Home equity lines of credit: pros and cons

Homeowners who want to tap into their home equity to consolidate high interest debt or finance home improvement projects often decide to take out a Home Equity Line of Credit (HELOC). One of the benefits of a HELOC is that you can only borrow the amount you need, which can lower your monthly payment. However, varying payment amounts can make a HELOC riskier for less disciplined borrowers.

What is a Home Equity Line of Credit (HELOC)?

Unlike a home equity loan, which lends you a lump sum, a HELOC offers a line of credit that you can borrow when you need it. Like credit cards, HELOCs come with variable interest rates, and your monthly payment will vary based on your current interest rate and how much you’re borrowing at any given time.

With a HELOC, you usually receive a maximum amount that you can borrow based on the equity in your home. You can choose to use part or all of your line, and you are charged interest only on the amount you actually borrow. So if you haven’t used your line of credit, you won’t owe principal or interest.

Benefits of a Home Equity Line of Credit

Home equity lines of credit normally allow you to borrow up to 85% of the value of your home, less any outstanding mortgage payments, which means these loans won’t work for consumers who don’t have a home equity loan. considerable net worth. You also usually need good credit to qualify, as well as provable income to pay off your loan.

If you’re a HELOC candidate, here are some of the biggest benefits.

Qualify for a low APR

Interest rates have been at their lowest for several years, or almost, and home equity lines of credit allow you to take advantage of that fact. HELOCs can have lower interest rates and upfront costs than credit cards, making them attractive for debt consolidation or current projects.

In fact, some of the best HELOC rates drop below 5%. Meanwhile, the average APR on variable rate credit cards is around 16%.

Interest may be tax deductible

Even after the Tax Cuts and Jobs Act of 2017, you can still deduct interest paid on a home equity line of credit (or home equity loan) if you use the money for home improvements. .

Specifically, the IRS states that interest payments on real estate products are deductible if they are used to “buy, build, or significantly improve the home of the taxpayer who secures the loan.”

Borrow only what you need

Another advantage of HELOCs is that you can use the funds as needed. When home equity loans and even personal loans require you to take out a lump sum, you can use a HELOC in bursts if you want, borrowing only the money you use as you go. If you need less money than you thought you would have a lower monthly payment.

Choose from flexible repayment options

HELOCs often offer flexibility in how you pay for them. The timing of your HELOC can vary depending on how much you want to borrow and which lender you choose from, but HELOCs can last up to 30 years. You will usually only have to make interest payments during the withdrawal period, or the first 10 years, but you also have the option of making principal payments to reduce the remaining balance when you enter the withdrawal period. repayment.

Some HELOC lenders have also started offering fixed rate options, which allow you to lock in a portion of your HELOC balance at a fixed interest rate for a period of time.

Increase your credit score

Two of the most important parts of your credit score are your payment history and the different types of credit you have. Adding a HELOC to your credit portfolio and making one-time, regular monthly payments can boost your credit score as it shows a series of good financial habits.

Few restrictions on how you use the funds

With a HELOC, there are very few restrictions on how you can use the funds. Although your HELOC is secured by your home, you don’t have to use HELOC funds for home improvements. You can use it for college expenses, travel, or debt consolidation.

Disadvantages of a Home Equity Line of Credit

Being able to tap into the equity in your home is a good option, but there are some HELOC downsides to be aware of. Consider these drawbacks before going ahead with this loan option.

You use your home as collateral

A HELOC is a secured loan, which means that you put your home as collateral for the loan. While a secured loan can help you get a lower interest rate, you take additional risk.

“Because you are borrowing against your home, if you can’t make your monthly payments, you risk foreclosure,” says Sean Murphy, assistant vice president of equity loans at the Navy Federal Credit Union.

You will have a variable interest rate

Where home equity loans offer a fixed interest rate that will never change, home equity lines of credit have variable rates. This means that your rate can go up or down depending on the decisions of the Federal Reserve. So even if you purchase a HELOC with a low rate, you may still face high rates when paying.

There is a risk of overtaking

A disadvantage of HELOCs often stems from the borrower’s lack of discipline. Since HELOCs allow you to make interest-only payments during the drawdown period, it’s also almost too easy to access money without immediately feeling the pain of your decisions.

“If the borrower does not repay the funds on that line of credit, the loan ends up amortizing and payments increase dramatically,” says Joseph Polakovic, owner and CEO of Castle West Financial in San Diego. If you don’t expect or keep track of the increase in monthly payments at the end of the draw period, it can be a nasty surprise.

You reduce the equity in your home

When you borrow through a HELOC, you are borrowing against the equity in your home that you have worked hard to build up. If house prices go down, you could owe more than your home’s value. Having an exceptional HELOC also limits your additional opportunities to borrow against your equity.

Alternatives to a home equity line of credit

HELOCs can be extremely useful, but they’re not exactly perfect, at least not for everyone. Here are some loan alternatives to consider in place of a HELOC.

Home equity loan

A home equity loan is very similar to a HELOC, but instead of a line of credit, it gives you a lump sum in cash. You will have a fixed repayment period and a fixed interest rate, which means your monthly payment will never change.

Murphy says that if you’re looking to spend as you go – and only pay for what you borrow, when you borrow it – a HELOC is probably a better option. If you know exactly how much you need up front, a home equity loan might be a better option than a HELOC.

Refinancing of collection

A cash-out refinance replaces your existing mortgage with a new loan with a higher balance. Many lenders will allow you to refinance and borrow up to 80% of the value of your home, allowing you to receive the difference in cash.

If your home is worth $ 400,000 and you owe $ 200,000, for example, you could potentially refinance with a new loan of $ 320,000 and get $ 120,000 in cash, less closing costs and other refinancing costs. .

Personal loan

Like home equity loans, personal loans come with a fixed monthly payment, a fixed interest rate, and a lump sum up front. The big difference between personal loans and home equity loans and HELOCs is that personal loans are unsecured, so you don’t have to pledge your home as collateral.

Personal loans can also be easier to apply for, as you can often complete an application online and don’t have to prove your home’s value. However, they tend to carry higher interest rates than home equity products.

The bottom line

Home equity lines of credit can be a great option if you have enough equity in your home because you have more flexibility in what to borrow and when to pay it back. However, you will need to put your home as collateral, and HELOCs come with variable interest rates. Before applying, think about your financial habits, as well as how you want to use your funds.

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