Home Equity Line of Credit (HELOC) Pros and Cons

Owning your own home comes with a number of advantages, including the financial benefit of home equity. As you pay off your mortgage, the equity in your home increases, and once enough has been built up, you have the option of turning it into usable funds for renovations, a second home purchase, or even high-interest debt relief. But what is the best way to access your equity?

A popular option for homeowners looking to take advantage of their home’s equity is a home equity line of credit (HELOC). Like other lending options, there are advantages and disadvantages. That means it can be a great tool for the right situation—but not necessarily for every situation. Here is what you need to know:

HELOC pros: Key advantages

A home equity line of credit (HELOC) is a line of credit based on the equity you have in your home. The following are some advantages that can make a HELOC a great option for homeowners looking into ways to access their equity.

1. Flexible access to funds

Similar to a home equity loan or cash-out refinance, a HELOC allows you to tap into your hard-earned equity and turn it into real funds that you can use for a variety of needs. Using one can shave off years of saving for home improvement costs or making a down payment on a second home.

Imagine you are planning to use your HELOC to finish your basement. Just as you are getting started with the project, your car breaks down. Fortunately, if you do not have an emergency fund, you can draw on your credit line to cover the cost of repairs or a new vehicle, plus building supplies. Or, if your project comes in under budget, you could use the extra funds to consolidate or pay off high-interest debt. This flexibility is just one of the reasons HELOCs are so popular among homeowners looking for ways to tap into their equity.

2. Lower interest rates

Since you are securing the loan with your home as the collateral, HELOCs typically offer lower interest rates than unsecured credit options like credit cards. Just keep in mind rates also depend on credit score and loan terms.

3. Interest-only payment during the draw period

A HELOC has two periods: the draw period and the repayment period. During the draw period, you can access the cash whenever you want it, and the payments you make during this time are interest-only. When you reach the repayment period, you begin making regular monthly payments on principal and interest.

With a HELOC, you may be able to adjust your payment schedules as necessary. It may even be possible to reduce your payment to interest-only for a period of time during the repayment period and then pay off the balance when you are more financially secure. 

4. Pay interest only on what you use

Another great aspect of a HELOC is that you will only have to pay the interest on the funds you withdraw, rather than the entire credit line limit. Let us say that you are eligible to borrow up to $140,000 from your line of credit, but your home renovation projects end up costing you $50,000. This means that you will only have to pay interest on the $50,000 you ended up borrowing when paying it back.

5. Potential tax benefits

Just like your primary mortgage interest, you may be able to deduct your HELOC interest if you itemize on your annual tax return. Typically, HELOC interest is tax deductible if the funds are used for home improvements or to buy a property. Be sure to talk to a tax advisor and document your purchases before pursuing this option. 

HELOC cons: Important risks to know

Although there are many advantages to using a HELOC, there are also a few risks that you should be aware of before deciding if one is right for your needs. Below are some of the cons that you should also consider when deciding what the best path to accessing your equity is.

1. Your home is collateral

Like a home equity loan, a HELOC uses your home as collateral to access your equity. That means your property serves as a guarantee to repay the loan. 

Putting up your home as collateral requires a solid repayment plan and some level of risk tolerance. But even the most meticulous budgeting and saving plan is not invincible. If something happens to cause you to default on the loan, your lender can take your home and sell it to recoup the money they are owed.

2. Variable interest rates

Interest rates can be fixed or variable. HELOCs typically start with a low introductory rate and then become variable. That means, once you enter the repayment period for your HELOC, your rate is likely to fluctuate with the market.

3. Budgeting challenges

Interest rates increasing or decreasing with the market can make it hard to know your exact payment amounts up front. So, during the repayment period in which your rate becomes variable, it can be harder to budget your monthly expenses. 

4. Spending discipline required

Convenience and flexibility can sometimes make it too easy to spend, so you will have to practice discipline during the draw period to avoid overspending.

It may also be tempting to put off paying down your principal during the draw period. However, if you do not, you will continue paying interest without reducing your overall debt. This will take longer to pay off and makes it cost more overall. 

Best uses for a HELOC

There are a number of ways you can use the funds from a HELOC, and what you decide to spend it on is completely up to you. Let us look at a real-life example:

Say you purchased your home for $400,000. Now that it has been a couple of years, you are thinking about upgrading your kitchen, but it is a pricey project. You will need a significant amount of money to cover the renovation costs, so you decide to look into taking out a HELOC.

You still owe $300,000 on your mortgage, but the value of the home has increased to $550,000. Your equity is calculated by taking the value ($550,000) and subtracting the debt you still owe ($300,000). This gives you a balance (or equity total) of $250,000 and a loan-to-value (LTV) ratio of 55%. Since your LTV ratio is less than 80%, if you have a credit score of 620 or higher, you may be eligible to borrow up to $140,000, which should be more than enough funding for your kitchen renovations.

Depending on your draw period terms, you will have access to this line of credit for a number of years. And you do not have to limit its use to renovations alone. Here are some other good ways to use a HELOC:

• Home upgrades and repairs

• Debt consolidation (for example: pay off student loans or high-interest credit cards)

• Investment property or second home purchases

While there are numerous ways to use a HELOC, you should be careful to avoid overspending. Remember, you will have to pay back the amount you withdraw, and the more cash you use, the higher your monthly payments may be during the repayment period.

When to avoid using a HELOC

Although your HELOC is yours to use how you wish, it is typically recommended to avoid using it on expenses that do not increase in value. Here are some examples of when a HELOC may be less advisable:

• Funding an expensive vacation

• Financing a wedding

• Buying a car or boat

• Starting a business

It may be tempting to use your HELOC for a number of expensive endeavors, but when your house is the collateral, you can put yourself at risk of losing it.

Is a HELOC right for you?

If you have taken the time to let the equity in your home build, have a good credit score, and a low LTV ratio, then it is likely you are eligible for a HELOC.

However, it is easier than you may think to overspend when you have access to a large line of credit. So, it is vital that you stick to a strict budget and avoid taking out more funds than you need for the project you have in mind.

It is best to consult with a trusted lender who can walk you through all of your loan options. For example, you may decide that a home equity loan makes more sense if you know how much a specific home renovation will cost. However, not all HELOC lenders also offer home equity loans.

Is a HELOC a good idea?

There are pros and cons of using home equity in all forms, including HELOCs, home equity loans, and refinances. Of all the options, HELOCs are favored for their convenience and flexibility. You access the funds only as you need them and pay only for what you borrowed—a great solution if you have one or more ongoing projects and do not know the total costs up front.

No matter how you decide to access your equity, taking the time to research and consult with financial professionals will go a long way in helping you make the best decision for your situation.