $20,000.
Then that’s all you take out. Also, depending on the loan, there are lots of different ways that they can be paid back.
What are the downsides?
- The interest rate is variable, which can get you into trouble-especially when borrowing such large amounts of cash.
- The line of credit can be frozen by the bank at any time, especially if your property value drops-which can delay planned payments.
- You are putting your home up as collateral and risk losing it if you default.
HELOC loans are a good resource for anyone who needs a large cash infusion. However, the cash isn’t free, and anyone considering a HELOC should work with their financial advisor to make sure that they are helping themselves in the short term and the long term.
HELOCs have their pros and cons; however, they can be used for a number of things, mainly home renovations, medical bills, emergency savings and even education.
Qualifying for a HELOC
When applying for a HELOC, borrowers can expect to encounter similar qualification requirements from most lenders. These include:
- Sufficient equity: Lenders require a minimum level of equity, usually ranging from 15% to 20% of the home’s value, though some may allow lower equity levels.
- Reliable credit history: While specific credit guidelines may vary, the majority of lenders require a credit score of 620 or higher.
- Low debt-to-income ratio (DTI): DTI is the percentage of your monthly income that goes toward debt payments. Lenders typically prefer a DTI ratio below 43%.
- Employment and income stability: Demonstrating a steady and dependable source of income is an essential factor in qualifying for a HELOC.
Is a HELOC the Right Choice for You?
Deciding whether a HELOC is the right choice for you will depend on your specific financial situation.
HELOCs are a practical option for ongoing expenses, as they provide a revolving line of credit. If your borrowing needs are primarily for a one-time expense, a home equity loan might be a more appropriate option.
The variable interest rates that come with HELOCs, which can rise or fall based on market conditions, are another important consideration. If you are concerned about potential rate increases and want more stability, a home equity loan with a fixed interest rate may be preferable.
As with any major financial decision, it’s always wise to speak with an expert. A loan officer or financial advisor can provide guidance based on your individual circumstances and help you evaluate whether a HELOC is the right choice.
They may also present alternatives such as personal loans, refinancing options or other forms of credit that might better suit your needs.