If you're a homeowner, you may be happy to learn you have a unique tool in your financial toolbox, a Home Equity Line of Credit, or HELOC. A HELOC allows you to borrow from your home's value at a competitive interest rate, with access to a line of credit. This credit can be used for anything — remodeling, medical bills, or a backup emergency fund.
Interested in a HELOC? Consider the pros and cons before applying for this low-cost form of borrowing.
What is a HELOC?
A HELOC allows you to borrow from your home's equity without selling the property. The equity you can borrow is based on your home's fair market value minus the amount you owe. HELOCs are approved with a preset line of credit so you can borrow and repay funds as many times as you need during the draw period. Interest rates and repayment periods are established upfront and vary by lender.
What is a draw period?
The draw period is typically five to ten years during which you can borrow money from the approved credit line. During this time, you can take out funds, make minimum monthly payments and borrow again all without needing to complete a new loan application.
What is a repayment period?
After the draw period ends, you must begin paying off the remaining balance on the HELOC and may no longer borrow money from the approved credit line. During the repayment period, typically 10 to 15 years, you must make monthly payments that include both principal and interest. The payment is typically calculated based on the amortization of the remaining balance over the repayment period.
Pros of a HELOC
- Competitive Interest Rates
HELOCs are often compared to credit cards, as the funds are not given to the borrower in one lump sum. But there are some major differences. HELOC interest rates are significantly lower than credit cards, which average 20.56%.1
- High Credit Limits
Access to a sizable amount of cash can provide a financial lifeline in an uncertain economy or after an unexpected job loss. HELOC lenders typically let qualified homeowners borrow up to a combined loan-to-value (CLTV) of 80% of their home's equity. The credit limit is contingent on the equity in the property, and homeowners with more equity may be approved for higher credit limits. While the maximum credit line varies greatly based on individual circumstances, it often exceeds even the highest limits available for most credit cards.
- Affordable Monthly Payments
HELOC repayment terms are often longer and more affordable than traditional loans disbursed in one lump sum. For example, many HELOCs allow you to withdraw funds during the first 10 years and make interest-only payments during that time. This could give your budget the breathing room it needs during a financial emergency. Principal and interest payments are then required during the remaining 15-year term of the repayment period.
Remember, a HELOC is a line of credit that only requires payment if you borrow funds. There are no payments required unless you draw money from the credit line.
- Funds Accessibility
HELOCs ensure homeowners have the money they need when they need it. For example, approved borrowers can easily transfer funds from an approved credit line to their checking account.
- Costs
Unlike a new mortgage, most lenders originate new HELOC accounts with no or very few upfront fees.
Cons of a HELOC
There are significant advantages to applying for a HELOC, but consider the cons, too.
- Collateral Required
A homeowner must agree to use their home as collateral for the credit line — and doing so assumes you will be able to make timely payments. Failing to repay the loan as agreed could result in the loss of your home.
- Less Equity Later
Accessing your equity now will likely mean you'll have less available later. For example, selling your home before paying off the HELOC could reduce the amount you receive at the closing table. You'll need to subtract the credit line balance, along with any other mortgages or liens, from the expected proceeds.
- Frequent Interest Rate Changes
The interest rate on your HELOC is tied to an economic index, typically the Prime Interest Rate.2 This means your rate and payment may rise or fall as often as the Prime Rate is changed. You should make sure that there is room in your monthly budget should interest rates rise during the life of your HELOC.
Should I Apply for a HELOC?
A HELOC is a low-cost way to pay for unexpected expenses, remodeling projects or keeping as an emergency fund if you don't have enough savings. If you own your home, a HELOC offers a fast, effective solution during turbulent economic times.
Since a HELOC gives you access to funds with interest-only payments during the draw period, you can more easily budget for unforeseen expenses.
- Source: creditcards.com.2. The most commonly used Prime Rate is the rate as published in The Wall Street Journal. 3. All loans subject to approval.